-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MfP9ZHrucDbRavR/5DOBaopoRcksgRRdCn/7VNeDaIR4XU3biA9W6QYuQpUIgipj w6mogIo0J+gTxOt/vNAezw== 0001032210-99-000426.txt : 19990331 0001032210-99-000426.hdr.sgml : 19990331 ACCESSION NUMBER: 0001032210-99-000426 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HERITAGE FINANCIAL CORP /WA/ CENTRAL INDEX KEY: 0001046025 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTIONS, NOT FEDERALLY CHARTERED [6036] IRS NUMBER: 911857900 STATE OF INCORPORATION: WA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-29480 FILM NUMBER: 99577264 BUSINESS ADDRESS: STREET 1: 205 5TH AVE SW STREET 2: P O BOX 1578 CITY: OLYMPIA STATE: WA ZIP: 98507 BUSINESS PHONE: 3609431500 MAIL ADDRESS: STREET 1: 201 5TH AVE SW STREET 2: P O BOX 1578 CITY: OLYMPIA STATE: WA ZIP: 98507 10-K 1 FORM 10-K - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 ---------------- FORM 10-K [_]Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 [X]Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from June 30, 1998 to December 31, 1998. Commission File No. 0-29480 ---------------- HERITAGE FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Washington 91-1857900 (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.)
201 Fifth Avenue SW, Olympia, Washington 98501 (Address of principal executive offices, including zip code) Registrant's telephone number, including area code: (360) 943-1500 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, no par value per share (Title of class) ---------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] The aggregate market value of the voting stock held by non-affiliates of the registrant is $84,158,016 and is based upon the last sales price as quoted on the NASDAQ Stock Market for March 22, 1999. The Registrant had 10,976,540 shares of common stock outstanding as of March 22, 1999. DOCUMENTS TO BE INCORPORATED BY REFERENCE Portions of the Registrant's definitive Proxy Statement dated March 31, 1999 for the 1999 Annual Meeting of Stockholders will be incorporated by reference into Part III of this Form 10-K. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- HERITAGE FINANCIAL CORPORATION FORM 10-K December 31, 1998 INDEX
Page ---- PART I ITEM 1. BUSINESS...................................................... 3 LENDING ACTIVITIES............................................ 4 INVESTMENT ACTIVITIES......................................... 11 DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................. 14 SUPERVISION AND REGULATION.................................... 17 COMPETITION................................................... 20 EMPLOYEES..................................................... 21 ITEM 2. PROPERTIES.................................................... 21 ITEM 3. LEGAL PROCEEDINGS............................................. 21 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 21 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................... 22 ITEM 6. SELECTED FINANCIAL DATA....................................... 23 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......................... 24 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 36 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES...................... 36 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 37 ITEM 11. EXECUTIVE COMPENSATION........................................ 37 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................................................... 37 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 37 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.................................................. 38
2 ITEM 1. BUSINESS General Heritage Financial Corporation (the "Company") is a bank holding company incorporated in the State of Washington in August 1997. The Company was organized for the purpose of acquiring all of the capital stock of Heritage Bank upon its reorganization from a mutual holding company form of organization to the stock holding company form of organization (the "Conversion"). The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary, Heritage Bank (the "Bank"). Heritage Bank is a Washington-chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF) and for the deposits acquired from North Pacific Bank, the Bank Insurance Fund (BIF). The Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce and Mason Counties. Effective June 12, 1998, the Company acquired North Pacific Bank, a Washington-chartered commercial bank, which was merged into the Bank effective November 20, 1998. The business of Heritage Bank consists primarily of focusing on lending and deposit relationships with small businesses and their owners in its market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western Washington. HB also makes residential construction loans, income property loans and consumer loans, primarily second mortgage loans. On September 28, 1998, the Company entered into a definitive merger agreement with Washington Independent Bancshares, Inc. (Washington Independent) whereby the Company would acquire all of the outstanding common stock of Washington Independent (whose wholly owned subsidiary is Central Valley Bank, N.A., Toppenish, Washington). Effective on the transaction closing on March 5, 1999, the Company exchanged 1,058,200 shares of its common stock for all of the 1,781,449 outstanding shares of Washington Independent common stock. At March 5, 1999, Central Valley Bank had total assets of $61 million and operated 5 full-service banking offices in Yakima County. This transaction will be accounted for as a pooling of interests and accordingly, the Company's historical consolidated financial statements presented in future reports will be restated to include the accounts and results of operations of Washington Independent. Market Areas The Company offers financial services to meet the needs of the communities it serves through community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, the Company conducts business from twelve full service offices, six in Pierce County, five in Thurston County and one in Mason County. The Company has two mortgage origination offices, one in Thurston and one in Pierce County, both of which operate within banking offices. Olympia enjoys a stable economic climate, largely due to government employment and military personnel, both retired and active. State government is by far the largest employer in Thurston County, employing over 40% of the total county work force. Federal, county and municipal government comprise nearly 50% of the county's employment base. Fort Lewis and McChord Air Force Base are both located in the Company's primary market area. Thurston County has a population of 199,700 as of April 1, 1998 and was one of the fastest growing metropolitan counties in the state of Washington as reported in the national 1990 census. Thurston County's growth has been spurred by an increase in government employment in the 1980's and the expansion of a large retirement population, including many former military personnel. Pierce County, where Tacoma is located, has a population of 686,800 as of April 1, 1998. Its economy is well-diversified, with the principal industry being aerospace, shipping, military-related government employment, 3 agriculture and forest products. The Puget Sound Economic Forecaster, a regional publication providing economic forecasts and commentary, predicts that Pierce County will likely have the strongest economic performance in the Puget Sound region through 1999. Forbes magazine recently published its prediction that the Tacoma area would be among the top twenty-five cities in the United States in terms of job growth, especially in the areas of computers and semiconductors. The Company's market area also includes Shelton and the surrounding Mason County area. The population of Mason county is approximately 49,500 as of April 1, 1998, and its economy is substantially dependent upon timber and the forest products industries. Lending Activities General. The Company's principal lending activities are carried on through the Bank. The Company traditionally has originated one- to four-family residential mortgage loans and, to a lesser extent, multifamily, commercial real estate and construction loans. In fiscal 1994, the Company implemented a growth strategy which is intended to broaden its products and services from traditional thrift products and services to those more closely related to commercial banking. In this regard, in 1993, the Company began to emphasize relationship banking, in order to improve customer loyalty through maximizing the number of lending and deposit relationships with a customer. This strategy also included expanding the Company's commercial business lending capabilities. In early fiscal 1997, several commercial loan officers, experienced in the Puget Sound region, were hired to continue the expansion. The loan officers, in addition to bringing to the Company some previous customer relationships, have taken advantage of the opportunity to attract customers of banks that have been acquired in the recent wave of mergers with out-of-area acquirers. In June 1998, the Company completed its acquisition of North Pacific Bank, a $104 million asset commercial bank, which accelerated the Company's expansion of its commercial banking focus. These efforts contributed to an increase in commercial loans to $111.8 million, or 38.7% of total loans, as of December 31, 1998 from $39.4 million, or 18.9% of total loans, as of June 30, 1997. As the Company pursues its strategy, management is continuing to emphasize strong asset quality. The Company's overall lending operations are guided by loan policies which are reviewed and approved annually by its Board of Directors, and which outline the basic policies and procedures by which lending operations are conducted. Generally, the policies address the types of loans, underwriting and collateral requirements, terms, interest rate and yield considerations, and compliance with laws and regulations. The Company supplements its own supervision of the loan underwriting and approval process with periodic loan audits by experienced external loan specialists who review credit quality, loan documentation and compliance with laws and regulations. Residential mortgage loans to be placed in the Company's loan portfolio are approved or denied by a loan committee consisting of senior loan officers and the Chief Executive Officer. Loan requests for less than $3.5 million and where the borrower's total bank liability is less then $3.5 million may be approved by the Chief Executive Officer. Loan requests for over $3.5 million or any request where the borrower's total bank liabilities exceeds $3.5 million must be approved by the Chief Executive Officer and either the Board of Directors or the Board's Executive Committee. 4 The following table sets forth at the dates indicated the Company's loan portfolio by type of loan. These balances are net of deferred loan fees and prior to deduction for the allowance for loan losses.
At June 30, ---------------------------------------------------------------------- At December 31, 1995 1996 1997 1998 1998 ---------------- ---------------- ---------------- ---------------- ---------------- % of % of % of % of % of Balance Total Balance Total Balance Total Balance Total Balance Total -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ (Dollars in thousands) Commercial.............. $ 9,983 6.31% $ 18,269 10.82% $ 39,445 18.95% $100,489 36.44% $111,817 38.72% Real Estate Mortgages One-four family residential(1)........ 90,985 57.52 93,157 55.15 103,439 49.68 97,598 35.39 93,442 32.36 Five or more family residential and commercial properties............ 38,494 24.33 42,560 25.20 51,209 24.60 57,158 20.73 55,121 19.09 Total real estate mortgages............. 129,479 81.85 135,717 80.35 154,648 74.28 154,756 56.12 148,563 51.45 Real estate construction One to four family residential........... 16,504 10.43 14,509 8.59 12,683 6.09 18,192 6.60 24,922 8.63 Five or more family residential and commercial properties............ 1,538 0.97 393 0.23 1,029 0.49 527 0.19 2,124 .74 Total real estate construction(2)....... 18,042 11.41 14,902 8.82 13,712 6.59 18,719 6.79 27,046 9.37 Consumer................ 1,812 1.15 1,105 0.65 1,467 0.70 3,030 1.10 2,717 .94 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total loans............ 159,316 100.71% 169,993 100.65% 209,272 100.52% 276,994 100.45% 290,143 100.48% Less deferred loan fees and other.............. (1,126) -0.71 (1,090) -0.65 (1,079) -0.52 (1.228) -0.45 (1,400) -0.48% -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Net loans.............. $158,190 100.00% $168,903 100.00% $208,193 100.00% $275,766 100.00% $288,743 100.00% ======== ====== ======== ====== ======== ====== ======== ====== ======== ======
- -------- (1) Includes loans held for sale of $5,944, $5,286, $6,323, $6,411, and $7,618, respectively. (2) Balances are net of undisbursed loan proceeds. The following table presents at December 31, 1998, (i) the aggregate maturities of loans in the named categories of the Company's loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.
Maturing -------------------------------- Within 1-5 After 1 year years 5 years Total ------- ------- ------- -------- (Dollars in thousands) Commercial................................. $34,163 $25,139 $52,515 $111,817 Real estate construction................... 20,418 6,628 -- 27,046 ------- ------- ------- -------- Total.................................... $54,581 $31,767 $52,515 $138,863 ======= ======= ======= ======== Fixed rate loans........................... $15,972 $16,660 $ 32,632 Variable or adjustable rate loans.......... 15,795 35,855 51,650 ------- ------- -------- Total.................................... $31,767 $52,515 $ 84,282 ======= ======= ========
Real Estate Lending One- to Four-Family Residential Real Estate Lending. The majority of the Company's residential loans are secured by one- to four-family residences located in the Company's primary market area. The Company's underwriting standards require that one- to four-family portfolio loans generally be owner- occupied and that loan amounts not exceed 80% (90% with private mortgage insurance) of the current appraised value or cost, whichever is lower, of the underlying collateral. Terms typically range from 15 to 30 years. The Company offers both fixed-rate mortgages and adjustable rate mortgages("ARMs"), with repricing based on a Treasury Bill or other index. The Company's ability to generate volume in ARMs however, is largely a function of consumer preference and the interest rate environment. The Company's current policy is not to make ARMs with discounted initial interest rates (i.e., "teasers"). The Company generally sells all government guaranteed mortgages, both fixed rate and adjustable rate. In addition, in connection with management's strategies to control the Company's interest rate sensitivity position, management determines from time to time to what extent it will 5 retain or sell other ARMs and other fixed rate mortgages. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Asset/Liability Management". Multifamily and Commercial Real Estate Lending. The Company has made, and anticipates continuing to make, on a selective basis, multifamily and commercial real estate loans in its primary market areas. Commercial real estate loans are made for small shopping centers, warehouses and professional offices, generally owner occupied. Cash flow coverage to debt servicing requirements is generally 1.2 times or more. The Company's underwriting standards generally require that the loan-to-value ratio for multifamily and commercial real estate loans not exceed 80% of appraised value or cost, whichever is lower. Multifamily and commercial real estate mortgage lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four- family residential mortgage loans. Because payments on loans secured by multifamily and commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Company seeks to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. The Company also generally obtains personal guarantees from financially capable borrowers based on a review of personal financial statements. Construction Loans. The Company originates one- to four-family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provides financing to builders for the construction of pre-sold homes and speculative residential construction. The Company loans to builders who have demonstrated a favorable record of performance and profitable operations and who are building in markets that management understands and in which management is comfortable with the economic conditions. The Company further endeavors to limit its construction lending risk through adherence to strict underwriting procedures. Loans to one builder are generally limited on a case-by-case basis with unsold home limits based on builder strengths. The Company's underwriting standards require that the loan- to-value ratio for pre-sold homes and speculative residential construction not exceed 80% of appraised value or builder's cost less overhead, whichever is less. Speculative construction and land development loans are generally priced with a variable rate of interest using the prime rate as the index. The Company generally requires builders to have some tangible form of equity in each construction project. That objective may be achieved by restricting draws to less than the acquisition cost of land plus a percentage of the builder's costs less overhead incurred to date, requiring the loan fees be paid from outside funds, requiring the builder to place equity funds in a construction loan account or by not reimbursing fees incurred by the builder such as legal fees, architectural fees, and building permits. Also, the Company generally requires prompt and thorough documentation of all draw requests and utilizes outside inspectors to inspect the project prior to paying any draw requests from builders. Construction lending affords the Company the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single- family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated costs of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, the Company may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Company may be confronted with a project whose value is insufficient to assure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan depends on the builder's ability to sell the property prior to the time that the construction loan is due. 6 Commercial Business Lending The Company offers commercial loans to sole proprietorships, partnerships and corporations with an emphasis on real estate related industries and firms in the health care, legal and other professions. The types of commercial loans offered are business lines of credit secured primarily by real estate, accounts receivable and inventory, business term loans secured by real estate for either working capital or lot acquisition, Small Business Association ("SBA") loans and unsecured business loans. All unsecured loans in excess of $750,000 require approval of the Board of Directors. Commercial business lending generally involves greater risk than residential mortgage lending and risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although the Company's commercial business loans are often collateralized by real estate, the decision to grant a commercial business loan depends primarily on the credit worthiness and cash flow of the borrower (and any guarantors), while liquidation of collateral is a secondary source of repayment. As of December 31, 1998, the Company had $111.8 million, or 38.7% of the Company's total loans receivable, in commercial business loans. Collateral for these loans is generally owner occupied business or residential real estate. The average loan size is approximately $200,000 with loans generally in amounts of $500,000 or less. The Company generally limits its exposure to any one borrowing relationship to around $4 million; however, there are a few lending relationships in excess of $4 million with the largest having approximately $6.0 million in loan commitments. Origination and Sales of Loans The Company originates real estate and other loans with approximately two- thirds of the residential mortgage volumes generated from its two mortgage loan origination offices. Walk-in customers and referrals from real estate brokers are important sources of loan originations. Consistent with the Company's asset/liability management strategy, the Company sells a majority of its fixed rate and ARM residential mortgage loans into the secondary market. Commitments to sell mortgage loans generally are made during the period between the taking of the loan application and the closing of the mortgage loan. The timing of making these sale commitments is dependent upon the timing of the borrower's election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a "best efforts" basis whereby the Company is only obligated to sell the mortgage if the mortgage loan is approved and closed by the Company. When the Company sells mortgage loans, it typically also sells the servicing of the loans (i.e., collection of principal and interest payments). The Company serviced $25.6 million and $18.8 million in loans for others as of June 30, 1998 and December 31, 1998, respectively. The Company received fee income of $60,000 and $79,000 for the year ended June 30, 1998 and during the six months ended December 31, 1998 for these servicing activities. The following table presents summary information concerning the Company's origination and sale of residential mortgage loans and the gains achieved on such activities.
Six Months Year ended June 30, ended -------------------------- December 31, 1996 1997 1998 1998 -------- -------- -------- ------------ (Dollars in thousands) One- to four-family residential mortgage loans: Originated...................... $140,232 $104,145 $118,774 $68,434 Sold............................ 119,544 87,003 101,903 57,490 Gains on sales of loans, net...... $ 3,049 $ 2,006 $ 2,406 $ 1,297
7 The Company has a minimal amount of purchased loans and loan participations. Commitments and Contingent Liabilities In the ordinary course of business, the Company enters into various types of transactions that include commitments to extend credit that are not included in the Consolidated Financial Statements. The Company applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The Company's exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. At December 31, 1998, the Company had outstanding commitments to extend credit, including letters of credit, in the amount of $44.7 million. Delinquencies and Nonperforming Assets Delinquency Procedures. When a borrower fails to make a required payment on a loan, the Company attempts to cause the delinquency to be cured by contacting the borrower. In the case of loans other than commercial business loans, a late notice is sent 15 days after the due date. If the delinquency is not cured by the 30th day, a second notice is mailed and, if appropriate, the borrower is contacted by telephone. Additional written and verbal contacts are made with the borrower between 60 and 90 days after the due date. In the event a real estate loan payment is past due for 45 days or more, loan servicing personnel perform an in-depth review of the loan status, the condition of the property, and the circumstances of the borrower. Based upon the results of its review, the Company may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when deemed necessary, initiate foreclosure proceedings. If foreclosed on, real property is sold at a public sale and the Company may bid on the property to protect its interest. A decision as to whether and when to initiate foreclosure proceedings is made by the loan committee and is based on such factors as the amount of the outstanding loan in relation to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower's ability and willingness to cooperate in curing the delinquency. Real estate acquired by the Company by deed in lieu of foreclosure is classified as real estate owned ("REO") until it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair value at the date of acquisition, not to exceed net realizable value, and any write-down resulting therefrom is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property's net realizable value. The Company considers loans as in-substance foreclosed if the borrower has little or no equity in the property based upon its estimated fair value, if repayment can be expected only to come from operation or sale of the collateral, and if the borrower has effectively abandoned control of the collateral or has continued to retain control of the collateral but because of the borrower's current financial status, it is doubtful that the borrower will be able to repay the loan in the foreseeable future. Delinquencies in the commercial business loan portfolio are handled on a case-by-case basis. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, the Company may negotiate and accept a modified payment program or take such other actions as the circumstances warrant. Classification of Assets. Federal regulations require that the Banks classify assets on a regular basis. In addition, in connection with examinations of each Bank, the Division and FDIC examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: Substandard, Doubtful, and Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not 8 corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Assets classified as Substandard or Doubtful require the institution to establish prudent general allowances for loan losses. If an asset or portion thereof is classified as Loss, the institution must charge off such amount. The most recent examinations by the Division were performed in September 1997 on North Pacific Bank and in March 1998 on Heritage Bank. The regulators' assessment of the Banks' classified assets is consistent with the Banks' internal classifications. Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and restructured loans and real estate owned. The following table sets forth at the dates indicated information with respect to nonaccrual loans, restructured loans and real estate owned of the Company.
June 30, --------------------------------- December 31, 1995 1996 1997 1998 1998 ------- ------- ------- ------ ------------ (Dollars in thousands) Nonaccrual loans.............. $ 96 $ 51 $ 133 $ 369 $ 392 Restructured loans............ -- -- -- -- -- ------- ------- ------- ------ ------ Total nonperforming loans... 96 51 133 369 392 Real estate owned............. -- -- -- 82 -- ------- ------- ------- ------ ------ Total nonperforming assets.. $ 96 $ 51 $ 133 $ 451 $ 392 ------- ------- ------- ------ ------ Accruing loans past due 90 days or more................. $ -- $ -- $ -- $ 15 $ 8 Potential problem loans....... 3,718 1,613 68 1,069 212 Allowance for loan losses..... 1,720 1,873 2,752 3,542 3,550 Nonperforming loans to loans.. 0.06% 0.03% 0.06% 0.13% 0.14% Allowance for loan losses to loans........................ 1.09% 1.11% 1.32% 1.28% 1.23% Allowance for loan losses to nonperforming loans.......... 1791.67% 3672.55% 2069.17% 959.89% 905.61% Nonperforming assets to total assets....................... 0.05% 0.02% 0.05% 0.11% 0.10%
Nonaccrual Loans. The Company's financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on its loan portfolio, unless a loan is placed on a nonaccrual basis. Loans are considered to be impaired and are placed on nonaccrual status when there are serious doubts about the collectibility of principal or interest. The Company's policy is to place a loan on nonaccrual status when the loan becomes past due for 90 days or more. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. Interest on nonaccrual loans foregone (recovered) was $0, $990, $5,431, and $(21,613) for the years ended June 30, 1996, 1997, and 1998 and for the six months ended December 31, 1998, respectively. Analysis of Allowance for Loan Losses The allowance for loan losses is maintained at a level considered adequate by management to provide for reasonably foreseeable loan losses based on management's assessment of various factors affecting the loan portfolio, including a review of problem loans, business conditions and loss experience and an overall evaluation of the quality of the underlying collateral, holding and disposal costs and costs of capital. The allowance is increased by provisions for loan losses charged to operations and reduced by loans charged off, net of recoveries. Over the past two years, the Company has increased its allowance for loan losses during a period of loan growth and change in loan portfolio composition. While the Company's loan portfolio, and in particular commercial loans, have grown substantially over the past three years, the Company's asset quality has remained 9 very solid as demonstrated by the low charge-offs and the low nonperforming assets to total assets ratio during that period. In the six months ended December 31, 1998, the Company experienced net charge offs of $172,000, most of which were related to loans originated and classified by North Pacific Bank prior to the Company's acquisition of North Pacific Bank in June 1998. Because commercial business lending generally involves greater risk than those associated with residential and commercial real estate lending, the Company has increased the portion of its general allowance for loan losses allocated to its commercial loans over the past three years. While management believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in determining the allowance. The following table sets forth for the periods indicated information regarding changes in the Company's allowance for loan losses:
Six Months Year Ended June 30, Ended -------------------------------------- December 31, 1995 1996 1997 1998 1998 -------- -------- -------- -------- ------------ (Dollars in thousands) Total loans outstanding at end of period(1)......... $158,190 $168,903 $208,192 $275,766 $288,743 -------- -------- -------- -------- -------- Average loans outstanding during period............ $144,266 $161,501 $184,617 $213,161 $284,376 -------- -------- -------- -------- -------- Allowance balance at beginning of period...... $ 1,705 $ 1,720 $ 1,873 $ 2,752 $ 3,542 Provision for loan losses................... -- -- (270) 120 180 Acquired with North Pacific Bank............. -- -- -- 670 -- Charge-offs: Real estate(2).......... -- -- -- -- (36) Commercial.............. -- -- (3) -- (145) Consumer................ -- -- -- -- -- -------- -------- -------- -------- -------- Total charge-offs..... -- -- (3) -- (181) -------- -------- -------- -------- -------- Recoveries: Real estate(2).......... 15 153 1,152 -- -- Commercial.............. -- -- -- -- 9 Consumer................ -- -- -- -- -- -------- -------- -------- -------- -------- Total recoveries...... 15 153 1,152 -- 9 -------- -------- -------- -------- -------- Net (charge-offs) recoveries......... 15 153 1,149 -- (172) -------- -------- -------- -------- -------- Allowance balance at end of period................ $ 1,720 $ 1,873 $ 2,752 $ 3,542 $ 3,550 ======== ======== ======== ======== ======== Ratio of net (charge-offs) recoveries during period to average loans outstanding.............. 0.01% 0.09% 0.62% 0.00% (0.06%) ======== ======== ======== ======== ========
- -------- (1) Includes loans held for sale (2) During the periods shown, all of the charge-offs and recoveries shown under the Real Estate category relate to real estate mortgages. None of the above activity related to real estate construction loans. 10 The following table shows the allocation of the allowance for loan losses for the indicated periods. The allocation is based upon an evaluation of defined loan problems, historical ratios of loan losses for the Company and industry wide and other factors which may affect future loan losses in the categories shown below:
At June 30, At --------------------------------------------------------------- December 31, 1995 1996 1997 1998 1998 --------------- --------------- --------------- --------------- --------------- % of % of % of % of % of Total Total Total Total Total Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) ------ -------- ------ -------- ------ -------- ------ -------- ------ -------- (Dollars in thousands) Balance applicable to: Commercial.............. $ 200 6.3% $ 446 10.8% $1,094 18.8% $2,044 36.3% $2,496 38.7% Real estate mortgages: One- to four-family residential........... 115 57.1 110 54.8 128 49.4 124 35.2 115 32.0 Five or more family residential and commercial properties............ 1,136 24.2 959 25.0 748 24.5 524 20.6 509 19.1 Real estate construction: One- to four-family residential........... 182 10.4 239 8.5 197 6.1 201 6.6 117 8.6 Five or more family residential and commercial properties............ 29 0.9 12 0.2 31 0.5 10 0.2 16 0.7 Consumer................ 10 1.1 3 0.7 7 0.7 38 1.1 40 0.9 Unallocated............. 48 103 546 601 257 ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- Total.................. $1,720 100.0% $1,873 100.0% $2,752 100.0% $3,542 100.0% $3,550 100.0% ====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- -------- (1) Represents the total of all outstanding loans in each category as a percent of total loans outstanding. Investment Activities At December 31, 1998, the investment securities portfolio totaled $38.9 million, consisting of $25.8 million of securities available for sale and $13.1 million of securities held to maturity. This compares with a total portfolio of $38.8 million at June 30, 1998, comprised of $9.0 million of securities available for sale and $29.7 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in the tables below. The investment policies of the Company are established by the Boards of Directors and monitored by the Audit and Finance Committee. They are designed primarily to provide and maintain liquidity, to generate a favorable return on investments without incurring undue interest rate and credit risk, and to compliment the Bank's lending activities. These policies dictate the criteria for classifying securities as either available for sale or held for investment. The policies permit investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, certain certificates of deposit of insured banks, mortgage backed and mortgage related securities, certain corporate notes, municipal bonds, FHLB stock and federal funds. Investment in non-investment grade bonds is not permitted under the policies. 11 The following table summarizes the amortized cost, gross unrealized gains and losses and the resulting fair value of securities available for sale:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------- (DOLLARS IN THOUSANDS) June 30, 1998 U.S. Government and its agencies........................ $ 8,022 $ 6 $-- $ 8,028 Corporate notes.................. 1,013 -- -- 1,013 ------- ---- ---- ------- Totals......................... $ 9,035 $ 6 $-- $ 9,041 ======= ==== ==== ======= December 31, 1998 U.S. Government and its agencies........................ $21,093 $ 56 $(47) $21,102 Collateralized mortgage obligations..................... 2,690 (10) 2,680 Corporate notes and other........ 2,001 9 2,010 ------- ---- ---- ------- Totals......................... $25,784 $ 65 $(57) $25,792 ======= ==== ==== =======
The Company had no securities available for sale at June 30, 1997. The Company had no securities available for trading at June 30, 1997 and 1998 and at December 31, 1998. The following table sets forth certain information regarding the carrying value, weighted average yields and maturities or periods to repricing of the Company's investment securities available for sale at December 31, 1998.
AT DECEMBER 31, 1998 ------------------------ WEIGHTED BOOK FAIR AVERAGE VALUE VALUE YIELD ------- ------- -------- (DOLLARS IN THOUSANDS) Obligations of US Government agencies: Due within one year............................... 3,993 4,028 6.08% Due after 1 year but within 5 years............... 17,100 17,074 5.42 ------- ------- 21,093 21,102 ------- ------- Corporate notes and other investments: Due after 1 year but within 5 years............... 501 510 6.73 Due after 5 years but within 10 years............. 500 500 6.29 Due after 10 years................................ 1,000 1,000 5.42 ------- ------- 2,001 2,010 ------- ------- Collateralized mortgage obligations................. Due after 10 years................................ 2,690 2,680 5.64 ------- ------- Total all investments available for sale............ $25,784 $25,792 ======= =======
12 The following table summarizes the amortized cost, gross unrealized gains and losses and the resulting fair value of investment securities held to maturity:
GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------- (DOLLARS IN THOUSANDS) June 30, 1998: U.S. Government and its agencies.............. $22,996 $ 5 $(22) $22,979 Mortgage backed securities.................... 3,844 247 (8) 4,083 Municipal bonds............................... 2,891 25 (3) 2,913 ------- ---- ---- ------- Total held for investment................. 29,731 277 (33) 29,975 ======= ==== ==== ======= December 31, 1998: U.S. Government and its agencies.............. 7,348 10 (3) 7,355 Mortgage backed securities.................... 3,262 86 -- 3,348 Municipal bonds............................... 2,539 76 -- 2,615 ------- ---- ---- ------- Total held for investment................. $13,149 $172 $ (3) $13,318 ======= ==== ==== =======
The following table sets forth certain information regarding the carrying value, weighted average yields and maturities or periods to repricing of the Company's investment securities held to maturity at December 31, 1998.
AT DECEMBER 31, 1998 ------------------------ WEIGHTED BOOK FAIR AVERAGE VALUE VALUE YIELD(1) ------- ------- -------- (DOLLARS IN THOUSANDS) Obligations of US Government agencies: Due within one year............................... 1,700 1,698 5.41% Due after 1 year but within 5 years............... 5,648 5,657 5.95 ------- ------- 7,348 7,355 ------- ------- Municipal bonds Due within one year............................... 392 398 7.55 Due after 1 year but within 5 years............... 1,047 1,074 6.76 Due after 5 years but within 10 years............. 1,100 1,143 6.49 ------- ------- 2,539 2,615 ------- ------- Mortgage backed securities Due after 1 year but within 5 years............... 36 36 7.63 Due after 5 years but within 10 years............. 159 161 8.25 Due after 10 years................................ 3,067 3,151 8.33 ------- ------- 3,262 3,348 ------- ------- Total all investments held to maturity.......... $13,149 $13,318 ======= =======
- -------- (1) Tax equivalent weighted average yield. The Company held $2.1 million of FHLB stock at December 31, 1998. The stock has no contractual maturity and amounts in excess of the required minimum for FHLB membership may be redeemed at par. At December 31, 1998, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $1.4 million. 13 Deposit Activities and Other Sources of Funds General. The Company's primary sources of funds are customer deposits and loan repayments. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic condition and other factors, are not. Although the Company's deposit balances have been increasing, such balances have been influenced in the past by adverse changes in the thrift industry and may be affected by such developments in the future. Borrowings may be used on a short term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer term basis to support expanded lending activities and to match the maturity of repricing intervals of assets. Deposit Activities. The Company offers a variety of accounts for depositors designed to attract both short term and long term deposits. These accounts include certificates of deposit ("CDs"), regular savings accounts, money market accounts, checking and negotiable order of withdrawal ("NOW") accounts, and individual retirement accounts ("IRAs"). These accounts generally earn interest at rates established by management based on competitive market factors and management's desire to increase or decrease certain types or maturities of deposits. At December 31, 1998, the Company had no brokered deposits. The more significant deposit accounts offered by the Company are described below. Certificates of Deposit. The Company offers several types of CDs with maturities ranging from 30 days to five years and which require a minimum deposit of $100. In addition, the Company offers a CD that has a maturity of four to 11 months and a minimum deposit of $2,500 and permits additional deposits at the initial rate throughout the certificate term. Interest is credited quarterly or at maturity. Finally, jumbo CDs are offered in amounts of $100,000 or more for terms of 30 days to 12 months. The jumbo CDs pay simple interest and are credited either quarterly or at maturity. Regular Savings Accounts. The Company offers savings accounts that allow for unlimited deposits and withdrawals, provided that a $100 minimum balance is maintained. Interest is compounded daily and credited quarterly. Money Market Accounts. Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary. Interest is compounded daily and paid monthly. Checking and NOW Accounts. Checking and NOW accounts are non-interest and interest bearing and may be charged service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges. Individual Retirement Accounts. IRAs permit contributions of up to $2,000 per year and pay interest at fixed rates. Maturities are available from one to five years and interest is compounded daily and credited quarterly. 14 Sources of Funds Deposit Activities. The following table sets forth for the periods indicated the average balances outstanding and the weighted average interest rates for each major category of deposits:
Year Ended June 30 -------------------------------------------------------- Six Months Ended 1996 1997 1998 December 31, 1998 ------------------ ------------------ ------------------ ------------------ Average Average Average Average Average Rate Average Rate Average Rate Average Rate Balance(1) Paid Balance(1) Paid Balance(1) Paid Balance(1) Paid ---------- ------- ---------- ------- ---------- ------- ---------- ------- (Dollars in thousands) Interest bearing demand and money market accounts............... $ 36,930 3.15% $ 42,271 3.18% $ 50,156 3.14% $ 71,484 2.72% Savings................. 28,407 3.63 29,703 3.55 36,033 3.60 57,675 3.55 Certificates of deposit................ 109,559 5.78 119,133 5.54 130,591 5.55 153,566 5.46 Total interest bearing deposits.............. 174,895 4.88 191,107 4.71 216,780 4.67 282,725 4.38 Demand and other noninterest bearing deposits............... 6,537 -- 7,955 -- 13,140 -- 22,914 -- -------- ---- -------- ---- -------- ---- -------- ---- Total deposits......... $181,432 4.70% $199,063 4.52% $229,920 4.40% $305,639 4.05% ======== ==== ======== ==== ======== ==== ======== ====
- -------- (1) Average balances were calculated using average daily balances. The following table sets forth for the periods indicated the change in the balances of deposits during the year and the impact of interest credited thereon.
Six Months Year Ended June 30, Ended -------------------------- December 31, 1996 1997 1998 1998 ------- ------- -------- ------------ (Dollars in thousands) Net increase (decrease) in deposits......................... $16,322 $18,662 $104,339 $ (5,309) Less: Interest credited......... (8,528) (8,999) (10,002) (5,393) ------- ------- -------- -------- Net increase (decrease) before interest credited................ $ 7,794 $ 9,663 $ 94,337 $(10,702) ======= ======= ======== ========
Of the $104.3 million net increase in deposits for the year ended June 30, 1998, $82.4 million resulted from the acquisition of North Pacific Bank, which was effective June 12, 1998. The following table shows the amount and maturity of certificates of deposits of $100,000 or more as of December 31, 1998:
December 31, 1998 ------------ (Dollars in thousands) Remaining maturity: Three months or less...................................... $14,139 Over three months through six months...................... 4,902 Over six months through 12 months......................... 6,256 Over twelve months........................................ 990 ------- Total................................................... $26,287 =======
At June 30, 1998 and December 31, 1998 certificates of deposits with balances of $100,000 or more totaled $23.0 million and $26.3 million, respectively. Borrowings. Savings deposits are the primary source of funds for the Company's lending and investment activities and for its general business purposes. The Company relies upon advances from the FHLB of Seattle to 15 supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB of Seattle has served as one of the Company's secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by the Company's first mortgage loans, and stock issued by the FHLB of Seattle, which is held by the Company. The FHLB functions as a central reserve bank providing credit for savings and loan associations and certain other member financial institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution's net worth or on the FHLB's assessment of the institution's creditworthiness. Under its current credit policies, the FHLB of Seattle generally limits advances to 20.0% of a member's assets, and short term borrowings of less than one year may not exceed 10.0% of the institution's assets. The FHLB of Seattle determines specific lines of credit for each member institution. The following table is a summary of FHLB advances for the years ended June 30, 1997 and 1998 and the six months ended December 31, 1998:
At or for At or for the year ended the six June 30, months ended ------------------ December 31, 1996 1997 1998 1998 ----- ------ ---- ------------ (Dollars in thousands) Balance at period end..................... $ -- $ 890 $698 $687 Average balance during the period......... -- 27 156 693 Maximum amount outstanding at any month end...................................... -- 1,300 698 696 Average interest rate During the period....................... -- 5.47% 5.73% 6.20% At period end........................... -- 6.45% 6.20% 6.20%
The following table is a summary of other borrowed funds for the year ended June 30, 1998 and the six months ended December 31, 1998. There were no other borrowed funds outstanding during the years ended June 30, 1996 and 1997.
At or for At or for the six months the year ended ended December June 30, 1998 31, -------------- -------------- (Dollars in thousands) Securities sold under agreements to repurchase: Balance at period end..................... $610 $ -- Average balance during the period......... 21 320 Maximum amount outstanding at any month end...................................... 610 483 Average interest rate During the period....................... 3.25% 3.25% At period end........................... 3.25% -- Subordinated debentures: Balance at period end..................... $500 $ -- Average balance during the period......... 25 500 Maximum amount outstanding at any month end...................................... 500 500 Average interest rate During the period....................... 7.64% 7.64% At period end........................... 7.64% --
16 Supervision and Regulation The Company and the Bank are subject to extensive federal and Washington state legislation, regulation and supervision. These laws and regulations are primarily intended to protect depositors and the FDIC rather than shareholders of the Company. The laws and regulations affecting banks and bank holding companies have changed significantly over recent years, and there is reason to expect that similar changes will continue in the future. Any change in applicable laws, regulations or regulatory policies may have a material effect on the business, operations and prospects of the Company. The Company is unable to predict the nature or the extent of the effects on its business and earnings that any fiscal or monetary policies or new federal or state legislation may have in the future. The following information is qualified in its entirety by reference to the particular statutory and regulatory provisions described herein. The Company. The Company is subject to regulation as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, (the "BHCA"). As such, the Company is supervised by the Federal Reserve. The Federal Reserve has the authority to order bank holding companies to cease and desist from unsound practices and violations of conditions imposed on it. The Federal Reserve is also empowered to assess civil money penalties against companies and individuals who violate the BHCA or orders or regulations thereunder in amounts up to $1.0 million per day or order termination of non-banking activities of non-banking subsidiaries of bank holding companies, and to order termination of ownership and control of a non- banking subsidiary by a bank holding company. Certain violations may also result in criminal penalties. The FDIC is authorized to exercise comparable authority under the Federal Deposit Insurance Act and other statutes with respect to state nonmember banks such as the Banks. The Federal Reserve takes the position that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Board's position that in serving as a source of strength to its subsidiary banks, bank holding companies should be prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Board to be an unsafe and unsound banking practice or a violation of the Board's regulations or both. The Federal Deposit Insurance Act requires an undercapitalized institution to submit to the Federal Reserve a capital restoration plan with a guarantee by each company having control of the bank's compliance with the plan. The BHCA prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of any company which is not a bank or from engaging in any activities other than those of banking, managing or controlling banks and certain other subsidiaries, or furnishing services to or performing services for its subsidiaries. One principal exception to these prohibitions allows a bank holding company to acquire an interest in companies whose activities are found by the Federal Reserve, by order or by regulation, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Company must obtain the approval of the Federal Reserve before it acquires all, or substantially all, of any bank, or ownership or control of more than 5% of the voting shares of a bank. The Company is required under the BHCA to file an annual report and periodic reports with the Federal Reserve and such additional information as the Federal Reserve may require pursuant to the BHCA. The Federal Reserve may examine a bank holding company and any of its subsidiaries and charge the company for the cost of such an examination. 17 The Company and any subsidiaries which it may control are deemed "affiliates' within the meaning of the Federal Reserve Act, and transactions between bank subsidiaries of the company and its affiliates are subject to certain restrictions. With certain exceptions, the Company and its subsidiaries are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by the Company or its affiliates. Bank regulations require bank holding companies and banks to maintain a minimum "leverage" ratio of core capital to adjusted quarterly average total assets of at least 3%. In addition, banking regulators have adopted risk-based capital guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders' equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations. Regulatory risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio (combined Tier I and Tier II) of 8%. Bank. Heritage Bank is a Washington state-chartered savings bank, the deposits of which are insured by the FDIC. The Bank is subject to regulation by the FDIC and the Washington Department of Financial Institutions (the "Division"). Although the Bank is not a member of the Federal Reserve System, the Federal Reserve supervisory authority over the Company may also affect the Bank. Among other things, applicable federal and state statutes and regulations which govern a bank's operations relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation, borrowings, issuance of securities, payment of dividends, establishment of branches and other aspects of its operations. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices. The Bank is required to file periodic reports with the FDIC and the Division and is subject to periodic examinations and evaluations by those regulatory authorities. Based upon such an evaluation, the regulators may revalue the assets of an institution and require that it establish specific reserves to compensate for the differences between the regulator-determined value and the book value of such assets. These examinations must be conducted every 12 months, except that certain well-capitalized banks may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination. As a subsidiary of a bank holding company, the Bank is subject to certain restrictions in their dealings with the Company and with other companies that may become affiliated with the Company. In addition to earnings on the portion of net stock offering proceeds retained by the Company, dividends paid by the Bank will provide substantially all of the Company's cash flow. Applicable federal and Washington state regulations restrict capital distributions by institutions such as the Bank, including dividends. Such restrictions are tied to the institution's capital levels after giving effect to such distributions. The FDIC has established the qualifications necessary to be classified as a "well-capitalized" bank, primarily for assignment of FDIC risk-based insurance premium rates beginning in 1993. To qualify as "well-capitalized", banks must have a Tier I risk- adjusted capital ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and a leverage ratio of at least 5%. The Bank qualified as "well-capitalized" at December 31, 1998. Federal laws generally bar institutions which are not well capitalized from accepting brokered deposits. The FDIC has issued rules which prohibit under- capitalized institutions from soliciting or accepting such deposits. Adequately capitalized institutions are allowed to solicit such deposits, but only to accept them if a waiver is obtained from the FDIC. Other Regulatory Developments. Congress has enacted significant federal banking legislation in recent years. Included in this legislation have been the FIRREA and the Federal Deposit Insurance Corporation 18 Improvement Act of 1991 ("FDICIA"). FIRREA, among other thing, (i) created two deposit insurance funds administered by the FDIC, the Bank Insurance Fund ("BIF") and the SAIF; (ii) permitted commercial banks that meet certain housing-related asset requirements to secure advances and other financial services from local FHLBs; (iii) restructured the federal regulatory agencies for savings associations; and (iv) greatly enhanced the regulators enforcement powers over financial institutions and their affiliates. FDICIA went substantially farther than FIRREA in establishing a more rigorous regulatory environment. Under FDICIA, regulatory authorities are required to enact a number of new regulations, substantially all of which are now effective. These regulations include, among other things, (i) a new method for calculating deposit insurance premiums based on risk, (ii) restrictions on acceptance of brokered deposits except by well-capitalized institutions, (iii) additional limitations on loans to executive officers and directors of banks, (iv) the employment of interest rate risk in the calculation of risk-based capital, (v) safety and soundness standards that take into consideration, among other things, management, operations, asset quality, earnings and compensation, (vi) a five-tiered rating system from well-capitalized to critically undercapitalized, along with the prompt corrective action the agencies may take depending on the category, and (vii) new disclosure and advertising requirements with respect to interest paid on savings accounts. FDICIA and regulations adopted by the FDIC impose additional requirements for annual independent audits and reporting when a bank begins a fiscal year with assets of $500 million or more. Such banks, or their holding companies, are also required to establish audit committees consisting of directors who are independent of management. Also, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Banking Act") provides banks with greater opportunities to merge with other institutions and to open branches nationwide. The Interstate Banking Act also allows a bank holding company whose principal operations are in one state to apply to the Federal Reserve for approval to acquire a bank that is headquartered in a different state. States cannot "opt out" but may impose minimum time periods, not to exceed five years, for the target bank's existence. The Interstate Banking Act also allows bank subsidiaries of bank holding companies to establish "agency" relationships with their depository institution affiliates. In an agency relationship, a bank can accept deposits, renew time deposits, close and service loans, and receive payments for a depository institution affiliate. States cannot "opt out". In addition, the Interstate Banking Act allows banks whose principal operations are located in different states to apply to federal regulators to merge. This provision took effect June 1, 1997, unless states enacted laws to either (i) authorize such transactions at an earlier date or (ii) prohibit such transactions entirely. The Interstate Banking Act also allows banks to apply to establish de novo branches in states in which they do not already have a branch office. This provision took effect June 1, 1997, but (i) states must enact laws to permit such branching and (ii) a bank's primary federal regulator must approve any such branch establishment. The Washington legislature passed legislation that allows, subject to certain conditions, mergers or other combinations, relocations of banks' main office and branching across state lines in advance of the June 1, 1997 date established by federal law. Further effects on the Company and the Banks may result from the Riegle Community Development and Regulatory Improvement Act of 1994 (the "Community Development Act"). The Community Development Act (i) establishes and funds institutions that are focused on investing in economically distressed areas and (ii) streamlines the procedures for certain transactions by financial institutions with federal banking agencies. Among other things, the Community Development Act requires the federal banking agencies to (i) consider the burdens that are imposed on financial institutions when new regulations are issued or new compliance 19 burdens are created and (ii) coordinate their examinations of financial institutions when more than one agency is involved. The Community Development Act also streamlines the procedures for forming certain one-bank holding companies and engaging in authorized non-banking activities. The Bank's deposit accounts are insured by the FDIC, primarily under the SAIF (and under the BIF for deposits acquired through North Pacific Bank) to the maximum extent permitted by law. The Bank pays deposit insurance premiums to the FDIC based on a risk-based assessment system established by the FDIC for all member institutions. Under applicable regulations, institutions are assigned to one of three capital groups that are based solely on the level of an institution's capital ("well capitalized", "adequately capitalized" or "undercapitalized"), which are defined in the same manner as the regulations establishing the prompt corrective action system under the FDIC as described above. The matrix so created results in nine assessment risk classifications. Pursuant to recent changes in federal law, the FDIC imposed a special assessment on each depository institution with SAIF-assessable deposits which resulted in the SAIF achieving its designated reserve ratio. In connection therewith, the FDIC reduced the assessment schedule for SAIF members, effective January 1, 1997, to a range of 0% to 0.27%, with most institutions, including the Bank, paying 0%. This assessment schedule is the same as that for the BIF, which reached its designated reserve ratio in 1995. In addition, since January 1, 1997, SAIF members are charged an assessment of approximately 0.06% of SAIF-assessable deposits for the purpose of paying interest on the obligations issued by the Financing Corporation ("FICO") in the 1980s to help fund the thrift industry cleanup. BIF-assessable deposits will be charged an assessment to help pay interest on the FICO bonds at a rate of approximately .013% until the earlier of December 31, 1999 or the date upon which the last savings association ceases to exist, after which time the assessment will be the same for all insured deposits. Recent legislative changes provide for the merger of the BIF and SAIF into the Deposit Insurance Fund on January 1, 1999, but only if no insured depository institutions were savings associations on that date. This merger did not occur. The recent Act contemplates the development of a common charter for all federally chartered depository institutions and the abolition of separate charters for national banks and federal savings associations. It is not known what form the common charter may take and what effect, if any, the adoption of a new charter would have on the operation of the Bank. In addition to the changes to the BIF and SAIF assessment rates implemented by the recent legislation, various regulatory relief provisions were enacted. The new legislation, among other things, (i) changes the Truth in Lending Act and the Real Estate Settlement Procedures Act to coordinate and simplify the two laws' disclosure requirements; (ii) eliminates civil liability for violations of the Truth in Savings Act after five years; (iii) streamlines the application process for a number of bank holding company and bank applications; (iv) establishes a privilege from discovery in any civil or administrative proceeding or bank examination for any fair lending self-test results conducted by, or on behalf of, a financial institution in certain circumstances; (v) repeals the FDICIA requirement that independent public accountants attest to compliance with designated safety and soundness regulations; (vi) imposes a continuous regulatory review of regulations to identify and eliminate outdated and unnecessary rules; and (vii) includes various other miscellaneous provisions to reduce bank regulatory burden. The Company is also subject to the information, proxy solicitation, insider trading restrictions and other requirements of the Securities Exchange Act of 1934. Competition The Company competes for loans and deposits with other thrifts, commercial banks, credit unions, mortgage bankers and other institutions in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of branches, among other things. Many of these competitors have substantially 20 greater resources than the Company. Particularly in times of high interest rates, the Company also faces significant competition for investors' funds from short term money market securities and other corporate and government securities. The Company competes for loans principally through the range and quality of the services it provides, interest rates and loan fees, and the locations of its Banks' branches. The Company actively solicits deposit-related clients and competes for deposits by offering depositors a variety of savings accounts, checking accounts and other services. Employees At December 31, 1998, the Company had 191 full-time equivalent employees. The Company believes that employees play a vital role in the success of a service company. None of the Company's employees are covered by a collective bargaining agreement with the Company and management believes that they have a good relationship with the employees. ITEM 2. PROPERTIES The Company's executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the headquarters building and adjacent office space which are owned and located in downtown Olympia. At December 31, 1998, the Bank had six offices located in Tacoma and surrounding areas of Pierce County, (all but one of which are owned) five offices located in Thurston County (all of which are owned with one office located on leased land) and one office in Shelton, Mason County (which is owned). ITEM 3. LEGAL PROCEEDINGS The Company and the Banks have certain litigation and negotiations in progress resulting from activities arising from normal operations. In management's opinion, none of these matters is likely to have a material adverse effect on the financial position or results of operations of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's Annual Meeting of Stockholders held on October 15, 1998, the directors nominated for election as described in the Proxy Statement (John A. Clees, James P. Senna and Peter K. Wallerich) were elected to serve as members of the Company's Board of Directors until the Annual Meeting of Stockholders in 2001 by a vote of 8,268,863 in favor and 197,156 votes in opposition. Directors Donald V. Rhodes, Daryl D. Jensen and H. Edward Odegard will continue in office until the 1999 Annual Meeting. Directors Lynn M. Brunton and Philip S. Weigand will continue in office until the 2000 Annual Meeting. In addition, the 1998 Stock Option and Restricted Stock Award Plan as described in the Proxy Statements was voted on at this meeting. The 1998 Stock Option and Restricted Award Plan provides for the grant of stock options and stock awards for up to 461,125 shares. The Plan was approved by a vote of 7,690,183 in favor, 647,026 votes in opposition and 128,810 votes abstained. On October 15, 1998, the Company's Board voted to change the Company's fiscal year from June 30 to the calendar year ending December 31 effective on January 1, 1999. The Proxy Statement for the October 15, 1998 annual meeting of the Company's shareholders indicated that shareholder proposals for the 1999 annual meeting would be due by May 1, 1999. Since the Company's fiscal year has changed, the Board determined to conduct the Company's 1999 annual meeting on April 27, 1999---earlier than the originally anticipated October, 1999 annual meeting date. The Board will receive shareholder proposals for review and, if appropriate, presentation at the April 27, 1999 annual meeting by April 17, 1999. 21 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the NASDAQ National Market under the symbol HFWA. At December 31, 1998, the Company had approximately 1,412 stockholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 9,793,145 outstanding shares of common stock. The last reported sales price on March 22, 1999 was $8.75 per share. The following table sets forth for the quarters indicated the range of high and low bid information per share of the common stock of the Company as reported on the NASDAQ National Market.
Quarter ended: ---------------------------------------- June March 31 30 September 30 December 31 -------- ------ ------------ ----------- High.............................. $15.50 $16.06 $15.00 $12.38 Low............................... $12.63 $13.50 $ 8.88 $ 9.13
Since its stock offering in January 1998, the Company has declared the following quarterly cash dividends:
Cash Dividend Declared per share Record Date Paid -------- ------------- ---------------- ---------------- March 24, 1998............. $0.035 April 6, 1998 April 15, 1998 June 23, 1998.............. $0.040 July 6, 1998 July 15, 1998 September 18, 1998......... $0.045 October 6, 1998 October 15, 1998 December 17, 1998.......... $0.050 January 15, 1999 January 25, 1999 March 25, 1999............. $0.055 April 15, 1999 April 26, 1999
Dividends from the Company depend, in part, upon earnings from the investment of the net proceeds from the Conversion retained by the Company and receipt of dividends from its subsidiary bank. The FDIC and the Division have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. For a period of ten years after the Conversion, the Bank may not, without prior approval of the Division, declare or pay a cash dividend in an amount in excess of one-half of (i) the greater of the Bank's net income for the current fiscal year or (ii) the average of the Bank's net income for the current fiscal year and not more than two of the immediately preceding fiscal years. In addition, the Bank may not declare or pay a cash dividend on its common stock if the effect thereof would be to reduce the Bank's net worth below the amount required for the liquidation account. Other than the specific restrictions mentioned above, current regulations allow the Company and its subsidiary bank to pay dividends on their common stock if the Company's or Bank's regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC. 22 ITEM 6. SELECTED FINANCIAL DATA
For the six months For the year ended June 30, ended ------------------------------------------------ December 31, 1994 1995 1996 1997 1998 1998 -------- -------- -------- -------- -------- ------------ (Dollars in thousands, except per share data) Operations Data: Net interest income..... $ 6,788 $ 8,227 $ 8,332 $ 9,512 $ 13,013 $ 9,412 Provision for loan losses................. -- -- -- (270) 120 180 Noninterest income...... 4,019 3,040 4,298 3,347 3,791 2,439 Noninterest expense..... 7,421 7,425 8,422 11,105 11,093 8,629 Provision (benefit) for income taxes........... 1,154 1,308 1,435 (245) 1,963 1,118 Net income.............. 2,232 2,534 2,773 2,269 3,628 1,924 Earnings per share (1) Basic................. NA 0.27 0.30 0.24 0.38 0.20 Diluted............... NA 0.27 0.30 0.24 0.37 0.19 Dividend payout ratio (2).................... NM NM NM NM 19.74% 47.50% Performance Ratios: Net interest spread..... 3.45% 4.14% 3.84% 4.06% 3.87% 4.03% Net interest margin (3).................... 3.83 4.57 4.31 4.50 4.80 5.07 Efficiency ratio (4).... 68.67 65.90 66.68 77.89 66.01 66.50 Return on average assets................. 1.18 1.30 1.31 0.99 1.24 0.94 Return on average equity................. 13.05 11.67 11.38 8.62 6.15 4.06 At June 30, ------------------------------------------------ At 1994 1995 1996 1997 1998 December 31, -------- -------- -------- -------- -------- ------------ Balance Sheet Data: Total assets............ $197,102 $204,897 $222,052 $242,164 $415,851 $411,983 Loans receivable, net... 123,258 150,526 161,744 199,188 265,813 277,575 Loans held for sale..... 4,110 5,944 5,286 6,323 6,411 7,618 Deposits................ 165,922 174,797 191,119 209,781 314,120 308,811 Federal Home Loan Bank advances............... -- -- -- 890 698 687 Other borrowings........ 4,100 3,252 -- -- 1,132 17 Stockholders' equity.... 20,662 23,065 25,633 27,714 93,887 95,433 Book value per share.... NM NM NM NM $ 9.72 $ 9.74 Equity to assets ratio.. 11.64% 11.26% 11.54% 11.44% 22.57% 23.16% Asset Quality Ratios: Nonperforming loans to loans.................. 0.07% 0.06% 0.03% 0.06% 0.13% 0.14% Allowance for loan losses to loans........ 1.32 1.09 1.11 1.32 1.28 1.23 Allowance for loan losses to nonperforming loans.................. 1,776.04 1,791.67 3,672.55 2,069.17 959.89 905.61 Nonperforming assets to total assets........... 0.05 0.05 .0.2 0.05 0.11 0.10 Other Data: Number of banking offices................ 5 7 8 10 12 12 Number of full-time equivalent employees.............. 119 116 136 145 192 191
- -------- (1) The Bank became a stock-owned company as of January 31, 1994. Per share data prior to 1995 is not applicable. (2) Dividend payout ratio is declared per share divided by earnings per share. Cash dividends prior to January 1998 stock offering and conversion are not comparable to prior periods due to the former mutual holding company's waiver of its pro rata cash dividends. (3) Net interest margin is net interest income divided by average interest earning assets. (4) The efficiency ratio is recurring noninterest expense divided by the sum of net interest income and noninterest income, excluding nonrecurring items. The Bank paid a one-time assessment of $ 1.09 million to the Savings Association Insurance Fund in November 1996. This amount was excluded from the calculation of the efficiency ratio for 1997. 23 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the December 31, 1998 audited consolidated financial statements and notes thereto included in this Form 10-K. Statements concerning future performance, development or events, concerning expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and subject to a number of risks and uncertainties which might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to the effect of interest rate changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses, and general economic condition. Additional information on these and other factors which could affect the Company's financial results are included in filings by the Company with the Securities and Exchange Commission. General In fiscal 1994, the Company began to implement a growth strategy intended to broaden its products and services from traditional thrift offerings to those more closely related to commercial banking. That strategy entails (1) geographic and product expansion, (2) loan portfolio diversification, (3) development of relationship banking, and (4) maintenance of asset quality. The Company has incurred substantial expenses as it carried out its growth strategy. Those expenses have been concentrated in (i) personnel hired in anticipation of growth and expanded market share; (ii) maintaining the mortgage origination capacity during times of fluctuating mortgage origination volumes; (iii) facilities expansion and (iv) upgrading data processing capabilities. These expenditures had a negative impact on the Company's earnings in fiscal 1997, fiscal 1998 and for the six months ended December 31, 1998. Management believes these investments will have a positive impact on earnings into 1999. In fiscal 1998, the Company's growth strategy was further bolstered by two significant events: (1) the January 1998 stock offering and conversion and (2) its acquisition of North Pacific Bancorporation. Through the January 1998 stock offering, the Company raised $63.0 million in net new capital which has, and will continue to, enhance its ability to implement its growth strategy. Using $17.5 million of the net proceeds of the stock offering, the Company completed its first bank acquisition in June 1998 by purchasing all of the outstanding stock of North Pacific Bancorporation whose wholly owned subsidiary was North Pacific Bank. This acquisition of North Pacific Bank provided further geographical expansion into the Pierce County market area and enhanced expertise in commercial banking. This is demonstrated by the substantial shift in loan portfolio composition as commercial loans increased to $111.8 million, or 38.7% of total loans, as of December 31, 1998 from $39.4 million, or 18.9% of total loans, as of June 30, 1997. While this acquisition had a significant impact on the Company's growth and financial condition at June 30, 1998, North Pacific Bank's operations had a minimal impact on the Company's earnings for the year ended June 30, 1998 due to the timing of the closing of the transaction on June 12, 1998. During the six months ended December 31, 1998, management integrated the operations of North Pacific Bank into Heritage Bank culminating in the merging of data processing systems effective November 20, 1998 and substantially upgrading North Pacific Bank's item processing capability to handle existing and projected future volumes. Management invested $1.1 million in item processing hardware and software and facilities which became operational in December 1998. Net Interest Income The Company's profitability depends primarily on its net interest income, which is the difference between the income it receives on its loan and investment portfolios and its cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, the Company's interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and by government policies. 24 Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing liabilities. The following tables set forth for the periods indicated information for the Company with respect to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest earning assets and interest expense on interest bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and the ratio of average interest earning assets to average interest bearing liabilities. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. The December 31, 1997 and 1998 figures are unaudited.
Six Months Ended December 31, -------------------------------------------------------- 1997 1998 --------------------------- --------------------------- Interest Interest Average Earned/ Average Average Earned/ Average Balance(1) Paid Rate(2) Balance(1) Paid Rate(2) ---------- -------- ------- --------- -------- ------- (Dollars in thousands) Interest Earning Assets: Loans................... $207,913 $ 9,599 9.23% $281,050 $13,181 9.38% Mortgage Backed Securities............. 4,929 208 8.45 3,593 151 8.42 Investment securities and FHLB stock......... 9,543 296 6.20 37,906 961 5.07 Interest earning deposits............... 11,578 327 5.64 48,895 1,353 5.53 -------- ------- ------ -------- ------- ------ Total interest earning assets................. 233,963 $10,430 8.92% 371,444 $15,646 8.42% Noninterest earning assets................. 20,793 37,026 -------- -------- Total assets........... $254,756 $408,470 ======== ======== Interest Bearing Liabilities: Certificates of deposit................ $126,546 $ 3,528 5.58% $153,566 $ 4,193 5.46% Savings accounts........ 35,279 656 3.72 57,675 1,024 3.55 Interest bearing demand and money market accounts............... 48,449 784 3.24 71,484 971 2.72 -------- ------- ------ -------- ------- ------ Total interest bearing deposits............... 210,274 4,968 4.73 282,725 6,188 4.38 FHLB advances........... 243 8 6.22 693 22 6.24 Other borrowed funds.... -- -- 0.00 891 24 5.45 -------- ------- ------ -------- ------- ------ Total interest bearing liabilities........... 210,517 $ 4,976 4.73% 284,309 $ 6,234 4.39% Demand and other noninterest bearing deposits............... 12,667 22,914 Other noninterest bearing liabilities.... 3,764 6,602 Stockholders' equity.... 27,808 94,644 -------- -------- Total liabilities and stockholders' equity.. $254,756 $408,469 ======== ======== Net interest income (2).................... $ 5,454 $ 9,412 Net interest spread (2).................... 4.19% 4.03% Net interest margin (2).................... 4.66% 5.07% Average interest earning assets to average interest bearing liabilities ........... 111.14% 130.65%
- -------- (1) Calculated using average daily balances (2) Annualized 25
Year Ended June 30, ------------------------------------------------------------------------------------- 1996 1997 1998 --------------------------- --------------------------- --------------------------- Interest Interest Interest Average Earned/ Average Average Earned/ Average Average Earned/ Average Balance(1) Paid Rate Balance(1) Paid Rate Balance(1) Paid Rate ---------- -------- ------- ---------- -------- ------- ---------- -------- ------- (Dollars in thousands) Interest Earning Assets: Loans................... $160,823 $14,894 9.26% $182,791 $16,743 9.16% $216,001 $19,888 9.21% Mortgage Backed Securities............. 6,715 552 8.22 5,598 464 8.29 4,603 397 8.63 Investment securities and FHLB stock......... 15,096 854 5.66 12,360 757 6.12 15,540 889 5.72 Interest earning deposits............... 10,820 575 5.31 10,414 548 5.26 34,863 1,967 5.64 -------- ------- ------ -------- ------- ------ -------- ------- ------ Total interest earning assets................. 193,454 $16,875 8.72% 211,163 $18,512 8.77% 271,007 $23,141 8.54% Noninterest earning assets................. 18,002 18,974 22,293 -------- -------- -------- Total assets........... $211,456 $230,137 $293,300 ======== ======== ======== Interest Bearing Liabilities: Certificates of deposit................ $109,559 $ 6,335 5.78% $119,133 $ 6,599 5.54% $130,591 $ 7,404 5.67% Savings accounts........ 28,407 1,031 3.63 29,703 1,055 3.55 36,033 1,298 3.60 Interest bearing demand and money market accounts............... 36,930 1,162 3.15 42,271 1,345 3.18 50,156 1,413 2.82 -------- ------- ------ -------- ------- ------ -------- ------- ------ Total interest bearing deposits............... 174,896 8,528 4.88 191,107 8,999 4.71 216,780 10,115 4.67 FHLB advances........... -- -- 27 1 4.99 156 10 6.69 Other borrowed funds.... 171 15 8.77 -- -- -- 46 3 4.61 -------- ------- ------ -------- ------- ------ -------- ------- ------ Total interest bearing liabilities............ 175,067 $ 8,543 4.88% 191,134 $ 9,000 4.71% 216,982 $10,128 4.67% Demand and other noninterest bearing deposits............... 6,537 7,955 13,140 Other noninterest bearing liabilities.... 5,489 4,711 4,168 Stockholders' equity.... 24,363 26,337 59,010 -------- -------- -------- Total liabilities and stockholders' equity.. $211,456 $230,137 $293,300 ======== ======== ======== Net interest income..... $ 8,332 $ 9,512 $13,013 Net interest spread..... 3.84% 4.06% 3.87% Net interest margin..... 4.31% 4.50% 4.80% Average interest earning assets to average interest bearing liabilities............ 110.51% 110.48% 124.90%
- -------- (1) Calculated using average daily balances 26 The following table sets forth the amounts of the changes in the Company's net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately to changes due to volume and the changes due to interest rates.
Six Months Ended December 31, 1997 Compared to 1998 Increase (Decrease) Due to -------------------------------- Volume Rate Total ---------- -------- ---------- Interest Earning Assets: Loans....................................... $ 3,371 $ 211 $ 3,582 Mortgage backed securities.................. (56) (1) (57) Investment securities and FHLB stock........ 879 (214) 665 Interest earning deposits................... 1,052 (26) 1,026 ---------- -------- ---------- Total interest income..................... 5,246 (30) 5,216 ========== ======== ========== Interest bearing liabilities: Certificates of deposit..................... (757) 92 (665) Savings accounts............................ (417) 49 (368) Interest bearing demand and money market accounts................................... (373) 186 (187) ---------- -------- ---------- Total interest bearing deposits........... (1,547) 327 (1,220) FHLB advances............................... (14) -- (14) Other borrowed fundings..................... (24) -- (24) ---------- -------- ---------- Total interest bearing liabilities........ (1,585) 327 (1,258) ========== ======== ==========
Year Ended June 30, ------------------------------------------------------------- 1996 Compared to 1997 1997 Compared to 1998 ------------------------------ ----------------------------- Increase (Decrease) Due to Increase (Decrease) Due to ------------------------------ ----------------------------- Volume Rate Total Volume Rate Total --------- -------- --------- --------- ------- --------- Interest Earning Assets: Loans................... $ 2,034 $ (185) $ 1,849 $ 3,042 $ 102 $ 3,144 Mortgage backed securities............. (92) 4 (88) (82) 15 (67) Investment securities and FHLB stock......... (155) 58 (97) 195 (63) 132 Interest earning deposits............... (22) (5) (27) 1,287 133 1,420 --------- -------- --------- --------- ------- --------- Total interest income.. $ 1,765 $ (128) $ 1,637 $ 4,442 $ 187 $ 4,629 ========= ======== ========= ========= ======= ========= Interest bearing liabilities: Certificates of deposit................ $ 554 $ (291) $ 263 $ 635 $ 10 $ 645 Savings accounts........ 47 (22) 25 225 18 243 Interest bearing demand deposits............... 168 15 183 251 (22) 229 --------- -------- --------- --------- ------- --------- Total interest on deposits.............. 769 (298) 471 1,111 6 1,117 FHLB advances........... 1 -- 1 9 -- 9 Other borrowed funds.... (15) -- (15) 2 -- 2 --------- -------- --------- --------- ------- --------- Total interest expense............... $ 755 $ (298) $ 457 $ 1,122 $ 6 $ 1,128 ========= ======== ========= ========= ======= =========
Financial Condition The Company's total assets and deposits at December 31, 1998 were $412.0 million and $308.8 million, respectively, which decreased slightly compared to June 30, 1998 due to the one time withdrawal of approximately $17 million in temporary funds deposited in June 1998. Excluding the impact of this $17 million 27 withdrawal, total assets and deposits increased 3% and 4%, respectively, during the six months ended December 31, 1998. Loans increased $13.0 million, or 5%, to $288.7 million for the six months ended December 31, 1998. Commercial loans increased to $111.8 million at December 31, 1998 compared with $100.5 million at June 30, 1998, an increase of 11.2%. Results of Operations for the Six Month Periods Ended December 31, 1998 and 1997 Net Income. The Company's net income before merger related charges was $2.4 million or $0.24 per diluted share for the six months ended December 31, 1998 as compared to $1.3 million or $0.13 per diluted share for the same period last year. Including merger related charges of $748,000 on a pre-tax basis, net income for the six months ended December 31, 1998 was $1.9 million or $0.19 per diluted share. These nonrecurring charges were related to severance and other costs associated with the merger and integration of North Pacific Bank into Heritage Bank in November 1998, costs associated with the formerly proposed acquisition of Harbor Bancorp which was terminated by mutual agreement in December 1998, and costs associated with the pending acquisition of Washington Independent Bancshares, Inc. (WIB). The WIB transaction was consummated effective March 5, 1999 and will be accounted for as a pooling of interests. Net Interest Income. Net interest income increased $4.0 million, or 72.6%, for the six months ended December 31, 1998 compared with the same period last year, primarily as a result of a $137.5 million increase in the average balance of interest earning assets. This growth in interest earning assets was attributable to $68.9 million in interest earning assets acquired through North Pacific Bank in June 1998 and the interest earning assets funded by the $63 million in net proceeds raised in the Company's January 1998 stock offering. Average loan balances increased $73.1 million, or 35.2%, which was concentrated in commercial loans. Net interest income as a percentage of average interest earning assets (net interest margin) annualized for the six months ended December 31, 1998 increased to 5.07% from 4.66% for the same period last year. The increase was the result of strong growth in commercial loans which have higher yields and a lower cost funding mix attributable to the $63 million in net proceeds from the Company's January 1998 stock offering and the addition of lower cost deposits acquired with North Pacific Bank. The significant shift in the Company's funding mix is demonstrated in the Company's ratio of average interest earning assets to average interest bearing liabilities which increased to 130.65% for the six months ended December 31, 1998 from 111.14% for the same period prior year. This ratio indicates that the Company is funding more of its earning asset growth with noninterest bearing funds (capital and noninterest bearing deposits). The Company's net interest spread annualized for the six months ended December 31, 1998 has declined to 4.03% from 4.19% for the same period last year as a result of the decrease in the average yield on earning assets to 8.42% for the six months ended December 31, 1998 from 8.92% for the same period last year. Although the average yield on loans increased to 9.38% for the six months ended December 31, 1998 from 9.23% for the same period last year due primarily to the growth in commercial loans with higher yields, the increase in the average balances of investment securities and interest earning deposits at yields significantly below the average earning asset yield, as well as the decline in market interest rates, had the effect of decreasing the overall earning asset yield for the six months ended December 31, 1998. Provision for Loan Losses. During the six months ended December 31, 1998, the Company provided $180,000 through operations to maintain its allowance for loan losses at an adequate level during a time of change in loan portfolio composition and loan growth. In the six months ended December 31, 1998, the Company experienced net charge-offs of $172,000, most of which were related to loans originated and classified by North Pacific Bank prior to the Company's acquisition of North Pacific Bank in June 1998. While the Company's loan portfolio, and in particular commercial loans, have grown substantially over the past three years, the Company's asset quality has remained very solid as demonstrated by the nonperforming assets to total assets ratio of 0.10% at December 31, 1998. Because commercial business lending generally involves greater risk than those associated with residential and commercial real estate lending, the Company has increased the portion of its general allowance for loan losses allocated to its commercial loans over the past three years. 28 Management considers the allowance for loan losses at December 31, 1998 to be adequate to cover reasonably foreseeable loan losses based on management's assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience and credit concentrations. Noninterest Income. Total noninterest income increased $666,000, or 37.6%, for the six months ended December 31, 1998 compared with the same period last year. This increase was primarily due to increases in gains on sales of loans, service charges on deposits and other income. Gains on sales of loans increased $195,000, or 17.7% for the 1998 period compared to the same period in 1997 due to the 27.2% increase in the volume of mortgage loans sold in the 1998 period. Service charges on deposits increased $187,000, or 73.6%, as a result of growth in business and personal checking accounts. Other income increased $243,000, or 120.3%, for the 1998 period due to $120,000 in fees from vehicle licensing activities (performed by a former subsidiary of North Pacific Bank) as well as increases in the volume of loan servicing fees and merchant card processing fees. Noninterest Expense. Total noninterest expense increased $3.4 million, or 65.3%, for the 1998 period compared to the 1997 period. This $3.4 million increase included $748,000 in merger related charges related to severance and other costs associated with the merger and integration of North Pacific Bank into Heritage Bank in November 1998, costs associated with the formerly proposed acquisition of Harbor Bancorp which was terminated by mutual agreement in December 1998 and costs associated with the then pending acquisition of Washington Independent Bancshares, Inc. Excluding merger related charges, noninterest expense increased $2.7 million, or 51.0%, primarily in the areas of salaries and employee benefits, occupancy, amortization of goodwill and other noninterest expenses due to the impact of the acquisition and integration of the operations of North Pacific Bank. Total noninterest expense (adjusted for the nonrecurring merger related charges) was 66.5% of total revenue (the sum of net interest income and noninterest income) for the six months ended December 31, 1998 as compared to 72.23% for the six months ended December 31, 1997. Results of Operations for the Years Ended June 30, 1998 and 1997 Net Income. The Company's earnings increased to $3.6 million, or $0.37 per diluted share, for the year ended June 30, 1998, compared with $2.3 million, or $0.24 per diluted share, for the same period in 1997, an increase of 60%. The increase in net income was primarily attributable to a $59.8 million increase in the average balance of earning assets and a widening of the net interest margin. The majority of the increase in earning assets and the widening of the net interest margin was the result of the large influx of equity capital ($63 million) from the Company's January 1998 stock offering. Net Interest Income. Net interest income increased $3.5 million, or 36.8% in 1998 compared to 1997, primarily as a result of a $59.8 million increase in the average balance of interest earning assets. This growth in interest earning assets was funded by the $63.0 million in net proceeds raised in the Company's January 1998 stock offering. Average loan balances increased $33.2 million, or 18.2%, which was concentrated in commercial loans with higher yields. Net interest income as a percentage of average interest earning assets (net interest margin) for 1998 increased to 4.80% from 4.50% in 1997. The increase was primarily attributable to growth in earning assets combined with a significant shift in the Company's funding mix due to the funds raised in the Company's recent stock offering. This is demonstrated by the increase in the Company's ratio of average interest earning assets to average interest bearing liabilities to 124.90% for 1998 from 110.51% for 1997 which indicates that the Company is funding more of its earning asset growth with non-interest bearing funds (capital and noninterest bearing deposits). The Company's net interest spread for 1998 has declined to 3.87% from 4.06% for 1997 as a result of the decrease in the average yield on earning assets to 8.54% for 1998 from 8.77% for 1997. Although the average yield on loans increased to 9.21% for 1998 from 9.16% for 1997 due primarily to the growth in commercial loans with higher yields, the increase in the average balances of investment securities and interest earning deposits at yields significantly below the average earning asset yield had the effect of decreasing the overall earning asset yield for 1998. 29 Provision for Loan Losses. During 1998, the Company provided $120,000 through operations to maintain its allowance for loan losses at an adequate level during a time of change in loan portfolio composition and loan growth. In 1997, the Company recorded a $1.2 million recovery on a multifamily mortgage loan which had been partially charged off in a prior year. In reviewing the adequacy of the Company's allowance for loan losses as of June 30, 1997, management determined that the allowance balance was more than adequate to cover any potential losses in the Company's loan portfolio and therefore reduced the allowance balance through a $270,000 negative provision for loan losses. Management considers the allowance for loan losses at June 30, 1998 to be adequate to cover reasonably foreseeable loan losses based on management's assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience and credit concentrations. Noninterest Income. Total noninterest income increased $444,000, or 13.3%, for 1998 compared with 1997 primarily due to the $400,000, or 19.9%, increase in gains on sales of loans for 1998. The increase in gains on sales of loans was attributable to the 17.1% increase in the volume of mortgages sold ($101.9 million for 1998 compared to $87.0 million for 1997) and the 14.0% increase in residential mortgage loan originations for 1998 compared to 1997. Commissions on sales of annuities and securities decreased $69,000, or 31.4%, as a result of lower sales volume due to staff turnover. Service charges on deposits increased $101,000, or 21.9%, due to growth in personal and business checking accounts. Other income increased $98,000, or 26.8%, for 1998 due to increases in the volume of fees related to merchant credit card processing and customer check ordering activity. Noninterest Expense. Total noninterest expense decreased $12,000, or 0.1%, in 1998 compared with 1997. Excluding the $1.1 million special SAIF assessment in 1997, noninterest expense in 1998 increased $1.1 million, or 10.7%, compared with adjusted 1997 expense levels. The increase in noninterest expenses during 1998 were concentrated in data processing and marketing expenses and represent a continuation of the Company's implementation of its growth strategy, specifically, (1) geographical and product expansion, (2) development of relationship banking and (3) loan portfolio diversification. The Company has (i) developed business checking accounts and commercial lending products and services for businesses and their owners; (ii) introduced credit and debit cards; (iii) installed an automated response system for customer account inquiries and (iv) developed products to assist realtors and potential borrowers to obtain information about loan programs. Total noninterest expense was 66.01% of total revenue (the sum of net interest income and noninterest income) for the year ended June 30, 1998 as compared to 77.89% (adjusted for the nonrecurring SAIF assessment) for 1997. Salaries and employee benefits increased $548,000, or 10.0%, for 1998 as a result of increases in mortgage commissions, salaries and benefits related to North Pacific Bank employees for June 1998 and increases in payroll taxes, health insurance and other employee benefits. Mortgage commissions increased $146,000, or 21.3%, due to the increased volume of residential mortgage loans originated and the increased proportion of that volume produced by commissioned loan officers. The increases in data processing, marketing and other expenses were due to the Company's implementation of its growth strategy as described in the paragraph above. Results of Operations for the Years Ended June 30, 1997 and 1996 Net Income. Net income was $2.3 million, or $0.24 per share, for the year ended June 30, 1997 compared to $2.8 million, or $0.30 per share, for the year ended June 30, 1996, an 18.2% decline, primarily as a result of noninterest expense increasing more rapidly than net interest income, coupled with a decrease in noninterest income. The increase in noninterest expenses was attributable to two factors: (1) the expansion in Pierce County of the Company's branch office network and development of the Company's relationship banking capacity; and (2) the legislatively-mandated, one-time assessment levied by the FDIC on all SAIF-insured institutions to recapitalize the SAIF deposit insurance fund. The decrease in noninterest income was principally the result of lower gains on sales of loans due to a decline in the volume of originations of residential mortgage loans. 30 Net Interest Income. Net interest income increased $1.2 million, or 14.2%, in 1997 compared to 1996 primarily due to a $22.0 million increase in the average balance of loans. The growth in average loan balances was most pronounced in commercial loans ($17.7 million of the total $22.0 million increase). Net interest income increased as a result of an improved net interest spread coupled with average interest earning assets increasing more rapidly than average interest bearing liabilities, with the difference funded by noninterest bearing deposits. Net interest margin, which is net income divided by average interest earning assets, for 1997 increased to 4.50% from 4.31% in 1996. The increase was primarily the result of a growth in earning assets at increased rates coupled with a decline in the average cost of interest bearing deposits (particularly for certificates of deposit). Certificates of deposit with scheduled maturities of one year or less increased to 90% of certificate accounts as of June 30, 1997 compared to 83% as of June 30, 1996, while average rates on certificates decreased to 5.54% from 5.78%. The increase in the average yield on interest earning assets was the result of shifting funds from lower yielding investments and mortgage backed securities into higher yielding loans and the overall growth in loans, particularly commercial loans. Noninterest Income. Total noninterest income decreased $951,000, or 22.1%, in 1997 compared with 1996. The major component of this category, gains on sales of loans, decreased $1.0 million, or 34.2% from 1996 to 1997 due to a lower volume of mortgage loans sold ($87.0 million in 1997 compared to $119.5 million in 1996). The decrease in volume of originations of one- to four- family residential mortgage loans in 1997 compared with 1996 was due to weakness in the residential mortgage market and the loss of two key producers by the end of fiscal 1996. Commissions on sales of annuities and securities declined $76,000, or 25.7%, as a result of lower sales volume due to staff turnover. Service charges on deposits increased $109,000, or 30.8%, due to growth in personal and business checking accounts. In June 1997, the Bank sold its former branch premises in Shelton, recognizing an $84,000 gain on the sale. Noninterest Expense. Total noninterest expense increased $2.7 million, or 31.9%, in 1997 compared with 1996. The increase was attributable to: (i) the Company's expansion of its branch network in Pierce County and development of the Company's relationship banking capacity; and (ii) a one-time special assessment of $1.1 million required by legislation enacted in August 1996, to recapitalize the SAIF fund of the FDIC. Total noninterest expense (less the nonrecurring SAIF assessment of $1.1 million) was 77.89% of adjusted revenue (the sum of net interest income plus noninterest income), for the year ended June 30, 1997 as compared to 66.68% for the same period in 1996. Salaries and employee benefits increased $757,000, or 16.1%. The increase reflects the hiring of a Senior Loan Administrator (in June 1996) and six commercial lending officers for the Pierce County market (four of which were hired in June 1996), the staffing additions for the 80th and Pacific branch (which opened in October 1996) and the full year effect of staffing additions for the Lakewood branch (which opened in February 1996). Occupancy expense increased $463,000, or 36.9%, as a result of the operating costs of the new branch facilities opened during 1996 and 1997 and the full year depreciation impact of the installation of a bank-wide personal computer network in March 1996. FDIC premiums and special assessment increased $855,000, or 210%, due to the $1.1 million special assessment mentioned above. The Bank's federal deposit insurance premiums were reduced by the FDIC from 0.23% (on an annualized basis) of insured deposits for the quarter ended September 30, 1996 to 0.06% of insured deposits for the semi-annual period ended June 30, 1997. Income taxes. The Company recorded a Federal income tax benefit of $245,000 for the year ended June 30, 1997 as a result of the reversal of $938,000 deferred tax liability related to the potential recapture of the pre-1988 additions to the tax bad debt reserve which could have been triggered by the MHC Reorganization in January 1994. Based on subsequent legislation, the Company reversed the $938,000 deferred tax liability as a reduction of Federal income tax expense during the year ended June 30, 1997. 31 Liquidity and Capital Resources The Company's primary sources of funds are customer deposits, loan repayments, loan sales, maturing investment securities and advances from the FHLB of Seattle. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets and to fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions and competition. The Company must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments and to fund operations. The Company generally maintains sufficient cash and short term investments to meet short term liquidity needs. At December 31, 1998 cash and cash equivalents totaled $56.7 million, or 13.8% of total assets, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $6.1 million, or 1.5% of total assets. At December 31, 1998, the Bank maintained a credit facility with the FHLB of Seattle for up to 20% of assets or $80.1 million (of which only $687,000 was outstanding at that date). To fund the growth of the Company, management's strategy has been to build core deposits (which the Company defines to include all deposits except public funds) through the development of its branch office network and commercial banking relationships. Total deposits decreased $5.3 million, or 1.7%, to $308.8 million at December 31, 1998 from $314.1 million at June 30, 1998 due to the one time withdrawal of approximately $17 million in temporary funds deposited in June, 1998. Excluding the impact of this $17 million withdrawal, total deposits increased 3.9% during the six months ended December 31, 1998. This net deposit outflow was concentrated in certificates of deposit which was somewhat attributable to management lowering offering rates on certificates to control its overall cost of funds. Historically, the Company has been able to retain a significant amount of its deposits as they mature. Management anticipates that the Company will continue to rely on the same sources of funds in the future and will use those funds primarily to make loans and purchase investment securities. The Company and its subsidiary bank are subject to certain regulatory capital requirements. As of December 31, 1998, the Company and its subsidiary bank were classified as a "well capitalized" institution under the criteria established by the FDIC Act. As of June 30, 1997 and 1998, Heritage Bank was also classified as a "well capitalized" institution. Asset/Liability Management The Company's primary financial objective is to achieve long term profitability while controlling its exposure to fluctuations in market interest rates. To accomplish this objective, management has formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position. The principal strategies which the Company employs to control its interest rate sensitivity are: (i) sale of most long term, fixed rate, one- to four-family residential mortgage loan originations in the secondary mortgage market; (ii) the origination of commercial loans and residential construction loans at variable interest rates for terms generally one year or less; and (iii) offers noninterest bearing demand deposit accounts to businesses and individuals. The longer term objective is to reduce its dependency on certificates of deposit, which tend to be a higher cost source of funds and most susceptible to movement from the Company if market interest rates increase, by increasing its proportion of noninterest bearing demand deposits, interest bearing demand deposits and money market accounts and savings deposits. The Company's asset and liability management strategies have resulted in a positive "gap" of 15.52% for the 0-3 month period and a relatively neutral one year "gap" of (0.79)% as of December 31, 1998. These "gaps" measure the difference between the dollar amount of its interest earning assets and interest bearing liabilities that mature or reprice within the designated period (0-3 months and one year) as a percentage of total 32 interest earning amounts, based on certain estimates and assumptions as discussed below. The acquisition of North Pacific Bank has accelerated the Company's progress toward its objective by adding more variable rate commercial loans to the Company's loan portfolio and reducing the percentage of certificates of deposit to total deposits from 60.4% as of June 30, 1997 to 47.9% as of December 31, 1998. Although management believes that the implementation of its operating strategies has reduced the potential effects of changes in market interest rates on the Company's results of operations, the positive gap for the 0-3 month period indicates that decreases in market interest rates may adversely affect the Company's results in the near term. The following table sets forth the estimated maturity or repricing and the resulting interest rate sensitivity gap of the Company's interest earning assets and interest bearing liabilities at December 31, 1998 based upon estimates of expected mortgage prepayment rates and deposit decay rates consistent with national trends. The Company has adjusted mortgage loan maturities for loans held for sale by reflecting these loans in the zero to three month category which is consistent with their sale in the secondary mortgage market. The amounts in the table are derived from the Company's internal data, and because certain assumptions have been utilized in presenting this data, the amounts may not be consistent with financial information appearing elsewhere in this document that have been prepared in accordance with generally accepted accounting principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits and competition.
Estimated Maturity or Repricing Within ---------------------------------------------------------- 0-3 4-12 1-5 5-10 More than months months years years 10 years Total -------- -------- -------- ------- --------- -------- (Dollars in thousands) Interest Earnings Assets: Loans................... $ 68,348 $ 67,358 $121,111 $21,061 $10,865 $288,743 Investment securities... 9,249 4,367 23,725 1,600 -- 38,941 FHLB stock.............. 2,062 -- -- -- -- 2,062 Fed funds sold.......... 10,000 -- -- -- -- 10,000 Interest earning deposits............... 36,355 -- -- -- -- 36,355 -------- -------- -------- ------- ------- -------- Total interest earning assets............... $126,014 $ 71,725 $144,836 $22,661 $10,865 376,101 Noninterest earning assets................. 35,882 -------- Total assets.......... $411,983 ======== Interest Bearing Liabilities: Deposits Certificates of deposit.............. $ 46,790 $ 94,671 $ 6,459 $ -- $ -- $147,920 Savings accounts...... 5,118 12,882 31,916 8,390 1,695 60,001 Interest bearing demand and money market deposits...... 15,735 25,500 26,024 4,825 972 73,056 -------- -------- -------- ------- ------- -------- Total interest bearing deposits............... 67,643 133,053 64,399 13,215 2,667 280,977 FHLB advances and other borrowings............. 3 7 7 328 360 705 -------- -------- -------- ------- ------- -------- Total interest bearing liabilities............ $ 67,646 $133,060 $ 64,406 $13,543 $ 3,027 281,682 Noninterest bearing liabilities and equity................. 130,301 -------- Total liabilities and equity............... $411,983 ======== Rate sensitivity gap.... $ 58,368 $(61,335) $ 80,430 $ 9,118 $ 7,838 Cumulative rate sensitivity gap: Amount.................. 58,368 (2,967) 77,463 86,581 94,419 As a percentage of interest earning assets................. 15.52% (0.79)% 20.60% 23.02% 25.10% ======== ======== ======== ======= =======
33 Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, certain assets, such as adjustable rate mortgages, have features which restrict changes in the interest rates of such assets both on a short term basis and over the lives of such assets. Further, in the event of a change in market interest rates, prepayment and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their adjustable rate debt may decrease in the event of a substantial increase in market interest rates. Year 2000 Issues The Company utilizes various computer software programs to provide banking products and services to its customers. Many existing computer programs use only two digits to identify a year in the date field and were not designed to consider the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000. The Year 2000 issue affects virtually all companies and organizations. The Company has completed the identification phase in which management has determined the extent to which all programs used in its business are Year 2000 compliant. Heritage Bank utilizes a service bureau to perform its most mission critical data processing services related to its loans, deposits, general ledger and other financial applications. The service bureau has completed the software programming for all of its applications used by the Bank. Testing of these service bureau programs commenced in November 1998 and are expected to be completed by mid-1999. The Company has evaluated its major third party business relationships, including vendors and its borrowers. The significant dependence on the service bureau creates potential exposure for the Company; however, management fully expects the service bureau to meet the scheduled timetable for testing which would ensure that the Company's mission critical applications would be Year 2000 compliant by July 1999. The Company has analyzed the extent that Year 2000 issues could adversely impact their borrowers' business operations, particularly its commercial borrowers. The Company has performed an initial assessment of each major borrower and has established an ongoing assessment as part of the Company's credit granting and loan review process. Management expects the Company's costs related to Year 2000 issues for 1999 to amount to approximately $20,000 primarily for the testing of service bureau applications. Of the past expenditures, approximately $43,000 was incurred in the year ended June 30, 1998 and approximately $120,000 was incurred to replace the existing North Pacific Bank telephone and voice mail system and modify the existing Heritage Bank telecommunications systems as part of the merger of operations which was completed in October 1998. The Company has prepared a contingency plan with timetables to pursue various alternatives based on failure of the service bureau to adequately modify and/or provide sufficient testing and validation resources for the Company and the service bureau to ensure the mission critical applications are Year 2000 compliant. The most likely worst case scenario would be that the testing and validation of the software modifications were not completed by the scheduled deadline of July 1999. This worst case scenario could increase the Company's overall expected Year 2000 costs; however, management believes that this scenario is not probable to occur and if the scenario should occur, that the impact of these additional costs would not be material to the Company's financial position and results of operations. Impact of Inflation and Changing Prices The primary impact of inflation on the Company's operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a 34 result, interest rates generally have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates. Recent Financial Accounting Pronouncements Effective July 1, 1998, the Company adopted Statement of Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting comprehensive income and its components (revenues, expenses, gains and losses) in a full set of financial statements. For the Company, comprehensive income includes net income and changes in unrealized gains and losses on securities available for sale. Effective July 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 requires public companies to report financial and descriptive information about its operating segments. Operating segments are components of a business about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. Based on the requirements of SFAS No. 131, management has determined that the Company does not have reportable operating segments. On January 28, 1997, the Securities and Exchange Commission amended their rules and regulations to require public companies to provide enhanced descriptions of accounting policies for derivative financial instruments and derivative commodity instruments in the footnotes to their financial statements. The accounting policy requirements become effective for all filings that include financial statements for periods ending after June 15, 1997. The Company had no derivative financial instruments or derivative commodity instruments at December 31, 1998 or at any time during the three year and six month period then ended. The Company believes that it is in compliance with this amended rule. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Under this statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company had no derivatives as of December 31, 1998 nor does the Company engage in any hedging activities. The Company does not anticipate that the adoption of SFAS No. 133 will have a material impact on its financial position or results of operations. In October 1998, the FASB issued SFAS No. 134 (which amended Statement No. 65), "Accounting for Certain Mortgage Banking Activities." This statement establishes accounting and reporting standards for securities retained after the securitization of mortgage loans. Under this statement, any retained mortgage-backed securities (after the securitization of a mortgage loan held for sale) will need to be classified as either "Available for Sale" or "Trading Securities." However, if the mortgage banking enterprise plans on selling retained mortgage backed securities before or during the securitization process, it must be classified as "Trading Securities." This statement is effective for the first quarter beginning after December 15, 1998. The Company does not expect that the adoption of SFAS No. 134 will have a material impact on its financial position or results of operations. 35 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to interest rate risk through its lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in the Company's interest rate risk profile during the past year, see "Asset/Liability Management". Neither the Company nor the Bank maintain a trading account for any class of financial instrument, nor do they engage in hedging activities or purchase high risk derivative instruments. Moreover, neither the Company nor the Bank are subject to foreign currency exchange rate risk or commodity price risk. The table below provides information as of December 31, 1998 about the Company's financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The data in this table may not be consistent with the amounts in the preceding table which represents amounts by the repricing date or maturity date (whichever occurs sooner) adjusted by estimates such as mortgage prepayments and deposit decay or early withdrawal rates.
By Expected Maturity Date ------------------------------------------------------------------------ Year Ended December 31, ------------------------------------------------------------------------ After Fair 1999 2000 2001 2002 2003 2003 Total Value -------- ------ ------- ------- ------- -------- -------- -------- (Dollars in thousands) Investment Securities Amounts maturing: Fixed rate............. $ 6,120 $3,120 $20,966 $ 200 $ 29 $ 7,472 $ 37,907 Weighted average interest rate......... 5.59% 5.91% 5.60% 4.68% 6.75% 7.51% Adjustable Rate........ 1,034 -- -- -- -- -- 1,034 Weighted average interest rate......... 6.65% -- -- -- -- -- -------- ------ ------- ------- ------- -------- -------- -------- Totals............... 7,154 3,120 20,966 200 29 7,472 $ 38,941 $ 39,110 Loans Amounts maturing: Fixed rate............. $ 14,802 $2,919 $ 3,977 $ 8,236 $ 8,308 $112,807 $151,049 Weighted average interest rate......... 9.16% 10.22% 10.02% 9.44% 9.41% 8.48% Adjustable rate........ 44,604 3,571 8,930 3,431 4,815 68,793 134,144 Weighted average interest rate......... 9.63% 9.59% 9.21% 9.64% 9.35% 8.45% -------- ------ ------- ------- ------- -------- -------- -------- Totals............... $ 59,406 $6,490 $12,907 $11,667 $13,123 $181,600 $285,193 $289,944 Certificates of Deposit Amounts maturing: Fixed rate............. $141,461 $4,313 $ 540 $ 272 $ 1,334 $ -- $147,920 $148,179 Weighted average interest rate......... 5.24% 4.94% 4.38% 4.96% 5.04% -- FHLB Advances Amounts maturing: Fixed rate............. $ 54 $ 30 $ 32 $ 34 $ 34 $ 503 $ 687 $ 719 Weighted average interest rate......... 5.95% 5.95% 5.95% 5.95% 5.95% 6.30% Other Borrowings Amounts maturing: Fixed rate............. $ 10 $ 7 $ -- -- -- -- $ 17 $ 16 Weighted average interest rate......... 5.25% 5.25% -- -- -- --
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA For financial statements, see Index to Consolidated Financial Statements on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 36 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning directors of the registrant is incorporated herein by reference to the section entitled "Election of Directors" of the Company's definitive Proxy Statement dated March 31, 1999 (the "Proxy Statement") for the annual meeting of shareholders to he held April 27, 1999. The required information with respect to the executive officers of the Company is incorporated herein by reference to the section entitled "Executive Officers" of the Proxy Statement. The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" of the Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION For information concerning executive compensation see "Executive Compensation" of the Proxy Statement, which is incorporated herein by reference. Neither the Report of the Personnel and Compensation Committee nor the Stock Performance Graph, both of which are contained in the Proxy statement, are incorporated by this reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information concerning security ownership of certain beneficial owners and of management see "Security Ownership of Management" of the Proxy Statement, which is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information concerning certain relationships and related transactions, see "Interest of Management in Certain Transactions" of the Proxy Statement, which is incorporated herein by reference. 37 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) The consolidated financial statements are contained herein as listed on the "Index to Consolidated Financial Statements" on page F-1 hereof. (2) All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or the notes thereto. (3) Exhibits
Exhibit No. ------- 3.1 Articles of Incorporation(1) 3.2 Bylaws of the Company(1) 10.1 1998 Stock Option and Restricted Stock Award Plan(2) 10.2 Employment Agreement between the Company and Donald V. Rhodes, effective as of October 1, 1997.(1) Severance Agreement between the Company and Brian L. Vance, effective 10.3 October 1, 1997.(1) Severance Agreement between the Company and John D. Parry, effective 10.4 October 1, 1997.(1) 10.5 Form of Severance Agreement entered into between the Company and seven additional executives, effective as of October 1, 1997.(1) 10.6 1997 Stock Option and Restricted Stock Award Plan(3) 21.0 Subsidiaries of the Company 23.0 Consent of KPMG LLP 24.0 Power of Attorney dated February 25, 1999 27.0 1998 Financial Data Schedule
- -------- (1) Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997. (2) Incorporated by reference to the definitive Proxy Statement dated September 14, 1998 for the Annual Meeting of Shareholders held on October 15, 1998. (3) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513). (b) Reports on Form 8-K. The Company filed three reports on Form 8-K between October 1, 1998 and December 31, 1998 as follows: (1) October 8, 1998 Form 8-K announcing that an agreement had been reached for the Company to acquire Washington Independent Bankshares, Inc. (2) October 29, 1998 Form 8-K announcing that the Board of the Company voted to change the Company's fiscal year from June 30 to December 31. (3) December 30, 1998 Form 8-K announcing that the Company and Harbor Bancorp, Inc. had mutually agreed to terminate the agreement calling for the Company to acquire Harbor. 38 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HERITAGE FINANCIAL CORPORATION Principal Executive Officer: /s/ Donald V. Rhodes ------------------------------------- Donald V. Rhodes Chairman, President and Chief Executive Officer Principal Financial Officer: /s/ James Hastings ------------------------------------- James Hastings Vice President and Treasurer Dated: March 29, 1999 Donald V. Rhodes, pursuant to powers of attorney which are being filed with this Annual Report on Form 10-K, has signed this report on March 29, 1999, as attorney-in-fact for the following directors who constitute a majority of the board of directors. Lynn M. Brunton John A. Clees Daryl D. Jensen H. Edward Odegard James P. Senna Peter K. Wallerich Philip S. Weigand
/s/ Donald V. Rhodes ------------------------------------- Donald V. Rhodes Attorney-in-fact March 29, 1999 39 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS June 30, 1996, 1997, 1998 and December 31, 1998 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page ---- Independent Auditors' Report.............................................. F-2 Consolidated Statements of Financial Condition--June 30, 1998 and December 31, 1998................................................................. F-3 Consolidated Statements of Income--for the years ended June 30, 1996, 1997 and 1998 and for the six month periods ended December 31, 1997 and 1998.. F-4 Consolidated Statements of Stockholders' Equity and Comprehensive Income-- Years ended June 30, 1996, 1997 and 1998 and for the six months ended December 31, 1998........................................................ F-5 Consolidated Statements of Cash Flows--Years ended June 30, 1996, 1997 and 1998 and for the six month periods ended December 31, 1997 and 1998...... F-6 Notes to Consolidated Financial Statements................................ F-7
F-1 Independent Auditor's Report The Board of Directors Heritage Financial Corporation: We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (Corporation) as of June 30, 1998 and December 31, 1998, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended June 30, 1998 and for the six month period ended December 31, 1998. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Heritage Financial Corporation and subsidiaries as of June 30 and December 31, 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 1998 and for the six month period ended December 31, 1998 in conformity with generally accepted accounting principles. /s/ KPMG LLP Seattle, Washington January 29, 1999 F-2 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Dollars in thousands)
June 30, December 31, 1998 1998 -------- ------------ ASSETS ------ Cash on hand and in banks............................... $ 12,065 $ 10,369 Interest earning deposits............................... 50,542 36,355 Federal funds sold...................................... 12,000 10,000 Investment securities available for sale................ 9,041 25,792 Investment securities held to maturity.................. 29,731 13,149 Loans held for sale..................................... 6,411 7,618 Loans receivable........................................ 269,355 281,125 Less: Allowance for loan losses......................... (3,542) (3,550) -------- -------- Loans, net............................................ 265,813 277,575 Real estate owned....................................... 82 -- Premises and equipment, at cost, net.................... 15,923 15,878 Federal Home Loan Bank stock, at cost................... 1,985 2,062 Accrued interest receivable............................. 2,275 2,106 Prepaid expenses and other assets....................... 1,352 2,707 Goodwill................................................ 8,631 8,372 -------- -------- $415,851 $411,983 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Deposits................................................ $314,120 $308,811 Advances from Federal Home Loan Bank.................... 698 687 Other borrowings........................................ 1,132 17 Advance payments by borrowers for taxes and insurance... 419 476 Accrued expenses and other liabilities.................. 4,412 5,524 Deferred Federal income taxes........................... 1,183 1,035 -------- -------- 321,965 316,550 -------- -------- Stockholders' equity: Common stock, no par, 15,000,000 shares authorized; 9,656,176 and 9,793,145 shares outstanding at June 30, 1998 and December 31, 1998, respectively......... 70,515 70,969 Unearned compensation--ESOP and Other................. (1,328) (1,241) Retained earnings, substantially restricted........... 24,696 25,699 Unrealized gain on securities available for sale, net of deferred taxes.................................... 4 6 -------- -------- Total stockholders' equity.......................... 93,887 95,433 Commitments and contingencies........................... -------- -------- $415,851 $411,983 ======== ========
See accompanying notes to consolidated financial statements. F-3 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share amounts)
Six Months ended Year ended June 30 December 31 ------------------------ ------------------- 1996 1997 1998 1997 1998 ------- ------- ------- ----------- ------- (unaudited) Interest income: Loans........................... $14,894 $16,743 $19,888 $9,599 $13,181 Mortgage backed securities...... 552 464 397 208 151 Investment securities and Federal Home Loan Bank dividends...................... 854 757 889 296 961 Interest bearing deposits....... 575 548 1,967 327 1,174 Interest on fed funds sold...... -- -- -- -- 179 ------- ------- ------- ------ ------- Total interest income......... 16,875 18,512 23,141 10,430 15,646 ------- ------- ------- ------ ------- Interest expense: Deposits........................ 8,528 8,999 10,115 4,968 6,188 Other borrowings................ 15 1 13 8 46 ------- ------- ------- ------ ------- Total interest expense........ 8,543 9,000 10,128 4,976 6,234 ------- ------- ------- ------ ------- Net interest income......... 8,332 9,512 13,013 5,454 9,412 Provision for loan losses....... -- (270) 120 60 180 ------- ------- ------- ------ ------- Net interest income after provision for loan losses.. 8,332 9,782 12,893 5,394 9,232 ------- ------- ------- ------ ------- Noninterest income: Gains on sales of loans, net.... 3,049 2,006 2,406 1,102 1,297 Commissions on sales of annuities and securities....... 296 220 151 75 101 Services charges on deposits.... 353 462 563 254 441 Rental income................... 221 210 208 104 112 Gain on sale of premises........ -- 84 -- 36 43 Other income.................... 379 365 463 202 445 ------- ------- ------- ------ ------- Total noninterest income...... 4,298 3,347 3,791 1,773 2,439 ------- ------- ------- ------ ------- Noninterest expense: Salaries and employee benefits.. 4,711 5,468 6,016 2,963 4,381 Building occupancy.............. 1,254 1,717 1,768 857 1,239 FDIC premiums and special assessment..................... 407 1,262 135 65 72 Data processing................. 493 534 700 324 568 Marketing....................... 162 257 380 181 263 Office supplies and printing.... 229 243 268 128 187 Goodwill amortization........... -- -- -- -- 288 Other........................... 1,166 1,624 1,826 702 1,631 ------- ------- ------- ------ ------- Total noninterest expense..... 8,422 11,105 11,093 5,220 8,629 ------- ------- ------- ------ ------- Income before Federal income tax expense (benefit)...... 4,208 2,024 5,591 1,947 3,042 Federal income tax expense (benefit)........................ 1,435 (245) 1,963 691 1,118 ------- ------- ------- ------ ------- Net income.................. $ 2,773 $ 2,269 $ 3,628 $1,256 $ 1,924 ======= ======= ======= ====== ======= Basic earnings per common share... $0.30 $0.24 $0.38 $0.14 $0.20 Diluted earnings per common share............................ $0.30 $0.24 $0.37 $0.13 $0.19
See accompanying notes to consolidated financial statements. F-4 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (Dollars and shares in thousands)
Unrealized gain on Total Number of Additional Unearned securities stock- common Common paid-in compensation-- Retained available holders' shares stock capital ESOP and Other earnings for sale equity --------- ------- ---------- -------------- -------- ---------- -------- Balance at June 30, 1995................... 1,805 $ 1,805 $ 4,062 $ -- $17,198 $-- $23,065 Restricted stock award.. 1 1 5 -- -- -- 6 Net income.............. -- -- -- 2,773 -- 2,773 Cash dividend declared.. -- -- -- (211) -- (211) ----- ------- ------- ------- ------- ---- ------- Balance at June 30, 1996................... 1,806 $ 1,806 4,067 -- 19,760 -- 25,633 Exercise of stock options................ 4 4 36 -- -- -- 40 Net income.............. -- -- -- 2,269 -- 2,269 Cash dividend declared.. -- (228) -- (228) ----- ------- ------- ------- ------- ---- ------- Balance at June 30, 1997................... 1,810 1,810 4,103 -- 21,801 -- 27,714 Offering proceeds....... 6,481 64,352 -- (1,322) -- -- 63,030 Earned ESOP shares...... 3 17 -- 37 -- -- 54 Conversion transaction.. 1,329 4,223 (4,103) -- -- -- 120 Exercise of stock options................ 30 70 -- -- -- -- 70 Restricted stock award.. 3 43 -- (43) -- -- -- Net income.............. -- -- -- 3,628 -- 3,628 Net increase in unrealized gain on securities available for sale, net of taxes.................. -- -- -- -- 4 4 Cash dividend declared.. -- -- -- (733) -- (733) ----- ------- ------- ------- ------- ---- ------- Balance at June 30, 1998................... 9,656 70,515 -- (1,328) 24,696 4 93,887 Earned ESOP shares...... 4 11 -- 44 -- -- 55 Exercise of stock options................ 136 486 -- -- -- -- 486 Restricted stock award terminated............. (3) (43) -- 43 -- -- -- Net income.............. -- -- 1,924 1,924 Net increase in unrealized gain on securities available for sale, net of taxes.................. -- -- -- -- 2 2 Cash dividend declared.. -- -- -- -- (921) -- (921) ----- ------- ------- ------- ------- ---- ------- Balance at December 31, 1998................... 9,793 $70,969 $ -- $(1,241) $25,699 $ 6 $95,433 ===== ======= ======= ======= ======= ==== =======
Six months ended Year ended June 30 December 31 -------------------- ------------- Comprehensive Income 1996 1997 1998 1997 1998 -------------------- ------ ------ ------ ------ ------ (unaudited) Net income.......................... $2,773 $2,269 $3,628 $1,256 $1,923 Increase in unrealized gain on securities available for sale, net of tax......................... -- -- -- -- 2 ------ ------ ------ ------ ------ Comprehensive income................ $2,773 $2,269 $3,628 $1,256 $1,925 ====== ====== ====== ====== ======
See accompanying notes to consolidated financial statements. F-5 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
Year Ended Six Months Ended June 30 December 31 --------------------------- -------------------- 1996 1997 1998 1997 1998 ------- -------- -------- ----------- -------- (Unaudited) Cash flows from operating activities: Net income............... $ 2,773 $ 2,269 $ 3,628 $ 1,256 $ 1,924 Adjustments to reconcile net income to net cash provided by operating activities, net of effect of acquisition: Depreciation and amortization.......... 349 996 1,000 501 543 Deferred loan fees, net of amortization....... 35 11 (149) (38) (172) Provision for loan losses................ -- (270) 120 60 180 Net increase in loans held for sale......... 615 (1,037) (88) 1,281 (1,206) Deferred Federal income tax expense (benefit)............. 262 (549) (17) -- (148) Federal Home Loan Bank stock dividends....... (99) (111) (129) (61) (77) Recognition of compensation related to ESOP............... -- -- 54 -- 57 Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities..... 411 392 (397) (1,111) (3) ------- -------- -------- ------- -------- Net cash provided by operating activities.......... 4,346 1,701 4,022 1,888 1,098 ------- -------- -------- ------- -------- Cash flows from investing activities, net of effect of acquisition: Loans originated, net of principal payments and loan sales.............. (11,211) (37,115) (18,128) (8,541) (11,599) Principal payments of mortgage backed securities.............. 1,493 825 1,335 457 588 Maturities of investment securities held to maturity................ 13,300 9,160 6,271 2,770 17,110 Purchase of investment securities held to maturity................ (10,445) (2,345) (20,748) (1,950) (1,099) Purchase of investment securities available for sale.................... -- -- -- -- (16,683) Purchase of premises and equipment............... (2,204) (2,023) (353) (182) (579) Cash acquired, net of cash paid for acquisition............. -- -- 10,573 -- -- ------- -------- -------- ------- -------- Net cash used in investing activities.......... (9,067) (31,498) (21,050) (7,446) (12,262) ------- -------- -------- ------- -------- Cash flows from financing activities, net of effect of acquisition: Net increase (decrease) in deposits............. 16,322 18,662 22,049 14,106 (5,309) Net increase (decrease) in FHLB advances........ -- 890 (890) (890) (11) Net increase (decrease) in other borrowed funds................... (3,252) -- 185 -- (1,114) Net increase (decrease) in advance payments by borrowers for taxes and insurance............... (100) (62) (54) 2 57 Cash dividends paid...... (211) (228) (342) -- (826) Issuance of restricted stock award and exercise of stock options........ 6 40 70 -- 484 Proceeds received and held for stock conversion.............. -- -- -- 72,506 -- Net proceeds from stock offering................ -- 63,030 -- -- ------- -------- -------- ------- -------- Net cash provided by (used in) financing activities.......... 12,765 19,302 84,048 85,724 (6,719) ------- -------- -------- ------- -------- Net increase (decrease) in cash and cash equivalents......... 8,044 (10,495) 67,020 80,166 (17,883) Cash and cash equivalents at beginning of year...... 10,038 18,082 7,587 7,587 74,607 ------- -------- -------- ------- -------- Cash and cash equivalents at end of year............ $18,082 $ 7,587 $ 74,607 $87,753 $ 56,724 ======= ======== ======== ======= ======== Supplemental disclosures of cash flow information: Cash payments for: Interest expense......... $ 8,527 $ 8,945 $ 10,420 $ 5,010 $ 6,145 Federal income taxes..... 1,395 620 1,578 540 1,360 Supplemental disclosure of noncash investing activities: Mortgage loans transferred to real estate owned............ -- -- 82 -- (82)
See accompanying notes to consolidated financial statements. F-6 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) (1) Summary of Significant Accounting Policies (a) Description of Business Heritage Financial Corporation (the Company) is a bank holding company incorporated in the State of Washington in August 1997. The Company was organized for the purpose of acquiring all of the capital stock of Heritage Bank upon its reorganization from a mutual holding company form of organization to the stock holding company form of organization. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary: Heritage Bank (the Bank). Heritage Bank is a Washington-chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). The Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce and Mason Counties. Effective June 12, 1998, the Company acquired North Pacific Bank, a Washington-chartered commercial bank which was merged into the Bank effective November 20, 1998. The business of Heritage Bank consists primarily of focusing on lending and deposit relationships with small businesses and their owners in its market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western Washington. The Bank also makes residential construction loans, income property loans and consumer loans. Although the Bank has a diversified loan portfolio and its market area enjoys a stable economic climate, a substantial portion of its borrowers' ability to repay these loans is dependent upon the economic stability of the major employers, Federal, State and local governments. (b) Basis of Presentation The accounting and reporting policies of the Company and its subsidiaries conform to generally accepted accounting principles and to general practices within the financial institutions industry, where applicable. In preparing the consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of income and expense during the reported periods. Actual results could differ from these estimates. The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The financial statements shown herein prior to the January 8, 1998 stock conversion are for Heritage Bank only as the Company did not engage in any material transactions until after January 8, 1998. The par value of common stock and additional paid-in capital of the Company have been restated to reflect the new par value of the holding company which became effective January 8, 1998. The formation of the holding company was treated in a manner similar to a pooling-of-interests. All significant intercompany balances and transactions among the Company and its subsidiaries have been eliminated in consolidation. Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current consolidated financial statement presentation. On October 28, 1998, the Company's Board of Directors voted to change the Company's fiscal year ending June 30 to a calendar year beginning January 1st and ending December 31st. (c) Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks and interest bearing deposits and fed funds sold. F-7 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (d) Investment Securities Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity. Investment securities held to maturity are recorded at cost, adjusted for amortization of premiums or accretion of discounts using the interest method. Securities available for sale are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and are reported net of tax as a separate component (Accumulated other comprehensive income) of stockholders' equity until realized. Realized gains and losses on sale are computed on the specific identification method. (e) Loans Receivable and Loans Held for Sale Loans are generally recorded at cost, net of discounts, unearned fees and deferred fees. Discounts and premiums on purchased loans are amortized using the interest method over the remaining contractual life, adjusted for actual prepayments. Mortgage loans held for sale are carried at the lower of amortized cost or market value determined on an aggregate basis. Any loan that management determines will not be held to maturity is classified as held for sale at the time of origination, purchase or securitization. Unrealized losses on such loans are included in income. (f) Loan Fees Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yields of the loans over their contractual lives, adjusted for prepayment of the loans, using the interest method. In the event loans are sold, the deferred net loan origination fees or costs are recognized as a component of the gains or losses on the sales of loans. (g) Allowance for Loan Losses A valuation allowance for loans is based on management's estimate of the amount necessary to recognize possible losses inherent in the loan portfolio. In determining the level to be maintained, management evaluates many factors including the borrowers' ability to repay, economic and market trends and conditions, holding costs and absorption periods. In the opinion of management, the present allowance is adequate to absorb reasonably foreseeable loan losses. While management uses available information to recognize losses on these loans, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the western Washington region. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to make additions to the allowance based on their judgments about information available to them at the time of their examinations. (h) Impaired Loans The accrual of interest on loans is discontinued and the loan is considered impaired when, in the opinion of management, the collectibility of principal or interest is in doubt or generally when the loans are contractually past due 90 days or more with respect to principal or interest. When accrual of interest is discontinued on a loan, the interest accrued but not collected is charged against operations. Thereafter, payments received are generally applied to principal. However, based on management's assessment of the ultimate collectibility of an impaired F-8 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) or nonaccrual loan, interest income may be recognized on a cash basis. Impaired loans and other nonaccrual loans (smaller balance, homogeneous loans) are returned to an accrual status when management determines that the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible. (i) Mortgage Banking Operations The Bank sells mortgage loans primarily on a servicing released basis and recognizes a cash or a present value gain or loss. A cash gain or loss is recognized to the extent that the sales proceeds of the mortgage loans sold exceed or are less than the net book value at the time of sale. Loan servicing income is recorded when earned. Loan servicing costs are charged to expense as incurred. (j) Real Estate Owned Real estate acquired by the Bank in satisfaction of debt is recorded at fair value at time of foreclosure and is carried at the lower of the new cost basis or fair value. Subsequently, foreclosed assets are carried at the lower of cost or fair value less estimated costs to sell. (k) Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight- line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization include buildings and building improvements, 30 to 40 years; and furniture, fixtures and equipment, 3 to 10 years. (l) Goodwill Goodwill represents the costs in excess of net assets acquired arising from the purchase of North Pacific Bank and is being amortized on a straight line basis over 15 years. The Company will periodically evaluate goodwill for impairment. (m) Federal Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. (n) Employee Stock Ownership Plan Heritage Bank sponsors an Employee Stock Ownership Plan (ESOP). The ESOP purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company in order to fund the purchase of the Company's common stock. The loan to the ESOP will be repaid principally from the Bank's contributions to the ESOP. The Bank's contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%, after the effect of cash dividends on unallocated shares. As the debt is repaid, F-9 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) shares are released and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares and the shares become outstanding for earnings per share calculations. Cash dividends on allocated shares are recorded as a reduction of retained earnings and paid or distributed directly to participants' accounts. Cash dividends on unallocated shares are recorded as a reduction of debt and accrued interest. (o) Recent Financial Accounting Pronouncements Effective July 1, 1998, the Company adopted Statement of Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting comprehensive income and its components (revenues, expenses, gains and losses) in a full set of financial statements. For the Company, comprehensive income includes net income and the change in unrealized gains and losses on securities available for sale. Effective July 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 requires public companies to report financial and descriptive information about its operating segments. Operating segments are components of a business about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. Based on the requirements of SFAS No. 131, management has determined that the Company does not have reportable operating segments. On January 28, 1997, the Securities and Exchange Commission amended their rules and regulations to require public companies to provide enhanced descriptions of accounting policies for derivative financial instruments and derivative commodity instruments in the footnotes to their financial statements. The accounting policy requirements become effective for all filings that include financial statements for periods ending after June 15, 1997. The Company had no derivative financial instruments or derivative commodity instruments at December 31, 1998 or at any time during the three years ended June 30, 1998 and the six month period ended December 31, 1998. The Company believes that it is in compliance with this amended rule. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Under this statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company had no derivatives as of December 31, 1998 nor does the Company engage in any hedging activities. The Company does not anticipate that the adoption of SFAS No. 133 will have a material impact on its financial position or results of operations. In October 1998, the FASB issued SFAS No. 134 (which amended SFAS No. 65), "Accounting for Certain Mortgage Banking Activities." This statement establishes accounting and reporting standards for securities retained after the securitization of mortgage loans. Under this statement, any retained mortgage-backed securities (after the securitization of a mortgage loan held for sale) will need to be classified as either "Available for Sale" F-10 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) or "Trading Securities." However, if the mortgage banking enterprise plans on selling retained mortgage backed securities before or during the securitization process, it must be classified as "Trading Securities." This statement is effective for the first quarter beginning after December 15, 1998. The Company does not expect that the adoption of SFAS No. 134 will have a material impact on its financial position or results of operations. (2) Business Combinations (a) North Pacific Bank The Company completed the acquisition of North Pacific Bank effective June 12, 1998. The Company paid the former stockholder of North Pacific Bancorporation $17.5 million in cash for the common stock of North Pacific Bancorporation. This acquisition was treated as a purchase for accounting purposes. Accordingly, under generally accepted accounting principles, the assets and liabilities of North Pacific Bank have been recorded on the books of the Company at their respective fair values at the date the acquisition was consummated. Goodwill, the excess of the purchase price (cost) over the net fair value of the assets and liabilities acquired, was recorded at $8.6 million. Accumulated amortization of goodwill amounted to $288 as of December 31, 1998. The following are the fair values of assets acquired and liabilities assumed as of the June 12, 1998 acquisition date: Cash acquired, net of cash paid for acquisition..................... $10,573 Securities.......................................................... 12,277 Loans, net.......................................................... 48,620 Premises and equipment.............................................. 4,397 Goodwill............................................................ 8,631 Other assets........................................................ 499 ------- Total assets...................................................... $84,997 ======= Deposits............................................................ $82,410 FHLB advances....................................................... 698 Other borrowed funds................................................ 947 Deferred federal income taxes....................................... 499 Other liabilities................................................... 443 ------- Total liabilities................................................. $84,997 =======
The financial statements for the year ended June 30, 1998 include the operations of North Pacific Bank from June 12, 1998 to June 30, 1998. Effective November 20, 1998, the operations of North Pacific Bank were merged with Heritage Bank. The following information presents the actual results of operations for the year ended June 30, 1998 and the proforma results of operations for the years ended June 30, 1998, 1997 and 1996, as though the acquisition had occurred on July 1, 1995. The proforma results do not necessarily indicate the actual result that would have been obtained nor are they necessarily indicative of the future operations of the combined companies.
Years Ended June 30, Unaudited proforma Actual ----------------------- 1998 1996 1997 1998 ------- ------- ------- ------- (in thousands, except per share amounts) Net interest income before provision for loan loss................................ $13,013 $11,125 $12,665 $16,068 Net income................................ 3,628 2,480 2,002 3,090 Earnings per common share: Basic................................... $0.38 $0.27 $0.21 $0.33 Diluted................................. $0.37 $0.27 $0.21 $0.31
F-11 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (b) Washington Independent Bancshares, Inc On September 28, 1998, the Company entered into a definitive merger agreement with Washington Independent Bancshares, Inc. (Washington Independent) whereby the Company would acquire all of the outstanding common stock of Washington Independent (whose wholly owned subsidiary is Central Valley Bank). The transaction closed on March 5, 1999, and the Company exchanged 1,058,200 shares of its common stock for all of the outstanding Washington Independent common stock. This transaction is expected to be accounted for as a pooling of interests and accordingly, the Company's historical consolidated financial statements presented in future reports will be restated to include the accounts and results of operations of Washington Independent. (3) Loans Receivable and Loans Held for Sale Loans receivable and loans held for sale consist of the following:
June 30, December 31, 1998 1998 -------- ------------ Commercial loans.................................... $100,489 $111,817 Real Estate Mortgages: One to four family residential.................... 97,598 93,442 Five or more family residential and commercial real estate...................................... 57,158 55,121 -------- -------- Total Real Estate Mortgage........................ 154,756 148,563 Real Estate Construction: One to four family residential.................... 18,192 24,922 Five or more family residential and commercial real estate...................................... 527 2,124 -------- -------- Total Real Estate Construction...................... 18,719 27,046 Consumer............................................ 3,030 2,717 -------- -------- Subtotal.......................................... 276,994 290,143 Unamortized yield adjustments....................... (1,228) (1,400) -------- -------- Total Loans Receivable and Loans Held for Sale.... $275,766 $288,743 ======== ========
Accrued interest on loans receivable amounted to $1,553 and $1,561 as of June 30, 1998 and December 31, 1998, respectively. The Company had $369 and $392 of impaired loans which are nonaccruing as of June 30, 1998 and December 31, 1998, respectively. The weighted average interest rate on loans was 8.8% and 8.5% as of June 30, 1998 and December 31, 1998, respectively. Details of certain mortgage banking activities are as follows:
June 30, December 31, 1998 1998 -------- ------------ Loans held for sale at lower of cost or market....... $6,411 $7,618 Loans serviced for others............................ 25,648 18,832 Commitments to sell mortgage loans................... 12,418 11,533 Commitments to fund mortgage loans (at interest rates approximating market rates) Fixed rate......................................... 6,266 4,704 Variable or adjustable rate........................ 249 --
F-12 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) Servicing fee income from loans serviced for others amounted to $90, $75, $60 and $79 for the years ended June 30, 1996, 1997 and 1998 and the six months ended December 31, 1998, respectively. Commitments to sell mortgage loans are made primarily during the period between the taking of the loan application and the closing of the mortgage loan. The timing of making these sale commitments is dependent upon the timing of the borrower's election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a best- efforts basis whereby the Bank is only obligated to sell the mortgage if the mortgage loan is approved and closed by the Bank. As of December 31, 1998, the Company had $28.5 million in other loan commitments (which includes business and consumer credit lines ), $10.7 million in real estate loan commitments outstanding, and $0.8 million in commitments under letters of credit. (4) Allowance for Loan Losses Activity in the allowance for loan losses is summarized as follows:
Six Months Year Ended June 30, Ended --------------------- December 31, 1996 1997 1998 1998 ------ ------ ------ ------------ Balance at beginning of period........... $1,720 $1,873 $2,752 $3,542 Provision.............................. -- (270) 120 180 Recoveries............................. 153 1,152 -- 9 Charge offs............................ -- (3) -- (181) Acquired with North Pacific Bank....... -- -- 670 -- ------ ------ ------ ------ Balance at end of period................. $1,873 $2,752 $3,542 $3,550 ====== ====== ====== ======
In May 1996, the Bank sold its interest in two loans which were partially charged off. This sale resulted in an excess of net proceeds over the book basis of these loans of $1.3 million. The Bank recorded a recovery of $148 in 1996 which was the pro rata portion of the sale proceeds received in cash versus the amount the Bank financed for the purchaser. The additional $1,152 was recognized as a recovery in 1997 when the Bank received additional collateral on this financing. (5) Investment Securities Available For Sale The amortized cost and fair values of investment securities available for sale at the dates indicated are as follows:
Gross Gross Amortized unrealized unrealized Fair cost gains losses value --------- ---------- ---------- ------- June 30, 1998 U.S. Government and its agencies... $ 8,022 $ 6 $-- $ 8,028 Corporate notes.................... 1,013 -- -- 1,013 ------- ---- ---- ------- $9,035 $ 6 $-- $ 9,041 ======= ==== ==== ======= December 31, 1998 U.S. Government and its agencies... $21,093 $ 56 $(47) $21,102 Mortgage backed and related securities: Collateralized mortgage obligations..................... 2,690 -- (10) 2,680 Other............................ 1,000 -- -- 1,000 Corporate notes.................... 1,001 9 -- 1,010 ------- ---- ---- ------- Totals......................... $25,784 $ 65 $(57) $25,792 ======= ==== ==== =======
F-13 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) The amortized cost and fair value of securities available for sale, by contractual maturity, at December 31, 1998 are shown below:
Amortized Fair cost value --------- ------- Due in one year or less............................... $ 3,993 $ 4,028 Due after one year through three years................ 17,601 17,584 Due after five years through ten years................ 500 500 Due after ten years................................... 3,690 3,680 ------- ------- Totals................................................ $25,784 $25,792 ======= =======
There were no sales of investment securities available for sale during the periods ended June 30, 1996, 1997, 1998, and December 31, 1998. Accrued interest on investment securities available for sale amounted to $131 and $201 as of June 30, 1998 and December 31, 1998, respectively. At June 30, 1998 and December 31, 1998, investment securities available for sale with amortized cost values of $2,415 and $1,997 were pledged to secure public deposits and for other purposes as required or permitted by law. (6) Investment Securities Held to Maturity The amortized cost and fair values of investment securities held to maturity are as follows:
Gross Gross Amortized unrealized unrealized Fair cost gains losses value --------- ---------- ---------- ------- June 30, 1998 U.S. Government and its agencies.... $22,996 $ 5 $(22) $22,979 Mortgage backed securities: FNMA certificates................. 944 48 (8) 984 FHLMC certificates................ 970 61 -- 1,031 GNMA certificates................. 1,930 138 -- 2,068 Municipal bonds..................... 2,891 25 ( 3) 2,913 ------- ---- ---- ------- $29,731 $277 $(33) $29,975 ======= ==== ==== ======= December 31, 1998 U.S. Government and its agencies.... $ 7,348 $ 10 $ (3) $ 7,355 Mortgage backed securities: FNMA certificates................. 734 10 -- 743 FHLMC certificates................ 851 22 -- 873 GNMA certificates................. 1,677 54 -- 1,732 Municipal bonds..................... 2,539 76 -- 2,615 ------- ---- ---- ------- $13,149 $172 $ (3) $13,318 ======= ==== ==== =======
The amortized cost and fair value of investment securities held to maturity, by contractual maturity, at December 31, 1998 are shown below: F-14 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands)
Amortized Fair cost value --------- ------- Due in one year or less............................... $ 2,092 $ 2,096 Due after one year through three years................ 6,502 6,530 Due after three years through five years.............. 229 237 Due after five years through ten years................ 1,259 1,304 Due after ten years................................... 3,067 3,151 ------- ------- Totals.............................................. $13,149 $13,318 ======= =======
There were no sales of investment securities held to maturity during the years ended June 30, 1996, 1997, 1998 and for the six months ended December 31, 1998. Accrued interest on investment securities held to maturity amounted to $408 and $189 as of June 30, 1998 and December 31, 1998, respectively. At December 31, 1998, investment securities held to maturity with amortized cost values of $1,401 were pledged to secure public deposits and for other purposes as required or permitted by law. (7) Premises and Equipment A summary of premises and equipment follows:
June 30, December 31, 1998 1998 -------- ------------ Land................................................. $ 4,483 $ 3,824 Buildings and building improvements.................. 10,453 12,213 Furniture, fixtures and equipment.................... 7,533 8,817 -------- ------- 22,469 24,854 Less accumulated depreciation........................ 6,546 8,976 -------- ------- $ 15,923 $15,878 ======== =======
(8) Deposits Deposits consist of the following:
December 31, June 30, 1998 1998 ---------------- ---------------- Amount Percent Amount Percent -------- ------- -------- ------- Demand deposits.......................... $ 25,811 8.2% $ 27,834 9.0% NOW accounts............................. 36,679 11.7 40,275 13.0 Money market accounts.................... 34,635 11.0 32,781 10.6 Savings accounts......................... 65,764 20.9 60,001 19.5 Certificate accounts..................... 151,231 48.2 147,920 47.9 -------- ----- -------- ----- $314,120 100.0% $308,811 100.0% ======== ===== ======== =====
The combined weighted average interest rate of deposits was 4.02% and 3.77% at June 30, 1998 and December 31, 1998, respectively. Accrued interest payable on deposits was $148 and $74 at June 30, 1998 and December 31, 1998, respectively. F-15 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) Interest expense, by category, is as follows:
Six Months Year Ended June 30, Ended --------------------- December 31, 1996 1997 1998 1998 ------ ------ ------- ------------ NOW accounts............................ $ 404 $ 490 $ 557 $ 371 Money market accounts................... 1,489 1,603 1,808 1,237 Savings accounts........................ 300 307 346 387 Certificate accounts.................... 6,335 6,599 7,404 4,193 ------ ------ ------- ------ $8,528 $8,999 $10,115 $6,188 ====== ====== ======= ======
Scheduled maturities of certificate accounts at December 31, 1998 are as follows: Within one year................................ $ 141,461 Between one and two years...................... 4,313 Between two and three years.................... 540 Between three and four years................... 272 Between four and five years.................... 1,334 --------- $ 147,920 =========
Certificates of deposit issued in denominations in excess of $100,000 totaled $22,975 and $22,187 at June 30, 1998 and December 31, 1998. (9) FHLB Advances and Stock The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank of Seattle FHLB in an amount equal to at least 1% of the unpaid principal balances of the Bank's residential mortgage loans or 5% of its outstanding advances from the FHLB, whichever is greater. At December 31, 1998, the Bank was required to maintain an investment in the stock of FHLB of Seattle of at least $1.4 million. Purchases and sales of stock are made directly with the FHLB at par value. A summary of FHLB Advances follows:
June 30, December 31, 1998 1998 -------- ------------ Balance at period end................................ $698 $687 Average balance...................................... 156 693 Maximum amount outstanding at any month end.......... 698 696 Average interest rate: During the period.................................. 5.73% 6.20% At period end...................................... 6.20% 6.20%
FHLB advances which have fixed interest rates are scheduled to mature as follows:
June 30, December 31, 1998 1998 -------- ------------ Note payable, interest only payable monthly at 6.48%, maturing on September 6, 2005...................... $328 $328 Note payable, in monthly installments including interest at 5.95%, maturing on January 2, 2009..... 370 359 ---- ---- $698 $687 ==== ====
F-16 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Company, deposits at the FHLB and all mortgages or deeds of trust securing such properties. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 125% of outstanding advances depending on the type of collateral. The Bank may borrow from the FHLB in amounts up to 20% of its total assets. (10) Other Borrowings Other borrowings consist of the following:
June 30, December 31, 1998 1998 ------- ------------ Securities sold under agreements to repurchase.......... $ 610 $-- Subordinated debentures................................. 500 -- Other................................................... 22 17 ------- ---- $ 1,132 $ 17 ======= ====
The maximum and average outstanding balances and average interest rates on repurchase agreements were as follows:
Year Six Months Ended Ended June 30, December 31, 1998 1998 -------- ------------ Maximum outstanding at any month-end................... $610 $483 Average outstanding.................................... 21 320 Weighted average interest rate: For the period....................................... 3.25% 3.25% End of period........................................ 3.25% --
The subordinated debentures were repaid on December 31, 1998. (11) Federal Income Taxes Federal income tax expense (benefit) consists of the following:
Six Months Year Ended June 30, Ended -------------------- December 31, 1996 1997 1998 1998 ------ ----- ------ ------------ Current................................... $1,173 $ 304 $1,980 $1,266 Deferred.................................. 262 (549) (17) (148) ------ ----- ------ ------ $1,435 $(245) $1,963 $1,118 ====== ===== ====== ======
Federal income tax expense differs from that computed by applying the Federal statutory income tax rate of 34% as follows:
Year Ended Six Months June 30, Ended ---------------------- December 31, 1996 1997 1998 1998 ------ ----- ------ ------------ Income tax expense at Federal statutory rate....................... $1,431 $ 688 $1,901 $1,034 Reversal of provision for base year bad debt reserve..................... -- (938) -- -- Other, net............................ 4 5 62 84 ------ ----- ------ ------ $1,435 $(245) $1,963 $1,118 ====== ===== ====== ======
F-17 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) Heritage Bank has been permitted under the Internal Revenue Code to deduct an annual addition to a reserve for bad debts in determining taxable income, subject to certain limitations. The deduction was based on either specified experience formulas or a percentage of taxable income before such deduction. The Bank used the percentage of taxable income method for the years ended June 30, 1995 and 1996. This deduction was historically greater than the loan loss provisions recorded for financial accounting purposes. Deferred income taxes are provided on differences between the bad debt reserve for tax and financial reporting purposes only to the extent of the tax reserves arising subsequent to June 30, 1988. Savings institutions were not required to provide a deferred tax liability for the tax bad debt reserves accumulated as of June 30, 1988 which for The Bank amounted to $938. Starting in the fiscal year ended June 30, 1994, The Bank established and maintained a deferred income tax liability of $938 due to the potential recapture of the pre-1988 tax bad debt reserve which could have been triggered by the formation of the mutual holding company; a change to a commercial bank charter (which management had been contemplating); or possible legislation which was being debated in Congress. Legislation enacted in August 1996 eliminated certain conditions under which recapture of the pre-1988 additions to the tax bad debt reserve would be required. Such conditions are principally conversion to a commercial bank charter or merger with a commercial bank. The pre-1988 reserves would be required to be recaptured under certain other conditions such as payment of dividends in excess of accumulated earnings and profits or other distributions made in connection with the dissolution or liquidation of the Bank. Based on this legislation, the Bank reversed the $938 deferred tax liability as a reduction of Federal income tax expense during the year ended June 30, 1997. The following table presents major components of the deferred Federal income tax liability resulting from differences between financial reporting and tax bases.
June 30, December 31, 1998 1998 -------- ------------ Deferred tax liabilities: Deferred loan fees................................... $ 437 $ 363 Premises and equipment............................... 1,277 1,282 FHLB stock........................................... 399 425 Other................................................ 28 -- ------ ------- Total deferred tax liabilities..................... $2,141 $ 2,070 ====== ======= Deferred tax assets: Loan loss allowances................................. $ (573) $ (682) Management bonus..................................... (218) (178) Vacation benefits.................................... (90) (108) Charitable contributions............................. (36) (36) Other................................................ (41) (31) ------ ------- Total deferred tax assets.......................... (958) (1,035) ------ ------- Deferred taxes payable, net........................ $1,183 $ 1,035 ====== =======
The realization of the Company's deferred tax assets is dependent upon the Company's ability to generate taxable income in future periods. Management has evaluated available evidence supporting the realization of its deferred tax assets and determined it is more likely than not that deferred tax assets will be realized. F-18 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (12) Stockholders' Equity (a) Stock Offering and Conversion Effective January 8, 1998, the Company sold 6.6 million shares of its common stock at a subscription price of $10 per share to the Bank's customers, its existing stockholders and the general public. Of the 1.8 million shares of Heritage Savings Bank common stock outstanding at December 31, 1997, 1.2 million shares owned by Heritage Financial Corporation, M.H.C. (the "Mutual Holding Company") were canceled on January 8, 1998 and the Mutual Holding Company was merged into the Bank. The remaining 0.6 million shares of the Bank's common stock owned by its stockholders were converted into 3.1 million shares of the Company's common stock outstanding. Concurrent with the January 1998 stock conversion ("Conversion"), Heritage Savings Bank established a liquidation account equal to $18.4 million which represents the Mutual Holding Company's ownership interest in its Bank subsidiary at June 30, 1997 plus the amount of dividends waived by the Mutual Holding Company. The liquidation account is maintained for the benefit of eligible depositors who maintain eligible accounts in the Bank after the conversion. In the event of a complete liquidation of the Bank (and only in such an event), eligible depositors who continue to maintain eligible accounts shall be entitled to receive a distribution from the liquidation account before any liquidating distribution may be made with respect to common stock. (b) Earnings Per Common Share The following table illustrates the reconciliation of weighted average shares used for earnings per share computations:
Six Months Year Ended June 30, Ended ----------------------------- December 31, 1996 1997 1998 1998 --------- --------- --------- ------------ Basic: Weighted average shares........ 1,805,140 1,807,782 9,464,896 9,744,403 Effect of stock conversion..... 7,469,888 7,500,848 -- -- --------- --------- --------- ---------- Weighted average shares outstanding................... 9,295,028 9,308,630 9,464,896 9,744,403 ========= ========= ========= ========== Diluted: Basic weighted average shares outstanding................... 9,295,028 9,308,630 9,464,896 9,744,403 Incremental shares from stock options....................... 59,594 83,004 351,497 278,398 --------- --------- --------- ---------- Weighted average shares outstanding................... 9,354,622 9,391,634 9,816,393 10,022,800 ========= ========= ========= ==========
For purposes of calculating basic and diluted EPS, the numerator of net income is the same. Earnings per share information for periods prior to January 8, 1998 is based on the historical weighted average common shares outstanding for the Bank during the applicable period multiplied by the exchange ratio utilized in the stock conversion (5.1492). On January 8, 1998, the former stockholders of the Bank received 5.1492 shares of the Company's common stock for each share of the Bank's common stock exchanged. At December 31, 1998, there were options to purchase 92,700 shares of common stock outstanding which were antidilutive and therefore not included in the computation of diluted earnings per share. There were no antidilutive outstanding options to purchase common stock at June 30, 1998, 1997, and 1996. F-19 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (c) Cash Dividend Declared On December 18, 1998, the Company announced a quarterly cash dividend of 5 cents per share payable on January 25, 1999, payable to shareholders of record on January 15, 1999. (d) Restrictions on Dividends Dividends from the Company depend, in part, upon receipt of dividends from its subsidiary bank because the Company currently has no source of income other than dividends from the Bank and earnings from the investment of the net proceeds from the Conversion retained by the Company. The FDIC and the Washington State Department of Financial Institutions ("DFI") have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. For a period of ten years after the Conversion, Heritage Bank may not, without prior approval of the DFI, declare or pay a cash dividend in an amount in excess of one-half of (i) the greater of the Bank's net income for the current fiscal year or (ii) the average of the Bank's net income for the current fiscal year and not more than two of the immediately preceding fiscal years. In addition, the Bank may not declare or pay a cash dividend on its common stock if the effect thereof would be to reduce the net worth of the Bank below the amount required for the liquidation account. Other than the specific restrictions mentioned above, current regulations allow the Company and its subsidiary banks to pay dividends on their common stock if the Company's or Bank's regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC. (13) Regulatory Capital Requirements The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Each of the Banks is a state chartered, federally insured institution and thereby subject to the capital requirements established by the Federal Deposit Insurance Corporation (FDIC). The Federal Reserve requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Pursuant to minimum capital requirements of the FDIC, the Bank is required to maintain a leverage ratio (capital to assets ratio) of 3% and risk-based capital ratios of Tier 1 capital and total capital (to total risk-weighted assets) of 4% and 8%, respectively. At December 31, 1998, the Company and the Bank exceeded the minimum capital requirements and the requirements for well capitalized institutions as shown below. As of June 30, 1998 and December 31, 1998, the Banks (Heritage Bank and North Pacific Bank, where applicable) were classified as "well capitalized" institutions under the criteria established by the FDIC Act. There are no conditions or events since that notification that management believes have changed the Bank's classification as a well capitalized institution. F-20 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands)
Minimum Well-capitalized Requirements Requirements Actual --------------------------------------------- $ % $ % $ % -------- --------------- -------------- ----- As of December 31, 1998: The Company consolidated Tier 1 leverage capital to average assets............. $ 10,953 3% $ 18,255 5% $87,056 23.8% Tier 1 capital to risk-- weighted assets............ 11,436 4% 17,154 6% 87,056 30.5% Total capital to risk-- weighted assets............ 22,872 8% 28,589 10% 90,606 31.7% Heritage Bank Tier leverage capital to average assets............. 10,305 3% 17,176 5% 74,652 21.7% Tier 1 capital to risk-- weighted assets............ 11,337 4% 17,006 6% 74,652 26.3% Total capital to risk-- weighted assets............ 22,674 8% 28,343 10% 78,195 27.6% As of June 30, 1998: The Company consolidated Tier 1 leverage capital to average assets............. 10,466 3% 17,443 5% 85,155 24.4% Tier 1 capital to risk-- weighted assets............ 10,829 4% 16,243 6% 85,155 31.5% Total capital to risk-- weighted assets............ 21,657 8% 27,072 10% 89,041 32.9% Heritage Bank Tier 1 leverage capital to average assets............. 8,830 3% 14,717 5% 63,221 21.5% Tier 1 capital to risk-- weighted assets............ 8,289 4% 12,434 6% 63,221 30.5% Total capital to risk-- weighted assets............ 16,579 8% 20,723 10% 65,815 31.8% North Pacific Bank Tier 1 leverage capital to average assets............. 2,383 3% 3,972 5% 8,967 11.3% Tier 1 capital to risk-- weighted assets............ 2,438 4% 3,658 6% 8,967 14.7% Total capital to risk-- weighted assets............ 4,877 8% 6,096 10% 10,137 16.6%
(14) Stock Option Plans In September 1994, the Bank's stockholders approved the adoption of the 1994 stock option plan, providing for the award of a restricted stock award to a key officer, incentive stock options to employees and nonqualified stock options to directors of the Bank at the discretion of the Board of Directors. On September 24, 1996, the Bank's stockholders approved the adoption of the 1997 stock option plan which is generally similar to the 1994 plan. On October 15, 1998, the Company's stockholders approved the adoption of the 1998 stock option plan which is similar to the 1994 and 1997 plans. The 1998 plan does not affect any options granted under the 1994 or 1997 plans. Under these stock option plans, on the date of grant, the exercise price of the option must at least equal the market value per share of the Bank's or Company's common stock. The 1994 plan provides for the grant of options and stock awards up to 67,000 shares. The 1997 plan provides for the granting of options and stock awards for up to 50,000 common shares. The above 117,000 shares approved under the 1994 and 1997 plans for the grant of options and stock awards were converted to 602,456 shares at January 8, 1998 using the exchange ratio of one share of the Bank's common stock for 5.1492 shares of the Company's common stock. The 1998 plan provides for the grant of stock options and stock awards for up to 461,125 shares. Stock options generally vest ratably over three years and expire five years after they become exercisable which amounts to an average term of seven years. F-21 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) The following table summarizes stock option activity for the years ended June 30, 1996, 1997, 1998 and the six months ended December 31, 1998. Option activity for the periods prior to the stock offering January 8, 1998 has been restated using the exchange ratio of one share of the Bank's common stock for 5.1492 shares of the Company's common stock.
Outstanding Exercisable Options Options ---------------- ---------------- Avg. Avg. Option Option Shares Under Option Shares Price Shares Price ------------------- -------- ------ -------- ------ Balance at June 30, 1995..................... 231,713 $ 1.98 77,237 $1.98 Options granted.............................. 36,044 3.11 -- -- Became exercisable........................... -- -- 77,237 1.98 Less: Exercised.............................. (3,429) 1.94 (3,429) 1.94 -------- ------ -------- ----- Balance at June 30, 1996..................... 246,328 $ 2.14 151,046 $1.99 ======== ====== ======== ===== Options granted.............................. 308,942 $ 3.58 -- $ -- Became exercisable........................... -- -- 88,207 2.14 Less: Exercised.............................. (20,339) 1.94 (20,339) 1.94 -------- ------ -------- ----- Balance at June 30, 1997..................... 552,931 $ 2.95 218,914 $2.05 ======== ====== ======== ===== Options granted.............................. 9,000 $14.38 -- $ -- Became exercisable........................... -- -- 108,009 3.53 Less: Exercised.............................. (30,291) 2.32 (30,291) 2.32 Expired or canceled........................ (15,053) 3.58 -- -- -------- ------ -------- ----- Balance at June 30, 1998..................... 516,587 $ 3.17 296,632 $2.56 ======== ====== ======== ===== Options granted.............................. 92,700 $11.13 -- $ -- Became exercisable........................... -- -- -- -- Less: Exercised.............................. (135,561) 2.29 (135,561) 2.27 Expired or canceled........................ (9,000) 14.38 -- -- -------- ------ -------- ----- Balance at December 31, 1998................. 464,726 $ 4.80 161,071 $2.80 ======== ====== ======== =====
Under the 1997 plan, a restricted stock award of 3,000 shares with a fair value of $43 was awarded to a key officer and required five years of continuous employment from the date of award. These shares were issued during June 1998. However, the officer left the Company's employment in December 1998, and therefore, the restricted stock award was rescinded. Financial data pertaining to outstanding stock options at December 31, 1998 were as follows:
Weighted Average Number of Option Remaining Contractual Exercise Price Shares Life (in years) -------------- ---------------- --------------------- $ 1.94................................ 57,002 2.1 $ 2.33................................ 17,146 2.5 $ 3.11................................ 36,042 4.5 $ 3.58................................ 261,836 5.1 $11.13................................ 92,700 7.0 ------- --- 464,726 5.0 ======= ===
F-22 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation, but applies APB Opinion No. 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. If the Company had elected to recognize compensation cost on the fair value at the grant dates for awards under its plans, consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts indicated below:
Six Months Year Ended June 30 Ended -------------------- December 31, 1996 1997 1998 1998 ------ ------ ------ ------------ Net income: As reported............................. $2,773 $2,269 $3,628 $1,924 Pro forma............................... 2,772 2,239 3,566 1,888 Earnings per common share: Basic: As reported............................. $0.30 $0.24 $0.38 $0.20 Pro forma............................... 0.30 0.24 0.38 0.19 Diluted: As reported............................. $0.30 $0.24 $0.37 $0.19 Pro forma............................... 0.30 0.24 0.36 0.19
The compensation expense included in the pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year. The fair value of options granted is estimated on the date of grant using the minimum value method for grants in 1996 and 1997. The fair value of options granted during the year ended June 30, 1998 and the six months ended December 31, 1998 is estimated on the date of grant using the Black-Scholes options pricing model. The following assumptions were used to calculate the fair value of the options granted:
Weighted Risk Free Expected Expected Average Interest Life (in Expected Dividend Fair Grant period ended Rate years) Volatility Yield Value ------------------ --------- -------- ---------- -------- -------- June 30, 1996................ 6.50% 7 NA 3% $3.09 June 30, 1997................ 6.50% 7 NA 3% 3.19 June 30, 1998................ 6.00% 7 25% 1.3% 5.35 December 31, 1998............ 4.60% 7 25% 2.6% 4.82
(15) Employee Benefit Plans The Company maintains a defined contribution retirement plan. The plan allows participation to all employees upon completion of one year of service and the attainment of 21 years of age. It is the Company's policy to fund plan costs as accrued. Employee vesting occurs over a period of seven years, at which time they become fully vested. Charges of approximately $192, $246, $240, and $203 are included in the consolidated statements of income for the years ended June 30, 1996, 1997, 1998 and six months ended December 31, 1998, respectively. The Company also maintains a salary savings 401(k) plan for its employees. All persons employed as of July 1, 1984 automatically participate in the plan. All employees hired after that date who are at least 21 years F-23 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) of age and with one year of service to the Company may participate in the plan. Employees who participate may contribute a portion of their salary which is matched by the employer at 50% up to certain specified limits. Employee vesting in employer portions is similar to the retirement plan described above. Employer contributions for the years ended June 30, 1996, 1997, 1998 and the six months ended December 31, 1998 were $82, $87, $104 and $69, respectively. (16) Employee Stock Ownership Plan and Trust Heritage Bank established for eligible employees an employee stock ownership plan (ESOP) and related trust effective July 1, 1994 which became active upon the former mutual holding company's conversion to a stock-based holding company in January 1995. Eligible participants include eligible employees of the Company who are at least 21 years of age and with one year of service. The ESOP is funded by employer contributions in cash or common stock. Employee vesting occurs over a period of seven years. Heritage Bank contributed $75 to the ESOP for the year ended June 30, 1997. Prior to the January 8, 1998 stock offering, the ESOP owned the common stock of Heritage Bank with no related debt. In January 1998, the ESOP borrowed $1,323 from the Company to purchase additional common stock of the Company. The loan will be repaid principally from HB's contributions to the ESOP over a period of fifteen years. The interest rate on the loan is 8.5% per annum. ESOP compensation expense was $95 and $65 for the year ended June 30, 1998 and the six months ended December 31, 1998, respectively. As of December 31, 1998, the Company has allocated or committed to be released to the ESOP 4,408 earned shares and has 124,169 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1,374 at December 31, 1998. (17) Fair Value of Financial Instruments Because broadly traded markets do not exist for most of the Company's financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. Fair valuations are management's estimates of values. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Bank. (a) Financial Instruments With Book Value Equal to Fair Value The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to book value. (b) Investment Securities The fair value of all investment securities excluding Federal Home Loan Bank (FHLB) stock was based upon quoted market prices. FHLB stock is not publicly traded, however it may be redeemed on a dollar-for-dollar basis, for any amount the Bank is not required to hold. The fair value is therefore equal to the book value. F-24 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (c) Loans For most loans, fair value is estimated using market prices for mortgage backed securities with similar rates and average maturities adjusted for servicing costs or calculated by discounting expected cash flows over the estimated life of the loans using a current market rate reflecting the risk associated with comparable loans. Commercial loans and construction loans which are variable rate and short-term are reflected with fair values equal to book value. (d) Deposits For deposits with no contractual maturity, the fair value is equal to the book value. The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and an alternative cost of funds rate. (e) FHLB Advances The fair value of FHLB advances are estimated based on discounting the future cash flows using the rate currently offered on similar borrowings with similar maturities. (f) Subordinated Debentures The fair value of the subordinate debentures is estimated based on discounting the estimated future cash flows using the rate currently offered on similar borrowings with similar remaining maturities. (g) Other Borrowings Other borrowings consist of reverse repurchase agreements and a note payable at no stated interest rate. Reverse repurchase agreements mature daily and are valued the same as book value. The note payable fair value is based on discounting the estimated future cash flows using the rate currently offered on similar borrowings with similar remaining maturities. (h) Off-Balance Sheet Financial Instruments The fair value of off-balance sheet commitments to extend credit is considered equal to its notional amount. The table below presents the book value amount of the Bank's financial instruments and their corresponding fair values:
June 30, 1998 December 31, 1998 ----------------- ----------------- Book Fair Book Fair value value value value -------- -------- -------- -------- Financial Assets ---------------- Cash on hand and in banks.............. $ 12,065 $ 12,065 $ 10,369 $ 10,369 Interest bearing deposits.............. 50,542 50,542 36,355 36,355 Federal funds sold..................... 12,000 12,000 10,000 10,000 Investment securities available for sale.................................. 9,041 9,041 25,792 25,792 Investment securities held to maturity.............................. 29,731 29,975 13,149 13,318 FHLB stock............................. 1,985 1,985 2,062 2,062 Loans.................................. 272,224 277,205 285,193 289,944 Financial Liabilities --------------------- Deposits: Savings, money market and demand..... 162,889 162,889 160,891 160,891 Time certificates.................... 151,231 151,204 147,920 148,179 -------- -------- -------- -------- Total deposits..................... $314,120 $314,093 $308,811 $309,070 ======== ======== ======== ======== FHLB advances.......................... $ 698 $ 714 $ 687 $ 719 Other borrowed funds................... $ 1,132 $ 1,134 $ 17 $ 16
F-25 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (18) Contingencies The Company is involved in numerous business transactions which, in some cases, depend on regulatory determination as to compliance with rules and regulations. Also, the Company has certain litigation and negotiations in progress. All such matters are attributable to activities arising from normal operations. In the opinion of management, after review with legal counsel, the eventual outcome of the aforementioned matters is unlikely to have a materially adverse effect on the Company's consolidated financial statements or its financial position. (19) Heritage Financial Corporation (Parent Company Only) Heritage Financial Corporation (HFC) was established in connection with the January 1998 stock conversion and stock offering. HFC's first operating period was from January 8, 1998 to June 30, 1998 and therefore no financial information is presented prior to that date. HERITAGE FINANCIAL CORPORATION (PARENT COMPANY ONLY) Condensed Statements of Financial Condition
June 30, December 31, 1998 1998 -------- ------------ ASSETS ------ Interest earning deposits................................. $ 12,280 $11,460 Loans receivable--ESOP.................................... 1,304 1,281 Investment in subsidiary banks............................ 80,895 83,025 Other assets.............................................. 111 230 -------- ------- $ 94,590 $95,996 ======== ======= LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Liabilities............................................... $ 728 $ 569 Total stockholders' equity................................ 93,862 95,427 -------- ------- $ 94,590 $95,996 ======== =======
F-26 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) HERITAGE FINANCIAL CORPORATION (PARENT COMPANY ONLY) Condensed Statements of Income
Year Six Months Ended Ended June 30, December 31, 1998 1998 -------- ------------ Interest income: Interest bearing deposits........................... $ 737 $ 309 ESOP loan........................................... 54 55 Other income: Equity in undistributed income of subsidiaries 3,273 2,134 ------ ------ Total income...................................... 4,064 2,498 Other expenses........................................ 253 682 ------ ------ Income before federal income taxes.................. 3,811 1,816 Provision for income taxes............................ 183 (108) ------ ------ Net income........................................ $3,628 $1,924 ====== ====== Basic earnings per common share....................... $0.38 $0.20 Diluted earnings per common share..................... $0.37 $0.19
F-27 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) HERITAGE FINANCIAL CORPORATION (PARENT COMPANY ONLY) Condensed Statements of Cash Flows
Year Six Months ended Ended June 30, December 31, 1998 1998 -------- ------------ Cash flows from operating activities: Net income............................................. $ 3,628 $ 1,924 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Undistributed income of subsidiaries................. (3,273) (2,134) Recognition of compensation related to ESOP.......... 54 55 Other................................................ (42) (1) Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities......................................... 617 (347) ------- ------- Net cash provided by (used in) operations........ 984 (503) Cash flows from investing activities: ESOP loan net of principal repayments.................. (1,304) 23 Acquisition of wholly owned bank subsidiaries.......... (50,158) -- ------- ------- Net cash provided by (used in) investing activities...................................... (51,462) 23 Cash flows from financing activities: Cash dividends paid.................................... (342) (826) Issuance of restricted stock award and exercise of stock options......................................... 70 486 Net proceeds from stock offering....................... 63,758 -- ------- ------- Net cash provided by financing activities........ 62,758 (340) ------- ------- Net increase (decrease) in cash and cash equivalents..................................... 12,280 (820) Cash and cash equivalents at beginning of period......... -- 12,280 ------- ------- Cash and cash equivalents at end of period............... $12,280 $11,460 ======= =======
F-28 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands) (20) Selected Quarterly Financial Data (Unaudited) Results of operations on a quarterly basis were as follows (dollars in thousands, except for per share amounts):
Six Months Ended December 31, 1998 --------------- First Second Quarter Quarter ------- ------- Interest income........................................... $7,816 $7,830 Interest expense.......................................... 3,144 3,090 ------ ------ Net interest income..................................... 4,672 4,740 Provision for loan losses................................. 90 90 ------ ------ Net interest income after provision for loan losses..... 4,582 4,650 Non-interest income....................................... 1,140 1,299 Non-interest expense...................................... 3,723 4,906 ------ ------ Income before provision for income taxes................ 1,999 1,043 Provision for income taxes................................ 722 396 ------ ------ Net income............................................ $1,277 $ 647 ====== ====== Basic earnings per share.................................. $.13 $.07 Diluted earnings per share................................ $.13 $.06 Cash dividends declared................................... $.045 $.05
Year ended June 30, 1998 ------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Interest income................................ $5,050 $5,380 $6,122 $6,589 Interest expense............................... 2,405 2,571 2,510 2,642 ------ ------ ------ ------ Net interest income.......................... 2,645 2,809 3,612 3,947 Provision for loan losses...................... 30 30 30 30 ------ ------ ------ ------ Net interest income after provision for loan losses...................................... 2,615 2,779 3,582 3,917 Non-interest income............................ 893 880 1,047 971 Non-interest expense........................... 2,563 2,657 2,849 3,024 ------ ------ ------ ------ Income before provision for income taxes..... 945 1,002 1,780 1,864 Provision for income taxes..................... 335 356 621 651 ------ ------ ------ ------ Net income................................. $ 610 $ 646 $1,159 $1,213 ====== ====== ====== ====== Basic earnings per share....................... $0.06 $0.07 $0.12 $0.13 Diluted earnings per share..................... $0.06 $0.07 $0.12 $0.12 Cash dividends declared........................ $-- $-- $0.035 $0.04
F-29 HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in thousands)
Year ended June 30, 1997 -------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Interest income................................ $4,459 $4,591 $4,592 $4,870 Interest expense............................... 2,246 2,270 2,199 2,285 ------ ------ ------ ------ Net interest income.......................... 2,213 2,321 2,393 2,585 Provision for loan losses...................... -- -- -- (270) ------ ------ ------ ------ Net interest income after provision for loan losses...................................... 2,213 2,321 2,393 2,855 Non-interest income............................ 866 846 726 909 Non-interest expense........................... 3,414 2,389 2,400 2,902 ------ ------ ------ ------ Income before provision for income taxes..... (335) 778 719 862 Provision for income taxes..................... (1,051) 266 245 295 ------ ------ ------ ------ Net income................................. $ 716 $ 512 $ 474 $ 567 ====== ====== ====== ====== Basic earnings per share....................... $0.08 $0.05 $0.05 $0.06 Diluted earnings per share..................... $0.08 $0.05 $0.05 $0.06 Cash dividends declared........................ NM NM NM NM
Cash dividends prior to January 1998 stock offering and conversion are not comparable to prior periods due to the former mutual holding company's waiver of its pro rata cash dividends. F-30 EXHIBIT INDEX
Exhibit No. Description ------- ----------- 3.1 Articles of Incorporation(1) 3.2 Bylaws of the Company(1) 10.1 1998 Stock Option and Restricted Stock Award Plan(2) 10.2 Employment Agreement between the Company and Donald V. Rhodes, effective as of October 1, 1997.(1) Severance Agreement between the Company and Brian L. Vance, effective 10.3 October 1, 1997.(1) Severance Agreement between the Company and John D. Parry, effective 10.4 October 1, 1997.(1) 10.5 Form of Severance Agreement entered into between the Company and seven additional executives, effective as of October 1, 1997.(1) 10.6 1997 Stock Option and Restricted Stock Award Plan(3) 21.0 Subsidiaries of the Company 23.0 Consent of KPMG LLP 24.0 Power of Attorney dated February 25, 1999 27.0 1998 Financial Data Schedule
- -------- (1) Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997. (2) Incorporated by reference to the definitive Proxy Statement dated September 14, 1998 for the Annual Meeting of Shareholders to be held on October 15, 1998. (3) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513). EX-21 2 SUBSIDIARIES OF THE COMPANY EXHIBIT 21 SUBSIDIARIES OF THE COMPANY Heritage Savings Bank, Olympia, Washington Central Valley Bank, N.A. WIB Premises, Inc. EX-23 3 CONSENT OF KPMG LLP Exhibit 23 Consent of Independent Certified Public Accountants The Board of Directors Heritage Financial Corporation: We consent to incorporation by reference in the registration statements (No. 333-57513 and No. 333-71415) on Form S-8 of Heritage Financial Corporation of our report dated January 29, 1999, relating to the consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries as of June 30 and December 31, 1998, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended June 30, 1998 and for the six month period ended December 31, 1998, which report appears in the December 31, 1998, annual report on Form 10-K of Heritage Financial Corporation. KPMG LLP Seattle, Washington March 25, 1999 EX-24 4 POWER OF ATTORNEY DATED FEBRUARY 25, 1999 EXHIBIT 24.0 POWER OF ATTORNEY The directors of Heritage Financial Corporation (the "Company"), whose signatures appear below, hereby appoint Donald V. Rhodes as their attorney to sign, in their name and behalf and in any and all capacities stated below, the Company's Annual Report on Form 10-K pursuant to Section 13 of the Securities Exchange Act of 1934, and likewise to sign any and all amendments and other documents relating thereto as shall be necessary, such persons hereby granting to such attorney power to act with full power of substitution and revocation, and hereby ratifying all that such attorney or his substitute may do by virtue hereof. This Power of Attorney has been signed on the 25th day of February, 1999 by the following directors which constitute a majority of the board of directors. Signature Title /s/ Lynn M. Brunton Director - ----------------------------- Lynn M. Brunton /s/ John A. Clees Director - ----------------------------- John A. Clees /s/ Daryl D. Jensen Director - ----------------------------- Daryl D. Jensen /s/ H. Edward Odegard Director - ----------------------------- H. Edward Odegard /s/ James P. Senna Director - ----------------------------- James P. Senna /s/ Peter K. Wallerich Director - ----------------------------- Peter K. Wallerich /s/ Philip S. Weigand Director - ----------------------------- Philip S. Weigand EX-27 5 1998 FINANCIAL DATA SCHEDULE
9 1,000 YEAR DEC-31-1998 JUL-01-1998 DEC-31-1998 10,369 36,355 10,000 0 25,792 13,149 13,318 288,743 3,550 411,983 308,811 0 7,035 700 0 0 69,728 25,705 411,983 13,181 1,112 1,353 15,646 6,188 6,234 9,412 180 0 8,629 3,042 3,042 0 0 1,924 0.20 0.19 8.42 392 8 0 212 3,542 181 9 3,550 3,550 0 257
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