Annual Report
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-K

 

x Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2006

 

¨ Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Commission File No. 0-29480

 


HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington   91-1857900

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

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 if the registrant is a well-seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨  No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨  No  x

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.    ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨   Accelerated filer  x   Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨  No  x

The aggregate market value of the voting stock held by non-affiliates of the registrant was $138,585,618 and was based upon the last sales price as quoted on the NASDAQ Stock Market for June 30, 2006.

The Registrant had 6,566,755 shares of common stock outstanding as of February 9, 2007.

DOCUMENTS TO BE INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement expected to be dated March 22, 2007 for the 2007 Annual Meeting of Stockholders will be incorporated by reference into Part III of this Form 10-K.

 



Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-K

December 31, 2006

TABLE OF CONTENTS

 

          Page
   PART I   

ITEM 1.

  

BUSINESS

   3
  

LENDING ACTIVITIES

   3
  

INVESTMENT ACTIVITIES

   10
  

DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS

   12
  

SUPERVISION AND REGULATION

   14
  

COMPETITION

   18

ITEM 1A.

  

RISK FACTORS

   18

ITEM 1B.

  

UNRESOLVED STAFF COMMENTS

   19

ITEM 2.

  

PROPERTIES

   19

ITEM 3.

  

LEGAL PROCEEDINGS

   19

ITEM 4.

  

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   19
   PART II   

ITEM 5.

  

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

   20

ITEM 6.

  

SELECTED FINANCIAL DATA

   23

ITEM 7.

  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   24

ITEM 7A.

  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   32

ITEM 8.

  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   32

ITEM 9.

  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

   32

ITEM 9A.

  

CONTROLS AND PROCEDURES

   33

ITEM 9B.

  

OTHER INFORMATION

   35
   PART III   

ITEM 10.

  

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   36

ITEM 11.

  

EXECUTIVE COMPENSATION

   36

ITEM 12.

  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

   36

ITEM 13.

  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   36

ITEM 14.

  

PRINCIPAL ACCOUNTING FEES AND SERVICES

   36
   PART IV   

ITEM 15.

  

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

   37

 

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Table of Contents

PART I

 

ITEM 1. BUSINESS

General

Heritage Financial Corporation (“Company”) is a bank holding company incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization (“Conversion”).

We are primarily engaged in the business of planning, directing and coordinating the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. Heritage Bank is a Washington state-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Deposit Insurance Fund (“DIF”). During 2004, Heritage Bank changed its charter from a savings bank to a commercial bank. Heritage Bank conducts business from its main office in Olympia, Washington and its thirteen branch offices located in Thurston, Pierce, Mason and south King Counties. Central Valley Bank is a Washington state-chartered commercial bank whose deposits are insured by the FDIC under the DIF. During 2005, Central Valley Bank changed its charter from a nationally-chartered commercial bank to a state-chartered commercial bank. Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties. In June 2006, the Company completed the acquisition of Western Washington Bancorp (“WWB”) and its wholly owned subsidiary, Washington State Bank, N.A. Washington State Bank, N.A. was mergered into Heritage Bank on the date of acquisition.

Our business consists primarily of lending and deposit relationships with small businesses including agribusiness and their owners in our market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State. We also make residential construction, income property, and consumer loans.

Market Areas

We offer financial services to meet the needs of the communities we serve through our community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and Central Valley Bank. Heritage Bank has fourteen full service offices, with seven in Pierce County, five in Thurston County, one in Mason County and one in south King County. Heritage Bank has mortgage origination offices in Thurston County, Mason County and Pierce County, which all operate within banking offices. The mortgage loan operations are performed in one office located in Thurston County. Central Valley Bank operates six full service offices, with five in Yakima County and one in Kittitas County.

Lending Activities

General.    Our lending activities are conducted through Heritage Bank and Central Valley Bank. We offer commercial, real estate, income property, agricultural, and consumer loans. Our focus is on commercial lending with commercial loans increasing in the recent year to $440.5 million, or 58.8% of total loans, as of December 31, 2006 from $359.8 million, or 55.2% of total loans, as of December 31, 2005. We continue to provide real estate mortgages, both single and multifamily residential and commercial. Real estate mortgages increased to $231.8 million, or 30.9% of total loans, at December 31, 2006, from $217.9 million, or 33.4% of total loans, at December 31, 2005.

Our overall lending operations are guided by loan policies, which are reviewed and approved annually by our board of directors. These policies outline the basic policies and procedures by which lending operations are conducted. The policies address the types of loans, underwriting and collateral requirements, terms, interest rate and yield considerations, compliance with laws and regulations, and compliance with internal lending limits. We

 

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supplement our 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.

The following table provides information about our loan portfolio by type of loan for the dates indicated. These balances are prior to deduction for the allowance for loan losses.

 

    At December 31,  
    2006     2005     2004     2003     2002  
    Balance
(3)
    % of
Total
    Balance     % of
Total
    Balance     % of
Total
    Balance     % of
Total
    Balance     % of
Total
 
    (Dollars in thousands)  

Commercial

  $ 440,450     58.75 %   $ 359,808     55.16 %   $ 336,227     56.06 %   $ 266,252     51.06 %   $ 243,872     51.86 %

Real Estate Mortgages

                   

One-four family residential(1)

    58,911     7.86       53,098     8.14       58,903     9.82       57,377     11.00       72,846     15.49  

Five or more family residential and commercial properties

    172,937     23.07       164,788     25.26       152,958     25.50       149,728     28.72       114,750     24.40  
                                                                     

Total real estate mortgages

    231,848     30.93       217,886     33.40       211,861     35.32       207,105     39.72       187,596     39.89  

Real estate construction

                   

One-four family residential

    53,298     7.11       42,245     6.48       23,266     3.88       19,881     3.81       29,201     6.21  

Five or more family residential and commercial properties

    13,532     1.80       21,355     3.27       17,121     2.85       19,570     3.75       3,169     0.67  
                                                                     

Total real estate construction(2)

    66,830     8.91       63,600     9.75       40,387     6.73       39,451     7.56       32,370     6.88  

Consumer

    12,976     1.73       12,855     1.97       13,045     2.18       10,043     1.93       7,616     1.62  
                                                                     

Gross loans

    752,104     100.32 %     654,149     100.28 %     601,520     100.29 %     522,851     100.27 %     471,454     100.25 %

Less deferred loan fees and other

    (2,403 )   (0.32 )     (1,852 )   (0.28 )     (1,759 )   (0.29 )     (1,438 )   (0.27 )     (1,190 )   (0.25 )
                                                                     

Total loans receivable and loans held for sale

  $ 749,701     100.00 %   $ 652,297     100.00 %   $ 599,761     100.00 %   $ 521,413     100.00 %   $ 470,264     100.00 %
                                                                     

(1) Includes loans held for sale of $0, $263, $381, $1,018, and $8,113 as of December 31, 2006, 2005, 2004, 2003, and 2002, respectively.
(2) Balances are net of undisbursed loan proceeds.
(3) The June 2006 acquisition of WWB included $41.5 million in total loans.

The following table presents at December 31, 2006 (i) the aggregate maturities of loans in the named categories of our 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 year

   1-5 years   

After

5 years

   Total
     (Dollars in thousands)

Commercial

   $ 164,517    $ 119,533    $ 156,400    $ 440,450

Real estate construction

     55,111      10,250      1,469      66,830
                           

Total

   $ 219,628    $ 129,783    $ 157,869    $ 507,280
                           

Fixed rate loans

      $ 60,539    $ 48,114    $ 108,653

Variable or adjustable rate loans

        69,244      109,754      178,998
                       

Total

      $ 129,783    $ 157,868    $ 287,651
                       

 

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Real Estate Lending

Single-Family Residential Real Estate Lending.    The majority of our one to four family residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% (90% with private mortgage insurance) of the appraised value at origination or cost, whichever is lower, of the underlying collateral. Terms typically range from 15 to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages (“ARMs”) with repricing based on a Treasury Bill or other index. However, our ability to generate volume in ARMs is largely a function of consumer preference and the interest rate environment. Under our current policy we do not originate ARMs with discounted initial interest rates (i.e., “teasers”). We generally sell all government guaranteed mortgages, both fixed rate and adjustable rate. Management determines to what extent we will retain or sell other ARMs and other fixed rate mortgages in their strategy to control our interest rate sensitivity position. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management”.

Multifamily and Commercial Real Estate Lending.    We originate, on a selective basis, multifamily and commercial real estate loans in our primary market areas. Commercial real estate loans are made for small shopping centers, warehouses, and professional offices. Cash flow coverage to debt servicing requirements is generally 1.2 times or more. Our underwriting standards generally require that the loan-to-value ratio for multifamily and commercial real estate loans not exceed 80% of appraised value at origination or cost, whichever is lower.

Multifamily and commercial real estate mortgage lending affords our banks an opportunity to receive interest at rates higher than those generally available from single-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 single-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 these loans may be affected by adverse conditions in the real estate market or the economy. We seek 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. We also generally obtain personal guarantees from financially capable borrowers based on a review of personal financial statements.

Construction Loans.    We originate single-family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provide financing to builders for the construction of pre-sold homes and speculative residential construction (i.e. built before a buyer is identified). We lend to builders who have demonstrated a favorable record of performance and profitable operations and who are building in markets that management understands and is comfortable with existing economic conditions. We further endeavor to limit our 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. Our underwriting standards require that the loan-to-value ratio for pre-sold homes and speculative residential construction generally not exceed 80% of appraised value or builder’s cost, whichever is less. Speculative construction and land development loans are short term in nature and priced with a variable rate of interest using the prime rate as the index. We generally require builders to have some tangible form of equity in each construction project. Also, we require prompt and thorough documentation of all draw requests and we inspect the project prior to paying any draw requests from builders.

Construction lending affords us the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does our single-family permanent mortgage lending. However, construction lending is 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. As a result, these loans are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally

 

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committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted with a project whose value is insufficient to ensure full repayment. Projects may also be jeopardized by disagreements between buyers and builders, and 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 liquidation of the loan depends on the builder’s ability to sell the property.

Commercial Business Lending

We offer commercial loans to sole proprietorships, partnerships, and corporations with an emphasis on real estate related industries and businesses in agricultural, 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 financing, business term loans secured by real estate for either working capital or lot acquisition, Small Business Administration (“SBA”) loans, and unsecured business loans.

Commercial business lending generally involves greater risk than residential mortgage lending and these risks differ from those associated with residential and commercial real estate lending. Commercial real estate lending is considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, where liquidation of the underlying real estate collateral is viewed as the primary source of repayment if the borrower defaults. Although our commercial business loans are often collateralized by real estate, the decision to grant a commercial business loan depends primarily on the creditworthiness and cash flow of the borrower (and any guarantors), while liquidation of collateral is a secondary source of repayment.

As of December 31, 2006, we had $440.5 million, or 58.8% of our total loans receivable, in commercial loans. The average loan size is approximately $330,000 with loans generally in amounts of $1,000,000 or less.

Origination and Sales of Loans

We originate real estate and other loans with the majority of the residential mortgage volumes generated from our mortgage loan origination offices. Walk-in customers and referrals from real estate brokers are important sources of loan originations.

Consistent with our asset/liability management strategy, we sell a significant portion of our fixed rate and ARM residential mortgage loans to 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 for 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 we are only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal. In addition, we have mortgage loan production which is brokered to other lenders prior to funding.

When we sell mortgage loans, we typically sell the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced $0.5 million, $0.7 million, and $0.9 million in mortgage loans for others as of December 31, 2006, 2005, and 2004, respectively. We received fee income for servicing activities on mortgage loans of $2,000, $4,000, and $10,000 for the years ended December 31, 2006, 2005, and 2004, respectively.

The following table presents summary information concerning our origination and sale of residential mortgage loans and the gains achieved on such activities.

 

     Years ended December 31,
     2006    2005    2004    2003    2002
     (Dollars in thousands)

Residential mortgage loans:

              

Originated

   $ 19,600    $ 25,097    $ 52,188    $ 125,438    $ 91,614

Sold

     8,856      13,632      35,822      105,790      74,318

Gains on sales of loans, net

   $ 133    $ 277    $ 640    $ 1,907    $ 1,404

 

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Commitments and Contingent Liabilities

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our consolidated financial statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. At December 31, 2006, we had outstanding commitments to extend credit, including letters of credit, in the amount of $209.9 million.

Delinquencies and Nonperforming Assets

Delinquency Procedures.    We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.

If a real estate loan payment is past due for 45 days or more, the collection manager may perform a review of the condition of the property if suspect. We may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is sold at a public sale and we bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings 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 resolving the delinquency.

Real estate acquired by us is classified as real estate owned 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 resulting write-down 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.

We consider loans as an in-substance foreclosure if the borrower has little or no equity in the property based upon its estimated fair value, repayment can be expected only from operation or sale of the collateral, the borrower has effectively abandoned control of the collateral, or it is doubtful the borrower will be able to repay the loan in the foreseeable future because of the borrower’s current financial status. In-substance foreclosures are accounted for as if the properties were held as “real estate owned”.

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, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.

Classification of Assets.    Federal regulations require that our banks periodically evaluate the risk inherent in their loan portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”) and the FDIC have authority to identify problem assets and, if appropriate, require them to be classified by risk. 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 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. There is a high possibility of loss in assets classified as Doubtful. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or a portion of the asset is classified as Loss, the institution must charge off this amount. We also have assets we classify as Watch and “other assets especially

 

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mentioned” (OAEM). Assets classified as watch are performing assets but have elements of risk that require more monitoring than other performing assets. Assets classified as OAEM are assets that continue to perform but have shown deterioration in credit quality and require close monitoring.

Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans, restructured loans, and real estate owned. The following table provides information about our nonaccrual loans, restructured loans, and real estate owned for the indicated dates.

 

     At December 31,  
     2006     2005     2004     2003     2002  
     (Dollars in thousands)  

Nonaccrual loans

   $ 2,807     $ 836     $ 319     $ 297     $ 1,987  

Real estate and other assets owned

     225       371       —         389       296  
                                        

Total nonperforming assets

   $ 3,032     $ 1,207     $ 319     $ 686     $ 2,283  
                                        

Accruing loans past due 90 days or more

   $ —       $ —       $ —       $ 19     $ 19  

Potential problem loans

   $ 5,509     $ 9,882     $ 12,184     $ 10,502     $ 11,261  

Allowance for loan losses

   $ 10,105     $ 8,496     $ 8,295     $ 7,748     $ 6,874  

Nonperforming loans to loans

     0.37 %     0.13 %     0.05 %     0.06 %     0.42 %

Allowance for loan losses to loans

     1.35 %     1.30 %     1.38 %     1.49 %     1.46 %

Allowance for loan losses to nonperforming loans

     360.05 %     1,016.27 %     2,603.60 %     2,611.97 %     346.05 %

Nonperforming assets to total assets

     0.36 %     0.16 %     0.05 %     0.11 %     0.38 %

Nonaccrual Loans.    Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual. Loans are considered to be impaired and are placed on nonaccrual when there are serious doubts about the collectibility of principal or interest. Our policy is to place a loan on nonaccrual when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.

Potential Problem Loans.    Potential problem loans are those loans that are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes us concerns as to their ability to comply with the present repayment program and could result in placing the loan on nonaccrual. As of December 31, 2006, potential problem loans decreased by $4.4 million to $5.5 million from $9.9 million at December 31, 2005.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified loan portfolio by considering a number of elements including:

• Risk rating of the credit portfolio;

• Levels and trends in delinquencies and nonaccruals;

• Trends in loan demand and structure including terms and interest rates;

• National and local economic trends;

• Specific industry conditions such as commercial and residential construction;

• Concentrations of credits in specific industries;

 

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• Bank regulatory examination results and our own credit examinations; and

• Recent loss experience in the portfolio.

We calculate an adequate allowance for the non-classified portion of our loan portfolio based on an appropriate percentage lossfactor that is calculated based on the above-noted elements and trends. We may add specific provisions for each classified loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for both our non-classified loans and the specific provisions made for each classified loan.

While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance, unforeseen market conditions arise or if we are directed to make adjustments to the allowance for loan losses by our regulators.

The following table provides information regarding changes in our allowance for loan losses for the indicated periods:

 

     Years Ended December 31,  
     2006     2005     2004     2003     2002  
     (Dollars in thousands)  

Total loans outstanding at end of period(1)

   $ 749,701     $ 652,297     $ 599,761     $ 521,413     $ 470,264  
                                        

Average loans outstanding during period

   $ 690,287     $ 613,655     $ 549,445     $ 481,404     $ 472,785  
                                        

Allowance balance at beginning of period

   $ 8,496     $ 8,295     $ 7,748     $ 6,874     $ 5,751  

Provision for loan losses

     720       810       645       1,125       1,835  

Allowance acquired through acquisition

     749       —         —         —         —    

Charge-offs:

          

Real estate

     (3 )     —         (41 )     (138 )     (69 )

Commercial

     (78 )     (630 )     (55 )     (102 )     (657 )

Agriculture

     —         —         (10 )     —         —    

Consumer

     (83 )     (61 )     (3 )     (19 )     (7 )
                                        

Total charge-offs

     (164 )     (691 )     (109 )     (259 )     (733 )
                                        

Recoveries:

          

Real estate

     24       7       8       3       1  

Commercial

     255       55       —         4       20  

Agriculture

     —         10       3       —         —    

Consumer

     25       10       —         1       —    
                                        

Total recoveries

     304       82       11       8       21  
                                        

Net (charge-offs) recoveries

     140       (609 )     (98 )     (251 )     (712 )
                                        

Allowance balance at end of period

   $ 10,105     $ 8,496     $ 8,295     $ 7,748     $ 6,874  
                                        

Ratio of net (charge-offs) recoveries during period to average loans outstanding

     .02 %     (0.10 )%     (0.02 )%     (0.05 )%     (0.15 )%
                                        

(1) Includes loans held for sale

 

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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 loan loss ratios, and industry wide and other factors that affect loan losses in the categories shown below:

 

     At December 31,  
     2006     2005     2004     2003     2002  
     Amount    % of
Total
Loans
(1)
    Amount    % of
Total
Loans
(1)
    Amount    % of
Total
Loans
(1)
    Amount    % of
Total
Loans
(1)
    Amount    % of
Total
Loans
(1)
 
     (Dollars in thousands)  

Commercial

   $ 7,276    58.6 %   $ 6,117    55.0 %   $ 5,971    55.9 %   $ 5,578    51.0 %   $ 4,949    51.8 %

Real Estate Mortgage

                         

One-four family residential

     398    7.8 %     335    8.1 %     327    9.8 %     305    11.0 %     271    15.4 %

Five or more family residential and commercial properties

     1,708    23.0 %     1,435    25.2 %     1,402    25.4 %     1,310    28.7 %     1,162    24.4 %

Real Estate Construction:

                         

One-four family residential

     547    7.1 %     460    6.4 %     449    3.9 %     419    3.7 %     370    6.2 %

Five or more family residential and commercial properties

     41    1.8 %     34    3.3 %     34    2.8 %     31    3.8 %     28    0.6 %

Consumer

     138    1.7 %     115    2.0 %     112    2.2 %     105    1.8 %     94    1.6 %
                                                                 

Total loans

   $ 10,105    100.0 %   $ 8,496    100.0 %   $ 8,295    100.0 %   $ 7,748    100.0 %   $ 6,874    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, 2006, our investment securities portfolio totaled $43.0 million, which consisted of $39.1 million of securities available for sale and $3.9 million of securities held to maturity. This compares with a total portfolio of $45.8 million at December 31, 2005, which was comprised of $41.9 million of securities available for sale and $4.0 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in financial statement Notes 4 and 5.

Our investment policy is established by the board of directors and monitored by the Audit and Finance Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and compliments our bank’s lending activities. The policy dictates the criteria for classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, some corporate notes, municipal bonds, and federal funds. Investment in non-investment grade bonds and stripped mortgage backed securities are not permitted under the policy.

 

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The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2006.

 

     Book
Value
   Fair
Value
   Weighted
Average
Yield(1)
 
     (Dollars in thousands)  

Obligations of US Government agencies

        

Due within one year

   $ 5,157    $ 5,140    4.40 %

Due after 1 year but within 5 years

     12,382      12,194    4.40  

Due after 5 years but within 10 years

     1,000      1,008    5.49  
                
     18,539      18,342   
                

Mortgage backed securities

        

Due within one year

     11,043      10,744    3.81  

Due after 1 year but within 5 years

     214      212    4.12  

Due after 5 years but within 10 years

     20      20    5.75  

Due after 10 years

     2,238      2,226    5.25  
                
     13,515      13,202   
                

Collateralized mortgage obligations

        

Due after 1 year but within 5 years

     109      109    4.75  

Due after 5 years but within 10 years

     1,499      1,455    3.08  

Due after 10 years

     6,270      6,016    4.26  
                
     7,878      7,580   
                

Total all investments available for sale

   $ 39,932    $ 39,124   
                

The following table provides information regarding our investment securities held to maturity, by contractual maturity, at December 31, 2006.

 

     Book
Value
   Fair
Value
   Weighted
Average
Yield(1)
 
     (Dollars in thousands)  

Obligations of US Government agencies

        

Due after 5 years but within 10 years

   $ 905    $ 896    4.78 %
                

Municipal bonds

        

Due within one year

     100      101    6.44  

Due after 1 year but within 5 years

     335      339    5.98  

Due after 5 years but within 10 years

     1,265      1,279    5.51  
                
     1,700      1,718   
                

Mortgage backed securities

        

Due within one year

     25      26    7.42  

Due after 1 year but within 5 years

     1,228      1,221    5.35  
                
     1,253      1,247   
                

Total all investments held to maturity

   $ 3,858    $ 3,861   
                

(1) Taxable equivalent weighted average yield.

We held $3.2 million of FHLB stock at December 31, 2006. The stock has no contractual maturity and amounts in excess of the required minimum for FHLB membership may be redeemed at par subject to certain restrictions. At December 31, 2006, we were required to maintain an investment in the stock of the FHLB of Seattle of at least $1.5 million.

 

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Deposit Activities and Other Sources of Funds

General. Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors are not. Our deposit balances increased by $89.4 million in 2006 over the prior year, with certificates of deposit accounts increasing slightly as a percentage of total deposits. The June 2006 acquisition of WWB included $44.3 million in deposit balances. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market conditions in the industry and may be affected by future developments such as interest rate fluctuations and new competitive pressures. 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 match the maturity of repricing intervals of assets.

Deposit Activities.    We offer a variety of deposit accounts 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, 2006, we had no brokered deposits. The more significant deposit accounts are described below.

Certificates of Deposit.    We offer several types of CDs with maturities ranging from one to five years, which require a minimum deposit of $100. In addition, we offer a CD that has a maturity of three to eleven months and a minimum deposit of $2,500, and permits additional deposits at the initial rate throughout the CD term. At Heritage Bank, interest is compounded daily and credited quarterly or at maturity. At Central Valley Bank, interest is accrued daily and compounded quarterly or at maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to 12 months. The negotiable CDs pay simple interest credited at maturity.

Regular Savings Accounts.    We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $100 minimum balance is maintained. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded 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. At Heritage Bank, interest is compounded daily and paid monthly. At Central Valley Bank, interest is accrued daily and compounded 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 annual contributions regulated by law and pay interest at fixed rates. Maturities are available from one to five years. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded quarterly.

 

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Sources of Funds

Deposit Activities.    The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the years ended December 31:

 

     2006     2005     2004  
    

Average

Balance

   Average
Rate
Paid
   

Average

Balance

   Average
Rate
Paid
   

Average

Balance

   Average
Rate
Paid
 
     (Dollars in Thousands)  

Interest bearing demand and money market accounts

   $ 189,458    1.93 %   $ 170,399    1.08 %   $ 165,486    0.73 %

Savings

     95,075    1.76       96,425    1.03       104,271    1.00  

Certificates of deposit

     307,902    4.19       264,078    2.94       222,279    2.01  
                                       

Total interest bearing deposits

     592,435    3.08       530,902    2.00       492,036    1.37  

Demand and other noninterest bearing deposits

     98,567    —         85,732    —         76,994    —    
                                       

Total deposits

   $ 691,002    2.64 %   $ 616,634    1.73 %   $ 569,030    1.18 %
                                       

The following table shows the amount and maturity of certificates of deposits of $100,000 or more as of December 31, 2006:

 

     (Dollars in
thousands)

Remaining maturity:

  

Three months or less

   $ 89,928

Over three months through six months

     34,085

Over six months through twelve months

     42,802

Over twelve months

     10,077
      

Total

   $ 176,892
      

Borrowings.    Deposits are the primary source of funds for our lending and investment activities, and our general business purposes. We rely upon advances from the Federal Home Loan Bank of Seattle (“FHLB”) to supplement our supply of lendable funds and meet deposit withdrawal requirements. The FHLB of Seattle serves as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by our first mortgage loans and stock issued by the FHLB, which is owned by us. Our subsidiary banks also have lines to purchase federal funds up to $29.8 million. In addition, Heritage Bank maintains a $5.0 million line to support letters of credit. We also maintain a line of credit of $5.0 million with Key Bank to supplement any cash needs not covered by dividends from the banks or earnings from investments. At December 31, 2006, our banks maintained credit facilities with the FHLB of Seattle for $155.3 million with an outstanding balance of $37.2 million.

The FHLB functions as a central reserve bank providing credit for member financial institutions. As members, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our 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 limits advances to 20% of assets for Heritage Bank and 10% of assets for Central Valley Bank.

The following table is a summary of FHLB advances for the years ended December 31:

 

     2006     2005     2004  
     (Dollars in thousands)  

Balance at period end

   $ 37,167     $ 39,900     $ 40,900  

Average balance during the period

     20,682       28,269       30,352  

Maximum amount outstanding at any month end

     47,145       48,800       48,900  

Average interest rate:

      

During the period

     5.19 %     3.29 %     1.49 %

At period end

     5.63 %     4.33 %     2.35 %

 

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We maintain a line of credit with Key Bank for short-term corporate funding needs. The following table is a summary of usage on the Key Bank line of credit for the years ended December 31:

 

     2006     2005    2004  
     (Dollars in thousands)  

Balance at period end

   $ 225     $   —      $ —    

Average balance during the period

     5       —        554  

Maximum amount outstanding at any month end

     225       —        2,194  

Average interest rate:

       

During the period

     7.75 %     —        4.38 %

At period end

     7.75 %     —        —    

There were no fed funds purchased for the years ended December 31, 2006, 2005 and 2004.

During 2006, we entered into a loan agreement with Key Bank in the amount of $3,700. The terms of the loan include quarterly payments of $345, interest at 6.8% and maturing July 2009. Principal reductions due for future years ending December 31 are as follows:

 

2007

   $ 888

2008

     1,257

2009

     1,001
      
   $ 3,146
      

Supervision and Regulation

We are subject to extensive federal and Washington state legislation, regulation, and supervision. These laws and regulations are primarily intended to protect depositors, the FDIC and shareholders. The laws and regulations affecting banks and bank holding companies have changed significantly over recent years, and it is reasonable 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 our business, operations, and prospects. We cannot predict the nature or the extent of the effects on our 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.

Heritage Financial.    We are subject to regulation as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and are 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 Bank Holding Company Act or orders or regulations thereunder in amounts up to $1.0 million per day. The Federal Reserve may order termination of non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties. The FDIC is authorized to exercise comparable authority under the Federal Deposit Insurance Act and other statutes for state nonmember banks such as Heritage Bank and Central Valley Bank.

The Federal Reserve has a policy 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, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being 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

 

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company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Federal Deposit Insurance Act requires an undercapitalized institution to send to the Federal Reserve a capital restoration plan with a guaranty by each company having control of the bank’s compliance with the plan.

We are required to file annual and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and charge us for the cost of the examination.

We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiaries and affiliates are subject to numerous restrictions. With some exceptions, we, and our subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by us, or our 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 stockholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets. Tier II capital includes Tier I capital plus the allowance for loan losses and subordinated debt, both subject to some 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% of risk-adjusted assets.

Subsidiaries.    Heritage Bank and Central Valley Bank are Washington state-chartered commercial banks, the deposits of which are insured by the FDIC. Heritage Bank and Central Valley Bank are subject to regulation by the FDIC and the Division of Banks of the Washington Department of Financial Institutions (“Division”). Although Heritage Bank and Central Valley Bank are not members of the Federal Reserve System, the Federal Reserve has supervisory authority over us and our subsidiary banks.

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 banks are required to file periodic reports with the FDIC and the Division, and are subject to periodic examinations and evaluations by those regulatory authorities. Based upon these evaluations, 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 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 subsidiaries of a bank holding company, our banks are subject to various restrictions in their dealings with us and other companies that may become affiliated with us.

Dividends paid by our subsidiaries provide substantially all of our cash flow. Applicable federal and Washington state regulations restrict capital distributions by our banks, 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 for a “well-capitalized” bank, which affects FDIC risk-based insurance premium rates. 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%. Both Heritage Bank and Central Valley Bank were “well-capitalized” at December 31, 2006.

 

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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 brokered deposits. Adequately capitalized institutions are allowed to solicit brokered deposits, but only to accept them if a waiver is obtained from the FDIC.

Deposit Insurance.    Heritage Bank’s and Central Valley Bank’s deposit accounts are insured by the FDIC under the DIF to the maximum extent permitted by law. Each 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.

Other Regulatory Developments.    Congress has enacted significant federal banking legislation in recent years. The following summarizes some of the recent significant federal banking legislation.

Financial Services Reform Legislation.    On November 12, 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted into law. The GLBA removes various barriers imposed by the Glass-Steagall Act of 1933, specifically those prohibiting banks and bank holding companies from engaging in the securities and insurance business. The GLBA also expands the bank holding company act framework to permit bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become a “financial holding company”.

Beginning March 2000, financial holding companies may engage in a full range of financial activities, including not only banking, insurance, and securities activities, but also merchant banking and additional activities determined to be “financial in nature” or “complementary” to an activity that is financial in nature. The GLBA also provides that the list of permissible financial activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological changes.

The GLBA also expands the activities in which insured state banks may engage. Under the GLBA, insured state banks are given the ability to engage in financial activities through a subsidiary, as long as the bank and its bank affiliates meet and comply with certain requirements. First, the state bank and each of its bank affiliates must be “well capitalized”. Second, the bank must comply with certain capital deduction and financial statement requirements provided under the GLBA. Third, the bank must comply with certain financial and operational safeguards provided under the GLBA. Fourth, the bank must comply with the limits imposed by the GLBA on transactions with affiliates.

USA Patriot Act.    On October 26, 2001, President George W. Bush signed into law the USA Patriot Act (“Patriot Act”). Title III of the Patriot Act concerns money laundering provisions that may affect many community banks. These provisions include:

 

   

The Secretary of the Treasury is authorized to impose special measures, such as recordkeeping or reporting, on domestic financial institutions that are a primary concern;

 

   

Financial institutions with private or correspondent accounts with non-U.S. citizens must establish policies and procedures to detect money laundering through those accounts;

 

   

Financial institutions are barred from maintaining correspondent accounts for foreign shell banks (that is a bank that does not have a physical presence in any country);

 

   

The Secretary of the Treasury is required to prescribe regulations to further encourage cooperation among financial institutions, regulators, and law enforcement agencies and officials to share information about terrorist acts and money laundering activities;

 

   

The Secretary of the Treasury is required to issue regulations to establish minimum procedures for financial institutions to use in verifying customer identity during the account-opening process;

 

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Depository institutions are permitted to provide information to other institutions concerning the possible involvement in potentially unlawful activity by a current or former employee;

 

   

The Secretary of the Treasury is required to establish a secure website to receive suspicious activity reports and currency transaction reports, and provide institutions with alerts and other information regarding suspicious activity that warrant immediate attention; and

 

   

The federal bank regulators are required to consider the anti-money laundering record of each depository institution in evaluating applications under the Bank Merger Act.

Sarbanes-Oxley Act.    On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate wrongdoing that occurred in Enron, WorldCom, and similar companies. The Sarbanes-Oxley Act’s principal legislation includes:

 

   

The creation of an independent accounting oversight board;

 

   

Auditor independence provisions that restrict non-audit services accountants may provide to their audit clients;

 

   

Additional corporate governance and responsibility measures, including the requirement that the chief executive officer and the chief financial officer certify financial statements and the expansion of powers of audit committees;

 

   

Expanded disclosure requirements, including accelerated reporting of stock transactions by insiders;

 

   

Mandatory disclosure by analysts of potential conflicts of interest; and

 

   

A range of enhanced penalties for fraud and other violations.

Website Access to Company Reports

We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website. We have also adopted a Code of Ethics applicable to all officers, directors, and employees, which is posted on our website.

Executive Officers

We have adopted a code of ethics that applies to our principal executive officer, principal financial officer, controller and assistant controller. We have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate Governance. Any waivers of the code of the ethics will be publicly disclosed to shareholders.

Audit Committee of the Board of Directors

The audit committee of our board of directors retains our independent auditors, reviews and approves the scope and results of the audits with the auditors and management, monitors the adequacy of our system of internal controls and reviews the annual report, auditors’ fees and non-audit services to be provided by the independent auditors. The members of our audit committee are Daryl D. Jensen, chair of the committee, Philip S. Weigand, Brian Charneski, Jeffrey Lyon, Peter Fleutsch, John Clees, James Senna, Gary Christensen and Kimberly Ellwanger, all of whom are considered “independent” as defined by the SEC. Our board of directors has determined that Mr. Jensen meets the definition of an audit committee financial expert, as determined by the requirements of the SEC.

 

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Competition

We compete for loans and deposits with other 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 our competitors have substantially greater resources than we do. Particularly in times of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities and other corporate and government securities.

We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees, and the locations of our banks’ branches. We actively solicit deposit-related clients and compete for deposits by offering depositors a variety of savings accounts, checking accounts, cash management and other services.

Employees

We have 233 full-time equivalent employees. We experienced an increase of 22 full-time equivalents during 2006 due to staff increases in the mortgage and lending departments, the opening of the Sumner branch and the acquisition of Western Washington Bancorp. We believe that employees play a vital role in the success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life insurance, a generous retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining agreement.

 

ITEM 1A. RISK FACTORS

The following are certain risks that management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order.

Future loan losses may exceed our allowance for loan losses

We are subject to credit risk, which is the risk of losing principal or interest due to borrowers’ failure to repay loans in accordance with their terms. A downturn in the economy or the real estate market in our market areas or a rapid change in interest rates could have a negative effect on collateral values and borrowers’ ability to repay. This deterioration in economic conditions could result in losses to the Company in excess of loan loss allowances. To the extent loans are not paid timely by borrowers, the loans are placed on non-accrual, thereby reducing interest income. To the extent loan charge-offs exceed our financial models, increased amounts charged to the provision for loan losses would reduce income.

Rapidly changing interest rate environments could reduce our net interest margin, net interest income, fee income and net income

Interest and fees on loans and securities, net of interest paid on deposits and borrowings, are a large part of our net income. Interest rates are key drivers of our net interest margin and subject to many factors beyond the control of management. As interest rates change, net interest income is affected. Rapid increases in interest rates in the future could result in interest expense increasing faster than interest income because of mismatches in financial instrument maturities. Further, substantially higher interest rates generally reduce loan demand and may result in slower loan growth. Decreases or increases in interest rates could have a negative effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore decrease net interest income. See “Quantitative and Qualitative Disclosures about Market Risk.”

Slower than anticipated growth in new branches and new product and service offerings could result in reduced net income

We have placed a strategic emphasis on expanding our branch network and product offerings. Executing this strategy carries risks of slower than anticipated growth both in new branches and new products. New

 

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branches and products require a significant investment of both financial and personnel resources. Lower than expected loan and deposit growth in new investments can decrease anticipated revenues and net income generated by those investments, and opening new branches and introducing new products could result in more additional expenses than anticipated and divert resources from current core operations.

The financial services industry is very competitive

We face competition in attracting and retaining deposits, making loans, and providing other financial services throughout our market area. Our competitors include other community banks, larger banking institutions, and a wide range of other financial institutions such as credit unions, government-sponsored enterprises, mutual fund companies, insurance companies and other non-bank businesses. Many of these competitors have substantially greater resources than us.

Decreased volumes and lower gains on sales and brokering of mortgage loans sold could adversely impact net income

We originate and sell mortgage loans as well as broker mortgage loans. Changes in interest rates affect demand for our loan products and the revenue realized on the sale of loans. A decrease in the volume of loans sold/brokered can decrease our revenues and net income.

Inability to hire or retain certain key professionals, management and staff could adversely affect our revenues and net income

We rely on key personnel to manage and operate our business, including major revenue generating functions such as our loan and deposit portfolios. The loss of key staff may adversely affect our ability to maintain and manage these portfolios effectively, which could negatively effect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

There are no unresolved staff comments from the Securities and Exchange Commission.

 

ITEM 2. PROPERTIES

Our 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 by Heritage Bank and located in downtown Olympia. At December 31, 2006, Heritage Bank had seven offices located in Tacoma and surrounding areas of Pierce County (all but two of which are owned), five offices located in Thurston County (all of which are owned with one office located on leased land), one office in south King County (which is leased) and one office in Shelton, Mason County (which is owned). Central Valley Bank had six offices, five located in Yakima County and one in Kittitas County (all of which are owned with two on leased land).

 

ITEM 3. LEGAL PROCEEDINGS

We, and our banks, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders in the fourth quarter of 2006.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the NASDAQ National Market System® under the symbol HFWA. At December 31, 2006, we had approximately 1,300 stockholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 6,558,206 outstanding shares of common stock. The last reported sales price on February 9, 2007 was $24.99 per share. The following table provides bid information per share of our common stock as reported on the NASDAQ National Market System® for the indicated quarters.

 

     2006 Quarter ended:
     March 31    June 30    September 30    December 31

High

   $ 29.13    $ 29.33    $ 27.77    $ 26.50

Low

   $ 23.80    $ 24.85    $ 25.40    $ 23.98
     2005 Quarter ended:
     March 31    June 30    September 30    December 31

High

   $ 21.43    $ 21.57    $ 24.20    $ 25.02

Low

   $ 19.91    $ 20.22    $ 20.49    $ 22.00

Since our stock offering in January 1998, we have declared quarterly cash dividends. The two most recent fiscal years quarterly cash dividends are listed below:

 

Declared

   Cash
Dividend
per share
   Record Date    Paid

March 24, 2005

   $ 0.167    April 15, 2005    April 28, 2005

June 21, 2005

   $ 0.171    July 15, 2005    July 29, 2005

September 15, 2005

   $ 0.185    October 17, 2005    October 28, 2005

December 15, 2005

   $ 0.190    January 16, 2006    January 30, 2006

March 23, 2006

   $ 0.195    April 17, 2006    April 28, 2006

June 20, 2006

   $ 0.200    July 17, 2006    July 31, 2006

September 21, 2006

   $ 0.205    October 16, 2006    October 31, 2006

December 20, 2006

   $ 0.210    January 15, 2007    January 31, 2007

In addition to the cash dividends, on September 15, 2005, the board of directors of the Company declared a 5% stock dividend to shareholders of record on September 30, 2005 and distributed October 14, 2005. The stock dividend distributed an additional share of common stock for every 20 shares held on the record date. Cash was paid for any fractional shares. All share and per share amounts have been properly restated to reflect the stock dividend.

Dividends to shareholders depend primarily upon the receipt of dividends from our subsidiary banks. The FDIC and the Division have the authority under their supervisory powers to prohibit the payment of dividends by Heritage Bank and Central Valley Bank to us. For a period of ten years after the conversion from mutual to stock ownership, Heritage Bank may not, without prior approval of the Division, declare or pay a cash dividend in excess of one-half of the greater of the Bank’s net income for the current fiscal year or the average of the Bank’s net income for the current fiscal year and the retained earnings of the two prior fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend on its common stock if the effect of the dividend 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 us, and our subsidiary banks to pay dividends on our common stock if our or our banks’ regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

 

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The Company has had various stock repurchase programs since March 1999. In August 2004, the Board of Directors approved a new stock repurchase plan, allowing the Company to repurchase up to 5% of the then outstanding shares, or approximately 309,750 shares over a period of eighteen months. This marked the Company’s eighth stock repurchase plan. On January 25, 2006, the Board of Directors authorized an eighteen month extension to this program. During the quarter ended December 31, 2006, the Company repurchased 22,424 shares at an average price of $24.42. In total, the Company has repurchased 111,139 shares at an average price of $21.56 under this plan.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended December 31, 2006.

 

Period

  Total Number
of Shares
Purchased
  

Average

Price Paid
Per Share

   Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
   Maximum Number of
Shares that May Yet Be
Purchased Under the
Plans or Programs

October 1, 2006 — October 31, 2006

  105    $ 24.24    5,936,786    220,930

November 1, 2006 — November 30, 2006

  319      24.50    5,937,105    220,611

December 1, 2006 — December 31, 2006

  22,000      24.41    5.959,105    198,611
                    

Total

  22,424    $ 24.42    5,959,105    198,611

 

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Stock Performance Graph

The chart shown below depicts total return to stockholders during the period beginning December 31, 2001 and ending December 31, 2006. Total return includes appreciation or depreciation in market value of Heritage common stock as well as actual cash and stock dividends paid to stockholders. Indices shown below, for comparison purposes only, are the Total Return Index for the NASDAQ Stock Market (U.S. Companies), which is a broad nationally recognized index of stock performance by publicly traded companies and the SNL Securities Bank Index which is comprised of publicly traded commercial banks with assets of $500 million to $1 billion. The chart assumes that the value of the investment in Heritage’s common stock and each of the three indices was $100 on December 31, 2001, and that all dividends were reinvested in Heritage stock.

HERITAGE FINANCIAL CORPORATION

LOGO

 

    

Period Ending

Index

   12/31/01    12/31/02    12/31/03    12/31/04    12/31/05    12/31/06

Heritage Financial Corporation

   100.00    154.33    191.47    202.92    242.67    254.20

NASDAQ Composite

   100.00    68.80    103.60    113.10    115.40    127.40

SNL $500M-$1B Bank Index

   100.00    127.67    184.09    208.62    217.57    247.44

* Source: SNL Financial LC, Charlottesville, VA

 

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ITEM 6. SELECTED FINANCIAL DATA

 

     For the years ended December 31,  
     2006     2005     2004     2003     2002  
     (Dollars in thousands, except per share data)  

Operations Data:

          

Net interest income

   $ 35,772     $ 33,881     $ 31,727     $ 29,817     $ 30,203  

Provision for loan losses

     720       810       645       1,125       1,835  

Noninterest income

     7,954       6,630       6,498       7,164       6,181  

Noninterest expense

     27,082       24,183       23,270       22,223       20,254  

Federal income tax expense

     5,377       5,042       4,725       4,729       4,871  

Net income

     10,547       10,476       9,585       8,904       9,424  

Earnings per share

          

Basic

     1.65       1.69       1.53       1.31       1.25  

Diluted

     1.60       1.65       1.49       1.26       1.21  

Dividend payout ratio(1)

     49.1 %     42.0 %     40.4 %     41.6 %     37.4 %

Performance Ratios:

          

Net interest spread

     4.30 %     4.75 %     4.91 %     5.14 %     5.17 %

Net interest margin(2)

     4.83 %     5.08 %     5.13 %     5.40 %     5.53 %

Efficiency ratio(3)

     61.94 %     59.69 %     60.88 %     60.09 %     55.67 %

Return on average assets

     1.33 %     1.46 %     1.44 %     1.49 %     1.58 %

Return on average equity

     14.18 %     16.13 %     15.80 %     13.03 %     12.18 %
     At December 31,  
     2006     2005     2004     2003     2002  

Balance Sheet Data:

          

Total assets

   $ 852,893     $ 751,152     $ 697,267     $ 640,920     $ 594,587  

Loans receivable, net

     739,596       643,538       591,085       512,647       455,277  

Loans held for sale

     —         263       381       1,018       8,113  

Deposits

     725,921       636,504       587,278       541,832       517,116  

Federal Home Loan Bank advances

     37,167       39,900       40,900       31,100       —    

Stockholders’ equity

     78,639       66,120       60,944       62,232       72,397  

Book value per share

   $ 11.99     $ 10.57     $ 9.76     $ 9.57     $ 10.13  

Equity to assets ratio

     9.22 %     8.80 %     8.74 %     9.71 %     12.18 %

Asset Quality Ratios:

          

Nonperforming loans to loans

     0.37 %     0.13 %     0.05 %     0.06 %     0.42 %

Allowance for loan losses to loans

     1.35 %     1.30 %     1.38 %     1.49 %     1.46 %

Allowance for loan losses to nonperforming loans

     360.05 %     1,016.27 %     2,603.60 %     2,611.97 %     346.05 %

Nonperforming assets to total assets

     0.36 %     0.16 %     0.05 %     0.11 %     0.38 %

Other Data:

          

Number of banking offices

     20       18       18       18       18  

Number of full-time equivalent employees

     233       211       196       206       195  

(1) Dividend payout ratio is declared dividends per share (excluding stock dividends) divided by basic earnings per share.
(2) Net interest margin is net interest income divided by average interest earning assets.
(3) The efficiency ratio is recurring noninterest expense divided by the sum of net interest income and noninterest income.

 

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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 with the December 31, 2006 audited consolidated financial statements and notes to those financial statements included in this Form 10-K.

Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and are 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 conditions. Additional information on these and other factors, which could affect our financial results are included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting estimate to be the allowance for loan losses. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio at the balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans. Estimated loss factors are based on subjective measurements including management’s assessment of the internal risk classifications, historical loss experience, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operation or liquidity.

For additional information regarding the allowance for loan losses, its relation to the provision for loans losses, risk related to asset quality and lending activity, see Part I, Item 1 as well as the Management’s Discussion and Analysis of Financial Condition and Results of Operation—Provision for Loan Losses.

Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial banking relationships, market expansion and a continual focus on asset quality. During 2006, we acquired Western Washington Bancorp, Inc. and its wholly-owned subsidiary, Washington State Bank, N.A. Washington State Bank, N.A. was merged into Heritage Bank as of the date of acquisition. This merger is consistent with our growth strategy and provides the opportunity to expand into the south King County market in Washington state.

During the period from 2002 through 2006 our total assets have grown $258.3 million, or 43.4%, with net loans growing $284.3 million during the period. Our emphasis in growing our commercial loan portfolio resulted in an increase in commercial loans of $196.6 million, or 80.6%, since 2002. Overall loan increases have benefited from our emphasis in growing our lending in the Pierce county market.

 

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Deposits increased $208.8 million, or 40.4%, for the period from 2002 through 2006 with an increase in the percentage of non-interest and low interest bearing demand deposits to total deposits. From 2002 to 2006, non-interest demand deposits and NOW accounts increased aggregately from 26.8% of total deposits to 30.3% of total deposits. Our deposit increases are due to our focus on growing our customer base as well as investors continuing to prefer deposit accounts over the stock market. As a whole, while our customers continue to prefer short term deposit products, we are seeing some extension out to two years in certificates. In turn, equity has increased by $6.2 million since December 31, 2002 due to a combination of earnings and issuances of stock partially offset by our stock repurchase programs. Since 1999, we have repurchased 5,959,105 shares totaling $72.7 million. During the period from 2002 through 2006, our annual net income has increased by 11.9% or $1.1 million. The result of these trends have provided our company with an increase in return on average equity from 12.18% for the year ended December 31, 2002 to 14.18% for year ended December 31, 2006.

Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

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 and non-interest bearing liabilities.

 

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The following table provides relevant net interest income information for selected time periods. 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. Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

 

    Years Ended December 31,  
    2006     2005     2004  
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
 
    (Dollars in thousands)  

Interest Earning Assets:

                 

Loans

  $ 690,287   $ 53,239   7.71 %   $ 613,655   $ 43,605   7.11 %   $ 549,444   $ 36,938   6.72 %

Taxable securities

    40,352     1,724   4.27       43,659     1,568   3.59       47,670     1,610   3.38  

Nontaxable securities

    4,586     167   3.64       4,117     149   3.62       3,779     141   3.74  

Interest earning deposits

    2,137     104   4.88       2,899     90   3.09       14,945     177   1.18  

Federal Home Loan Bank stock

    3,163     3   0.10       3,089     16   0.50       3,002     78   2.61  
                                                     

Total interest earning assets

  $ 740,525   $ 55,237   7.46 %   $ 667,419   $ 45,428   6.81 %   $ 618,840   $ 38,944   6.29 %

Noninterest earning assets

    54,694         48,430         46,478    
                             

Total assets

  $ 795,219       $ 715,849       $ 665,318    
                             

Interest Bearing Liabilities:

                 

Certificates of deposit

  $ 307,902   $ 12,902   4.19 %   $ 264,078   $ 7,755   2.94 %   $ 222,279   $ 4,477   2.01 %

Savings accounts

    95,075     1,677   1.76       96,425     993   1.03       104,271     1,094   1.05  

Interest bearing demand and money market accounts

    189,458     3,664   1.93       170,399     1,846   1.08       165,486     1,153   0.70  
                                                     

Total interest bearing deposits

    592,435     18,243   3.08       530,902     10,594   2.00       492,036     6,724   1.37  

FHLB advances and other borrowings

    22,784     1,222   5.36       28,544     953   3.34       30,909     493   1.60  
                                                     

Total interest bearing liabilities

  $ 615,219   $ 19,465   3.16 %   $ 559,446   $ 11,547   2.06 %   $ 522,945   $ 7,217   1.38 %

Demand and other noninterest bearing deposits

    98,567         85,732         76,994    

Other noninterest bearing liabilities

    7,038         5,732         4,708    

Stockholders’ equity

    74,395         64,939         60,671    
                             

Total liabilities and stockholders’ equity

  $ 795,219       $ 715,849       $ 665,318    
                             

Net interest income

    $ 35,772       $ 33,881       $ 31,727  

Net interest spread

      4.30 %       4.75 %       4.91 %

Net interest margin

      4.83 %       5.08 %       5.13 %

Average interest earning assets to average interest bearing liabilities

      120.37 %       119.30 %       118.34 %

 

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The following table provides the amount of change in our 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 for changes due to volume and interest rates.

 

     Years Ended December 31,  
     2006 Compared to 2005
Increase (Decrease) Due to
    2005 Compared to 2004
Increase (Decrease) Due to
 
     Volume     Rate     Total     Volume     Rate     Total  
     (Dollars in thousands)  

Interest Earning Assets:

            

Loans

   $ 5,911     $ 3,723     $ 9,634     $ 4,316     $ 2,351     $ 6,667  

Taxable securities

     (141 )     297       156       (135 )     94       (41 )

Nontaxable securities

     17       1       18       13       (5 )     8  

Interest earning deposits

     (38 )     52       14       (142 )     55       (87 )

Federal Home Loan Bank stock

     —         (13 )     (13 )     2       (65 )     (63 )
                                                

Interest income

   $ 5,749     $ 4,060     $ 9,809     $ 4,054     $ 2,430     $ 6,484  
                                                

Interest bearing liabilities:

            

Certificates of deposit

   $ 1,836     $ 3,311     $ 5,147     $ 842     $ 2,436     $ 3,278  

Savings accounts

     (24 )     708       684       (82 )     (19 )     (101 )

Interest bearing demand and money market accounts

     369       1,449       1,818       34       659       693  
                                                

Total interest bearing deposits

     2,181       5,468       7,649       794       3,076       3,870  

FHLB advances and other borrowings

     (309 )     578       269       (38 )     498       460  
                                                

Interest expense

   $ 1,872     $ 6,046     $ 7,918     $ 756     $ 3,574     $ 4,330  
                                                

Results of Operations for the Years Ended December 31, 2006 and 2005

Net Income.    Our net income was $10.55 million or $1.60 per diluted share for the year ended December 31, 2006 compared to $10.48 million or $1.65 per diluted share for the previous year. The 0.7% increase in actual net income was due to a combination of increased net interest income and non-interest income offset by increased non-interest expense.

Net Interest Income.    Net interest income increased $1.9 million to $35.8 million for the year ended December 31, 2006 compared with the previous year of $33.9 million. The increase in net interest income resulted primarily from average loans increasing greater than average interest bearing deposits.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2006 decreased to 4.83% from 5.08% for the previous year. Our net interest spread for the year ended December 31, 2006 decreased to 4.30% from 4.75% for the prior year. The average rate of interest earning assets increased to 7.46% for the year ended December 31, 2006 from 6.81% for the same period last year while the average cost of funds increased to 3.16% for the year ended December 31, 2006 from 2.06% for the same period last year. Overall, our net interest margin of 4.83% is in line with the median for West Coast publicly traded commercial banks of 4.81% as reported by D.A. Davidson and Companies for the period ending September 30, 2006.

Provision for Loan Losses.    During the year ended December 31, 2006, we provided $720,000 through operations compared to $810,000 for the year ended December 31, 2005. This decrease was due primarily to recoveries in the current year. For the year ended December 31, 2006, we experienced net recoveries of $140,000 compared to net charge-offs of $609,000 for the year ended December 31, 2005. The provision and corresponding net recoveries increased our allowance for loan losses as a percentage of total loans to 1.35% at December 31, 2006 from 1.30% at the end of 2005. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.36% at December 31, 2006, though up from 0.16% at December 31, 2005.

 

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We consider the allowance for loan losses at December 31, 2006 adequate to cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience including those related to our courtesy overdraft programs, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income.    Total noninterest income increased $1,324,000, or 20.0%, for the year ended December 31, 2006 compared with the prior year. Brokered mortgage income increased $471,000 from the prior year while loan sale gains decreased $144,000 from the prior year. This change is due to an increase in the number of mortgage bankers and an increased focus on brokering mortgages as opposed to funding and selling mortgages. Merchant visa income increased $316,000, or 14.0%, due to increased business volumes. Service charges on deposits also increased by $435,000, or 15.4%, due to our continued focus on growing our deposit relationships and the acquisition of Western Washington Bancorp.

Noninterest Expense.    Total noninterest expense increased $2,899,000, or 12.0%, for the year ended 2006 compared to the 2005 period. Salaries and employee benefits increased by $1,780,000 due to an increase in full-time equivalent employees and the effects of stock option compensation as a result of implementing SFAS 123(R) in 2006. The increase in employees was due to the hiring of additional loan officers and additional staff associated with the new Sumner branch and the acquisition of Western Washington Bancorp. The effect of the adoption of SFAS 123(R) on noninterest expense during 2006 was $352,000. Merchant Visa expenses increased by $252,000, or 14.3%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $866,000, or 8.8%, due to the increases in occupancy costs, data processing, marketing, and state and local taxes relating to the new Sumner branch and the acquisition of Western Washington Bancorp.

Results of Operations for the Years Ended December 31, 2005 and 2004

Net Income.    Our net income was $10.5 million or $1.65 per diluted share for the year ended December 31, 2005 compared to $9.6 million or $1.49 per diluted share for the previous year. The 9.3% increase in actual net income was primarily the result of increased loan growth while maintaining a strong net interest margin. 2004 included a fourth quarter after tax gain of $144,000 on the sale of stock held in HCB Bancorp, Inc. Excluding the gain on the sale of HCB Bancorp stock, 2004 net income would have been $9.4 million for an increase this year of 11.0% in actual net income and 12.1% in diluted earnings per share. The net interest margin declined a modest 5 basis points with average earning assets increasing $48.6 million for the year at $667.4 million compared to the previous year’s average of $618.8 million.

Net Interest Income.    Net interest income increased $2.2 million to $33.9 million for the year ended December 31, 2005 compared with the previous year of $31.7 million. The increase in net interest income resulted primarily from strong loan growth and maintenance of the net interest margin above 5.0%.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2005 decreased to 5.08% from 5.13% for the previous year. Our net interest spread for the year ended December 31, 2005 decreased to 4.75% from 4.91% for the prior year. The average rate of interest earning assets increased to 6.81% for the year ended December 31, 2005 from 6.29% for the same period last year while the average cost of funds increased to 2.06% for the year ended December 31, 2005 from 1.38% for the same period last year. Overall, our net interest margin is strong at 5.08% in comparison to the median for West Coast publicly traded commercial banks of 4.88% as reported by D.A. Davidson and Companies for the period ending September 30, 2005.

Provision for Loan Losses.    During the year ended December 31, 2005, we provided $810,000 through operations compared to $645,000 for the year ended December 31, 2004. This increase is necessary due to growth in outstanding loans to maintain our allowance at an adequate level. For the year ended December 31, 2005, we experienced net charge-offs of $609,000 up from $98,000 for the year ended December 31, 2004. The

 

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provision and corresponding net charge-offs decreased our allowance for loan losses as a percentage of total loans to 1.30% at December 31, 2005 from 1.38% at the end of 2004. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.16% at December 31, 2005 even though up from a very low 0.05% at December 31, 2004.

We consider the allowance for loan losses at December 31, 2005 adequate to cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience including those related to our courtesy overdraft programs, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income.    Total noninterest income increased $132,000, or 2.0%, for the year ended December 31, 2005 compared with the prior year. Gain on loan sales decreased $363,000, or 56.7%, over the prior year. Mortgage loans sold during 2005 were $13.6 million versus $35.8 million sold during 2004, a decrease of 62.0%. Merchant visa income increased $348,000, or 18.2%, due to increased business volumes. Service charges on deposits also increased by $263,000 due to our focus on growing our deposit relationships.

Noninterest Expense.    Total noninterest expense increased $913,000, or 3.9%, for the year ended 2005 compared to the 2004 period. Salaries and employee benefits increased by $396,000 primarily due to an increase in full-time equivalent employees. Merchant Visa expenses increased by $261,000, or 17.4%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $256,000, or 2.7%, primarily due to the increases in occupancy costs.

Liquidity and Capital Resources

Our primary sources of funds are deposits, loan repayments, loan sales, interest earned on and proceeds from 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 fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At December 31, 2006, cash and cash equivalents totaled $26.4 million, or 3.1% of total assets. At December 31, 2006, our banks maintained a credit facility with the FHLB of Seattle for $155.3 million of which we borrowed $37.2 million as of December 31, 2006. In addition, we maintain a credit facility with KeyBank of $5.0 million as well as another $5.0 million line to support letters of credit. Our subsidiary banks also maintain advance lines to purchase federal funds totaling $29.8 million as of December 31, 2006.

During 2006 total assets grew $101.7 million with net loans increasing by $96.1 million over the prior year-end and deposits increasing $89.4 million over the prior year-end. Borrowings from the FHLB of Seattle decreased by $2.7 million over the prior year-end. Our strategy has been to acquire core deposits (which we define to include all deposits except public funds) from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers, and use available borrowing capacity to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.

We, and our banks, are subject to various regulatory capital requirements. As of December 31, 2006, we, and our banks were classified as “well capitalized” institutions under the criteria established by the Federal Deposit Insurance Act. Our initial public offering in January of 1998 significantly increased our capital to levels well in excess of regulatory requirements and our internal needs. In 1999, we determined that buying our own shares with some of our excess capital was the best use of this capital and we began to buy back our Company’s

 

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outstanding shares. As of December 31, 2006, we have repurchased 5,959,105 shares of our stock representing 52.3% of the total outstanding as of March 31, 1999 at an average price of $12.20 reducing our capital levels by $72.7 million.

Our capital levels are also modestly impacted by our 401(k) Employee Stock Ownership Plan and Trust (“KSOP”). The Employee Stock Ownership Plan (“ESOP”) purchased 2% of the common stock issued in a January 1998 stock offering and borrowed from the Company 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%. As the debt is repaid, 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, our capital is increased, and the shares become outstanding for earnings per share calculations. For the year ended December 31, 2006, the Company has allocated or committed to be released to the ESOP 9,257 earned shares and has 56,317 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1.40 million at December 31, 2006.

Contractual Obligations

The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2006:

 

     Less than
1 year
  

1-3

years

  

4-5

years

   More than
5 years
   Indeterminate
maturity(1)
   Total
     (Dollars in thousands)

Contractual payments by period:

                 

Deposits

   $ 301,219    $ 24,486    $ 2,272    $ —      $ 397,944    $ 725,921

Long-term debt

     888      2,258      —        —        —        3,146

Operating leases

     532      715      663      1,325      —        3,235

Purchase obligations(2)

     440      —        —        —        —        440
                                         

Total contractual obligations

   $ 303,079    $ 27,459    $ 2,935    $ 1,325    $ 397,944    $ 732,742
                                         

(1) Represents interest-bearing and noninterest-bearing checking, money market and checking accounts.
(2) Represents agreements to purchase goods or services.

Asset/Liability Management

Our primary financial objective is to achieve long term profitability while controlling our exposure to fluctuations in market interest rates. To accomplish this objective, we have 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 we employ to control our interest rate sensitivity are: selling most long term, fixed rate, single-family residential mortgage loan originations; originating commercial loans and residential construction loans at variable interest rates repricing for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is to increase the proportion of noninterest bearing demand deposits, low interest bearing demand deposits, money market accounts, and savings deposits relative to certificates of deposit to reduce our overall cost of funds.

Our asset and liability management strategies have resulted in a positive 0-3 month “gap” of 6.83% and a negative 4-12 month “gap” of 0.68% as of December 31, 2006. These “gaps” measure the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months and 4-12 months) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We believe that the implementation of our operating

 

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strategies has reduced the potential effects of changes in market interest rates on our results of operations. The positive gap for the 0-3 month period indicates that decreases in market interest rates may adversely affect our results over that period.

The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2006 based upon estimates of expected mortgage prepayment rates and deposit run off rates consistent with national trends. We adjusted mortgage loan maturities for loans held for sale by reflecting these loans in the three-month category, which is consistent with their sale in the secondary mortgage market. The amounts in the table are derived from our internal data. We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information 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
months
    4-12
months
   

1-5

years

   

5-15

years

    More than
15 years
    Total
    (Dollars in thousands)

Interest Earnings Assets:

           

Loans

  $ 242,411     $ 111,587     $ 318,942     $ 70,643     $ 8,521     $ 752,104

Investment securities

    24,394       2,118       4,896       4,488       7,086       42,982

FHLB and Federal Reserve Stock

    3,227       —         —         —         —         3,227

Interest earning deposits

    2,673       —         —         —         —         2,718
                                             

Total interest earning assets

  $ 272,705     $ 113,750     $ 323,838     $ 75,131     $ 15,607     $ 801,031
                                             

Interest Bearing Liabilities:

           

Total interest bearing deposits

  $ 179,211     $ 173,170     $ 266,062     $ —       $ —       $ 618,444

FHLB advances and other borrowings

    38,817       737       983       —         —         40,538
                                             

Total interest bearing liabilities

  $ 218,028     $ 173,907     $ 267,045     $ —       $ —       $ 658,982
                                             

Rate sensitivity gap

  $ 54,677     $ (60,157 )   $ 56,793     $ 75,131     $ 15,607     $ 142,049

Cumulative rate sensitivity gap:

           

Amount

    54,677       (5,480 )     51,313       126,444       142,057    

As a percentage of total interest earning assets

    6.83 %     (0.68 )%     6.41 %     15.79 %     17.73 %  
                                         

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 some 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, some assets, such as adjustable rate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, 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 if market interest rates increase substantially.

Impact of Inflation and Changing Prices

Inflation affects our operations by increasing operating costs and indirectly by affecting the operations and cash flow of our customers. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, changes in 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 the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in our interest rate risk profile during the past year, see “Asset/Liability Management” under Management’s Discussion and Analysis of Financial Condition and Results of Operation.

Neither we, nor our banks, maintain a trading account for any class of financial instrument, nor do we, or they, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor our banks, are subject to foreign currency exchange rate risk or commodity price risk.

The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2006. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The expected maturity is the contractual maturity or earlier call date of the instrument. 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 reduction or early withdrawal rates.

 

     By Expected Maturity Date
     Year Ended December 31,
     2007     2008     2009    

2010-

2011

   

After

2011

    Total   

Fair

Value

     (Dollars in thousands)

Investment Securities

               

Amounts maturing:

               

Fixed rate

   $ 5,279     $ 9,279     $ 2,718     $ 1,352     $ 12,829     $ 31,457   

Weighted average interest rate

     4.06 %     3.61 %     4.34 %     3.08 %     4.21 %     

Adjustable Rate

     —         —         —         —         11,525       11,525   

Weighted average interest rate

     —         —         —         —         5.03 %     
                                                     

Totals

     5,279       9,279       2,718       1,352       24,354     $ 42,982    $ 42,985

Loans

               

Amounts maturing:

               

Fixed rate

   $ 47,143     $ 27,497     $ 22,347     $ 36,846     $ 117,137     $ 250,970   

Weighted average interest rate

     7.18 %     6.99 %     6.96 %     7.20 %     6.55 %     

Adjustable rate

     196,833       44,174       29,234       32,033       198,860       501,134   

Weighted average interest rate

     8.83 %     8.19 %     7.07 %     7.30 %     6.81 %     
                                                     

Totals

   $ 243,976     $ 71,671     $ 51,581     $ 68,879     $ 315,997     $ 752,104    $ 744,674

Certificates of Deposit

               

Amounts maturing:

               

Fixed rate

   $ 301,219     $ 19,864     $ 4,622     $ 2,272     $ —       $ 327,977    $ 327,337

Weighted average interest rate

     4.79 %     4.29 %     4.09 %     4.19 %     —         

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

For financial statements, see the Index to Consolidated Financial Statements on page F-1.

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

There were no changes in accountants nor disagreements with our accountants on accounting and financial disclosure.

 

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ITEM 9A. CONTROLS AND PROCEDURES

(i) Disclosure Controls and Procedures.

Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

(ii) Internal Control Over Financial Reporting.

(a) Management’s report on internal control over financial reporting.

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to our management and the board of directors regarding the preparation and fair presentation of published financial statements. Nonetheless, all internal control systems, no matter how well designed, have inherent limitations. Even systems determined to be effective as of a particular date can provide only reasonable assurance with respect to financial statement preparation and presentation and may not eliminate the need for restatements.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of December 31, 2006, the Company’s internal control over financial reporting is effective based on those criteria.

 

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The Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, as stated in their report following.

(b) Attestation report of the registered public accounting firm.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting that Heritage Financial Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries as of December 31, 2006 and 2005, 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 December 31, 2006, and our report dated March 5, 2007 expressed an unqualified opinion on those consolidated financial statements. Our report refers to the Company’s adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006.

/s/    KPMG LLP

Seattle, Washington

March 5, 2007

 

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(c) Changes in internal control over financial reporting.

There were no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

ITEM 9B. OTHER INFORMATION.

None.

 

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PART III

 

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information concerning directors of the registrant is incorporated by reference to the section entitled “Election of Directors” of our definitive Proxy Statement expected to be dated March 22, 2007 (“Proxy Statement”) for the annual meeting of shareholders to be held April 26, 2007.

The required information with respect to our executive officers is incorporated 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 by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement.

 

ITEM 11. EXECUTIVE COMPENSATION

Information concerning executive and director compensation and certain matters regarding participation in the Company’s compensation committee required by this item is set forth under the headings “Executive Compensation”, “Director Compensation”, and “Compensation Committee Report” of the Proxy Statement, which is incorporated as part of this document by reference.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table summarizes the consolidated activity within stock option plans 1994, 1997, 1998, 2002 and 2006 as of December 31, 2006, all of which were approved by stockholders.

 

Number of securities to be issued upon exercise of outstanding options and awards

     717,936

Weighted average exercise price of outstanding options

   $ 18.79

Number of securities remaining available for future issuance

     508,375

For information concerning security ownership of certain beneficial owners and management, see “Stock Ownership” of the Proxy Statement, which is incorporated as part of this document 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 as part of this document by reference.

 

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

For information concerning principal accounting fees and services, see “Relationship with Independent Public Accountants” of the Proxy Statement, which is incorporated as part of this document by reference.

 

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PART IV

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)(1) The consolidated financial statements are contained as listed on the “Index to Consolidated Financial Statements” on page F-1.

(2) All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or notes.

(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)

10.5    

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)

10.7    

Employment Agreement between the Company and Michael Broadhead, effective September 28, 1998(4)

10.8    

Employment Agreement between the Company and Brian L. Vance, effective October 1, 2006(9)

10.10  

2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(5)

10.11  

Revised Employment Agreement between the Company and Donald V. Rhodes, effective January 1, 2005(7)

10.12  

2006 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(8)

14.0    

Code of Ethics(6)

21.0    

Subsidiaries of the Company

23.0    

Consent of Independent Registered Public Accounting Firm

24.0    

Power of Attorney

31.0    

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.0    

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
  (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 Registration Statement on Form S-8 (Reg. No. 333-71415).

 

  (3) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).

 

  (4) Incorporated by reference to the Registration Statement on Form S-4 dated January 20, 1999.(5) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).

 

  (6) Incorporated by reference to the Annual Report on Form 10-K dated March 8, 2004.

 

  (7) Incorporated by reference to the Quarterly Report on Form 10-Q dated November 2, 2004.

 

  (8) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-134473; 333-134474; 333-134475).

 

  (9) Incorporated by reference to the Current Report on Form 8-K dated October 4, 2006.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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, on the 5th day of March, 2007.

 

HERITAGE FINANCIAL CORPORATION

(Registrant)

By  

/s/    BRIAN L. VANCE        

  Brian L. Vance
  President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 5th day of March, 2007.

 

Principal Executive Officer:   

/s/    BRIAN L. VANCE        

Brian L. Vance

  

President and Chief Executive Officer

Principal Financial Officer:   

/s/    EDWARD D. CAMERON        

Edward D. Cameron

  

Executive Vice President and Chief Financial Officer

Remaining Directors:

*Brian S. Charneski

*Gary B. Christensen

*John A. Clees

*Kimberly T. Ellwanger

*Peter N. Fluetsch

*Daryl D. Jensen

*Jeffrey S. Lyon

*Donald V. Rhodes

*James P. Senna

*Philip S. Weigand

 

*By

 

/s/    BRIAN L. VANCE        

  Brian L. Vance
  Attorney-in-Fact

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2006, 2005, and 2004

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Statements of Financial Condition—December 31, 2006 and December 31, 2005

   F-3

Consolidated Statements of Income—Years ended December 31, 2006, 2005, and 2004

   F-4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income—Years ended December 31, 2006, 2005, and 2004

  

F-5

Consolidated Statements of Cash Flows—Years ended December 31, 2006, 2005, and 2004

   F-6

Notes to Consolidated Financial Statements

   F-7

 

F-1


Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (the Company) as of December 31, 2006 and 2005, 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 December 31, 2006. These consolidated financial statements are the responsibility of the Company’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 the standards of the Public Company Accounting Oversight Board (United States). 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 financial position of Heritage Financial Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 of the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Heritage Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 5, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

Seattle, Washington

March 5, 2007

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2006 and 2005

(Dollars in thousands)

 

     2006     2005  
A S S E T S     

Cash on hand and in banks

   $ 23,713     $ 24,972  

Interest earning deposits

     2,718       3,030  

Investment securities available for sale

     39,124       41,856  

Investment securities held to maturity (market value of $3,861 and $3,962)

     3,858       3,966  

Loans held for sale

     —         263  

Loans receivable

     749,701       652,034  

Less: Allowance for loan losses

     (10,105 )     (8,496 )
                

Loans receivable, net

     739,596       643,538  

Real estate owned

     225       371  

Premises and equipment, net

     15,681       15,801  

Federal Home Loan Bank and Federal Reserve stock, at cost

     3,227       3,072  

Accrued interest receivable

     4,298       3,566  

Prepaid expenses and other assets

     4,550       2,811  

Deferred Federal income taxes, net

     2,242       1,266  

Intangible assets, net

     580       —    

Goodwill

     13,081       6,640  
                
   $ 852,893     $ 751,152  
                
L I A B I L I T I E S   A N D  S T O C K H O L D E R S’  E Q U I T Y     

Deposits

   $ 725,921     $ 636,504  

Advances from Federal Home Loan Bank

     37,167       39,900  

Other borrowings

     3,371       —    

Accrued expenses and other liabilities

     7,795       8,628  
                

Total liabilties

     774,254       685,032  
                

Stockholders’ equity:

    

Common stock, no par, 15,000,000 shares authorized; 6,558,206 and 6,252,689 shares outstanding at December 31, 2006 and 2005, respectively

     24,053       17,606  

Unearned compensation—ESOP and other

     (535 )     (1,151 )

Retained earnings, substantially restricted

     55,647       50,347  

Accumulated other comprehensive loss, net

     (526 )     (682 )
                

Total stockholders’ equity

     78,639       66,120  

Commitments and Contingencies

     —         —    
                
   $ 852,893     $ 751,152  
                

See accompanying notes to consolidated financial statements.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31, 2006, 2005 and 2004

(Dollars in thousands, except per share amounts)

 

     2006    2005    2004

Interest income:

        

Interest and fees on loans

   $ 53,239    $ 43,605    $ 36,938

Taxable interest on investment securities

     1,724      1,568      1,610

Nontaxable interest on investment securities

     167      149      141

Interest on federal funds sold and interest earning deposits

     104      90      177

Dividends on Federal Home Loan Bank stock

     3      16      78
                    

Total interest income

     55,237      45,428      38,944
                    

Interest expense:

        

Deposits

     18,243      10,594      6,724

Other borrowings

     1,222      953      493
                    

Total interest expense

     19,465      11,547      7,217
                    

Net interest income

     35,772      33,881      31,727

Provision for loan losses

     720      810      645
                    

Net interest income after provision for loan losses

     35,052      33,071      31,082
                    

Noninterest income:

        

Gains on sales of loans, net

     133      277      640

Brokered mortgage income

     661      190      96

Service charges on deposits

     3,254      2,819      2,556

Rental income

     321      309      294

Merchant visa income

     2,579      2,263      1,915

Other income

     1,006      772      997
                    

Total noninterest income

     7,954      6,630      6,498
                    

Noninterest expense:

        

Salaries and employee benefits

     14,398      12,618      12,222

Occupancy and equipment

     4,063      3,906      3,746

Data processing

     1,386      1,204      1,252

Marketing

     604      494      423

Office supplies and printing

     452      410      383

Merchant visa

     2,015      1,763      1,502

Professional Services

     722      662      645

State and Local Taxes

     810      699      641

Other

     2,632      2,427      2,456
                    

Total noninterest expense

     27,082      24,183      23,270
                    

Income before Federal income tax expense

     15,924      15,518      14,310

Federal income tax expense

     5,377      5,042      4,725
                    

Net income

   $ 10,547    $ 10,476    $ 9,585
                    

Basic earnings per common share

   $ 1.65    $ 1.69    $ 1.53

Basic weighted average shares outstanding

     6,375,059      6,189,497      6,248,418

Diluted earnings per common share

   $ 1.60    $ 1.65    $ 1.49

Diluted weighted average shares outstanding

     6,589,381      6,363,002      6,429,532

See accompanying notes to consolidated financial statements.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

For the years ended December 31, 2006, 2005 and 2004

(Dollars and shares in thousands)

 

     Number of
common
shares
    Common
stock
    Unearned
compensation—
ESOP and
Restricted Stock
Awards
    Retained
earnings
    Accumulated
other
comprehensive
income (loss), net
   

Total

stock-
holders’
equity

 

Balance at December 31, 2003

   6,193     $ 18,430     $ (1,087 )   $ 44,849     $ 40     $ 62,232  

Restricted stock awards granted

   25       598       (598 )     —         —         —    

Earned ESOP, incentive stock options and restricted stock shares

   9       93       306       —         —         399  

Exercise of stock options (including tax benefits from nonqualified stock options

   123       1,069       —         —         —         1,069  

Stock repurchased

   (403 )     (8,307 )     —         —         —         (8,307 )

Net income

   —         —         —         9,585       —         9,585  

Change in fair value of securities available for sale, net of taxes

   —         —         —         —         (257 )     (257 )

Cash dividends declared ($.62/share cumulative)

   —         —         —         (3,777 )     —         (3,777 )
                                              

Balance at December 31, 2004

   5,947     $ 11,883     $ (1,379 )   $ 50,657     $ (217 )   $ 60,944  

Restricted stock awards granted

   2       61       (61 )     —         —         —    

Earned ESOP, incentive stock options and restricted stock shares

   9       113       289       —         —         402  

Exercise of stock options (including tax benefits from nonqualified stock options

   71       839       —         —         —         839  

Stock repurchased

   (73 )     (1,606 )     —         —         —         (1,606 )

Net income

   —         —         —         10,476       —         10,476  

Change fair value of securities available for sale, net of taxes

   —         —         —         —         (465 )     (465 )

5% stock dividend

   297       6,316       —         (6,316 )     —         —    

Cash dividends declared ($.71/share cumulative)

   —         —         —         (4,470 )     —         (4,470 )
                                              

Balance at December 31, 2005

   6,253     $ 17,606     $ (1,151 )   $ 50,347     $ (682 )   $ 66,120  

Elimination of unearned compensation—restricted stock awards

   —         (527 )     527       —         —         —    

Restricted stock awards granted

   16       —         —         —         —         —    

Restricted stock awards cancelled

   (1 )     —         —         —         —         —    

Stock option compensation expense

   —         352       —         —         —         352  

Earned ESOP and restricted stock shares

   9       433       89       —         —         522  

Exercise of stock options (including tax benefits from nonqualified stock options)

   74       1,115       —         —         —         1,115  

Stock repurchased

   (24 )     (588 )     —         —         —         (588 )

Acquisition of Western Washington Bancorp

   231       5,662       —         —         —         5,662  

Net income

   —         —         —         10,547       —         10,547  

Change in fair value of securities available for sale, net of taxes

   —         —         —         —         156       156  

Cash dividends declared ($.81/share cumulative)

   —         —         —         (5,247 )     —         (5,247 )
                                              

Balance at December 31, 2006

   6,558     $ 24,053     $ (535 )   $ 55,647     $ (526 )   $ 78,639  
                                              

 

Comprehensive Income

   2006    2005     2004  

Net income

   $ 10,547    $ 10,476     $ 9,585  

Change in fair value of securities available for sale, net of tax of $84, ($248), and ($132)

     156      (465 )     (257 )
                       

Comprehensive income

   $ 10,703    $ 10,011     $ 9,328  
                       

See accompanying notes to consolidated financial statements.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31, 2006, 2005 and 2004

(Dollars in thousands)

 

     2006     2005     2004  

Cash flows from operating activities:

      

Net income

   $ 10,547     $ 10,476     $ 9,585  

Adjustments to reconcile net income to net cash provided by operating activities:

      

Depreciation and amortization

     1,641       1,770       1,708  

Deferred loan fees, net of amortization

     467       93       324  

Provision for loan losses

     720       810       645  

Federal Home Loan Bank stock dividends

     —         (16 )     (79 )

Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities

     (2,941 )     (212 )     2,705  

Recognition of compensation related to ESOP shares and restricted stock awards

     504       402       399  

Stock option compensation expense

     352       —         —    

Tax benefit realized from stock options exercised and dividends on restricted stock awards

     (149 )     —         —    

Amortization of intangible assets

     46       —         —    

Gain on sale of investment securities available for sale

     —         —         (218 )

Gain on sale of premises and equipment

     (71 )     (8 )     (7 )

Gain on sale of other real estate owned

     (14 )     (7 )     (73 )

Gain on sale of loans

     (133 )     (277 )     (640 )

Origination of loans held for sale

     (8,593 )     (13,514 )     (35,185 )

Proceeds from sale of loans

     8,989       13,909       36,462  

Deferred Federal income tax benefit

     (834 )     (207 )     (254 )

Purchase of Federal Home Loan Bank and Federal Reserve Bank stock

     —         (109 )     —    

Proceeds from sale of Federal Home Loan Bank and Federal Reserve Bank stock

     —         91       3  
                        

Net cash provided by operating activities

     10,531       13,201       15,375  
                        

Cash flows from investing activities:

      

Loans originated, net of principal payments

     (56,551 )     (53,903 )     (79,309 )

Purchase of Western Washington Bancorp, net of cash acquired

     (2,031 )     —         —    

Proceeds from other real estate owned

     430       183       571  

Maturities of investment securities available for sale

     6,884       6,781       26,829  

Sales of investment securities available for sale

     2,248       —         243  

Maturities of investment securities held to maturity

     503       638       691  

Purchase of investment securities available for sale

     (1,237 )     (3,421 )     (17,643 )

Purchase of investment securities held to maturity

     (415 )     (3,146 )     —    

Proceeds from redemption of Federal Reserve Bank stock

     141       —         —    

Purchase of premises and equipment

     (1,516 )     (738 )     (1,158 )

Proceeds from sale of premises and equipment

     146       13       11  
                        

Net cash used in investing activities

     (51,398 )     (53,593 )     (69,765 )
                        

Cash flows from financing activities:

      

Net increase in deposits

     45,135       49,226       45,446  

Net increase (decrease) in borrowed funds

     (4,461 )     (1,000 )     9,800  

Proceeds from issuance of long-term debt

     3,700       —         —    

Repayments of long-term debt

     (554 )     —         —    

Cash dividends paid

     (5,069 )     (4,291 )     (3,744 )

Exercise of stock options

     984       726       1,008  

Tax benefit realized from stock options exercised and dividends on restricted stock awards

     149       —         —    

Repurchase of common stock

     (588 )     (1,606 )     (8,307 )
                        

Net cash provided by financing activities

     39,296       43,055       44,203  
                        

Net increase (decrease) in cash and cash equivalents

     (1,571 )     2,663       (10,187 )

Cash and cash equivalents at beginning of year

     28,002       25,339       35,526  
                        

Cash and cash equivalents at end of year

   $ 26,431     $ 28,002     $ 25,339  
                        

Supplemental disclosures of cash flow information:

      

Cash payments for:

      

Interest expense

   $ 19,119     $ 11,217     $ 6,902  

Federal income taxes

     6,376       5,126       4,583  

Supplemental disclosure of noncash investing and financing activities:

      

Loans transferred to real estate owned

   $ 45     $ 547     $ 39  

Elimination of unearned compensation—restricted stock awards

     527       —         —    

Stock dividend

     —         6,316       —    

Tax benefit from nonqualified stock options

     —         113       61  

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share amounts)

 

(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 is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries: Heritage Bank and Central Valley Bank. Heritage Bank is a Washington-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Deposit Insurance Fund (DIF). Heritage Bank conducts business from its main office in Olympia, Washington and its twelve branch offices located in Thurston, Pierce and Mason Counties. Central Valley Bank is a Washington-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Deposit Insurance Fund (DIF). Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

The Company’s business consists primarily of lending and deposit relationships with small businesses including agribusiness 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 and central Washington. The Company also makes residential construction loans, income property loans and consumer loans.

(b) Basis of Presentation

The accounting and reporting policies of the Company and its subsidiaries conform to U.S. generally accepted accounting principles. 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 reporting periods. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Actual results could differ from these estimates.

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. 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.

(c) Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks, interest bearing deposits, and federal funds sold.

The Company is required to maintain an average reserve balance with the Federal Reserve Bank in the form of cash. For the years ended December 31, 2006 and 2005 the Company maintained adequate levels of cash to meet the Federal Reserve Bank requirement.

(d) Investment Securities

The Company identifies investments as held to maturity or available for sale at the time of acquisition. Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

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 in other comprehensive income. Realized gains and losses on sale are computed on the specific identification method.

A decline in the market value of any available for sale or held to maturity security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value, a charge to earnings and an establishment of a new cost basis for the security. Unrealized investment securities losses are evaluated at least quarterly to determine whether such declines in value should be considered “other than temporary” and therefore be subject to immediate loss recognition in income. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and the Company has the intent and ability to hold the security for a sufficient time to recover the carrying value. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer, and the Company has the intent and ability to hold the security for a sufficient time to recover the carrying value. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is “other than temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts.

(e) Loans Receivable and Loans Held for Sale

Loans are generally recorded at their outstanding principal balance adjusted for charge-offs, the allowance for loan losses and deferred fees or any costs on originated loans. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is doubtful.

All interest accrued but not collected on loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Discounts and premiums on purchased loans are amortized using the effective interest method over the remaining contractual lives, 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, or when such decision is made. Unrealized losses on such loans are included in income.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

(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 effective 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

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, historical loss considerations, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations.

(h) Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amounts of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment purposes.

(i) Mortgage Banking Operations

The Company sells mortgage loans on a servicing released basis and recognizes a cash 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

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

the net book value at the time of sale. Income from mortgage loans brokered to other lenders is recognized into income on date of loan closing.

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 a result, management believes that market risk is minimal.

Loan servicing income is recorded when earned. Loan servicing costs are charged to expense as incurred.

(j) Real Estate and Other Assets Owned

Real estate and other assets acquired by the Company in satisfaction of debt are held for sale and recorded at fair value at time of foreclosure and are carried at the lower of the new cost basis or fair value less estimated costs to sell.

(k) Premises and Equipment

Premises and equipment, including leasehold improvements, 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 or the lease period, whichever is shorter. The estimated useful lives used to compute depreciation and amortization for buildings and building improvements is 15 to 39 years; and for furniture, fixtures and equipment is 3 to 7 years. The Company reviews buildings, leasehold improvements and equipment for impairment whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.

(l) Goodwill

Goodwill represents the costs in excess of net assets acquired arising from the purchases of North Pacific Bank and Western Washington Bancorp. Goodwill is not amortized, but is reviewed for impairment and written down and charged to income during the periods in which the recorded value is more than its implied value. The Company evaluates any potential impairment of goodwill on an annual basis at the Heritage Bank level. The Company has evaluated goodwill and concluded there is no goodwill impairment for the years ended December 31, 2006, 2005 or 2004.

(m) Intangible Assets

The intangible assets represent the core deposit intangible arising from the purchase of Western Washington Bancorp. The core deposit intangible is being amortized to non-interest expense on a straight-line basis over 8 years. Amortization expense related to the core deposit intangible was $46,000 for the year ended December 31, 2006.

(n) Federal Income Taxes

The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

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 periods 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.

(o) Employee Stock Ownership Plan

The Company sponsors an Employee Stock Ownership Plan (ESOP). The ESOP purchased 2% of the common stock issued in a 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%. As the debt is repaid, 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.

(p) Share Based Payment

The Company maintains a number of stock-based incentive programs, which are discussed in more detail in Note 13. Prior to 2006, the Company applied the intrinsic value-based method, as outlined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) and related interpretations, in accounting for stock options granted under these programs. Under the intrinsic value-based method, no compensation expense was recognized if the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of the grant. Accordingly, prior to 2006, no compensation cost was recognized in the accompanying consolidated statements of income on stock options granted to employees, since all options granted under the Company’s share incentive programs had an exercise price equal to the market value of the underlying common stock on the date of the grant.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-based Payment.” This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB No. 25. SFAS No. 123R requires that all stock-based compensation be recognized as an expense in the financial statements and that such cost be measured at the fair value of the award on the grant date. This statement was adopted using the modified prospective method of application, which requires the Company to recognize compensation expense on a prospective basis. Therefore, prior period financial statements have not been restated. Under this method, in addition to reflecting compensation expense for new share-based awards, expense is also recognized to reflect the remaining service period of awards that had been included in pro forma disclosures in prior periods.

Total stock-based compensation expense (excluding ESOP expense) for the year ended December 31, 2006 was $611,000 ($502,000 after tax), or $0.08 for basic and diluted earnings per share. Included in this expense is $352,000 ($334,000 after tax), or $0.05 for basic and diluted earnings per share attributable to the Company’s adoption of SFAS 123R. As of December 31, 2006, the total unrecognized compensation expense related to non-vested stock awards was $686,000 and the related weighted average period over which it is expected to be recognized is approximately 1.8 years.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

The following table illustrates the effect on net income and earnings per share as if SFAS 123R had been applied to all outstanding awards for the years ended December 31 (dollars in thousands, except per share amounts):

 

     2005     2004  

Net income:

    

As reported

   $ 10,476     $ 9,585  

Plus compensation costs recognized under ABP No. 25, net of taxes

     135       143  

Less SFAS No. 123R compensation costs, net of taxes

     (392 )     (325 )
                

Pro forma

   $ 10,219     $ 9,403  
                

Basic earnings per share:

    

As reported

   $ 1.69     $ 1.53  

Plus compensation costs recognized under ABP No. 25, net of taxes

     0.02       0.02  

Less SFAS No. 123R compensation costs, net of taxes

     (0.06 )     (0.05 )
                

Pro forma

   $ 1.65     $ 1.50  
                

Diluted earnings per share:

    

As reported

   $ 1.65     $ 1.49  

Plus compensation costs recognized under ABP No. 25, net of taxes

     0.02       0.02  

Less SFAS No. 123 compensation costs, net of taxes

     (0.06 )     (0.05 )
                

Pro forma

   $ 1.61     $ 1.46  
                

The fair value of options granted during the year ended December 31, 2006, 2005 and 2004 is estimated on the date of grant using the Black-Scholes option pricing model based on the assumptions noted in the following table. The expected term of share options is derived from historical data and represents the period of time that share options granted are expected to be outstanding. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on historical volatility of Company shares. Expected dividend yield is based on dividends expected to be paid during the expected term of the share options.

 

Grant period ended

   Weighted
Average
Risk Free
Interest Rate
    Expected
Term in
years
   Expected
Volatility
    Expected
Dividend
Yield
    Weighted
Average Fair
Value

December 31, 2006

   4.93 %   4.50    20 %   3.69 %   $ 4.17

December 31, 2005

   3.91 %   6.00    20 %   4.32 %   $ 2.87

December 31, 2004

   2.99 %   6.00    20 %   4.31 %   $ 2.45

(q) Recently Issued Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainties in Income Taxes, an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company is currently assessing the impact of adopting the new pronouncement, which will become effective January 1, 2007, but it is not expected to have a material impact.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under Generally Accepted Accounting Principles (“GAAP”),

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Management is assessing the impact of adoption of SFAS 157 on the Company’s consolidated financial statements.

 

(2) Loans Receivable and Loans Held for Sale

Loans receivable and loans held for sale at December 31, 2006 and 2005 consist of the following:

 

     2006     2005  

Commercial loans

   $ 440,450     $ 359,808  

Real estate mortgages:

    

One to four family residential

     58,911       53,098  

Five or more family residential and commercial real estate

     172,937       164,788  
                

Total real estate mortgage

     231,848       217,886  

Real estate construction:

    

One to four family residential

     53,298       42,245  

Five or more family residential and commercial real estate

     13,532       21,355  
                

Total real estate construction

     66,830       63,600  

Consumer

     12,976       12,855  
                

Subtotal

     752,104       654,149  

Deferred loan fees and other

     (2,403 )     (1,852 )
                

Total loans receivable and loans held for sale

   $ 749,701     $ 652,297  
                

As of December 31, 2006 and 2005, the Company had loans to persons serving as Directors and Executive Officers, and entities related to such individuals, aggregating $16,401 and $15,620, respectively. All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and did not involve more than the normal risk of collectibility. The Company did not have any borrowings from Directors or Executive Officers at December 31, 2006.

Potential problem loans as of December 31, 2006 and 2005 were $5,509 and $9,882, respectively. Potential problem loans are those loans that are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes concern as to their ability to comply with the present repayment program and could result in placing the loan on nonaccrual.

Accrued interest on loans receivable amounted to $4,027 and $3,322 as of December 31, 2006 and 2005, respectively. The Company had $2,807 and $836 of impaired loans, which were nonaccruing as of December 31, 2006 and 2005, respectively. The annual average balance of impaired loans for the years ended December 31, 2006, 2005 and 2004 were $2,226, $658 and $433, respectively. The allowance for loan losses related to impaired loans at December 31, 2006 and 2005 totaled $494 and $125, respectively. There was no interest recognized on impaired loans for the year ended December 31, 2006 and 2005. Interest recognized on impaired loans for the year ended December 31, 2004 totaled $23.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

Details of certain mortgage banking activities at December 31, 2006 and 2005 are as follows:

 

     2006    2005

Loans held for sale at lower of cost or market

   $ —      $ 263

Loans serviced for others

     452      658

Total loans sold

     8,856      13,632

Commitments to sell mortgage loans

     —        563

Commitments to fund mortgage loans (at interest rates approximating market rates)

     

Fixed rate

     —        92

Variable or adjustable rate

     —        —  

Servicing fee income from mortgage loans serviced for others amounted to $2, $4 and $10 for the years ended December 31, 2006, 2005 and 2004, respectively.

As of December 31, 2006, the Company had commitments of $102,368 in other commercial lines of credit, $101,287 in real estate commitments (both construction and lines of credit), and $6,275 in other commitments (including consumer credit lines and letters of credit).

 

(3) Allowance for Loan Losses

Activity in the allowance for loan losses is summarized as follows for the years ended December 31:

 

     2006     2005     2004  

Balance at beginning of period

   $ 8,496     $ 8,295     $ 7,748  

Provision

     720       810       645  

Allowance acquired through acquisition

     749       —         —    

Recoveries

     304       82       11  

Charge offs

     (164 )     (691 )     (109 )
                        

Balance at end of period

   $ 10,105     $ 8,496     $ 8,295  
                        

The allocation of the allowance for loan losses is summarized as follows for the years ended December 31:

 

    2006     2005     2004  
    Amount   % of
Total
Loans
(1)
    Amount    % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
 
    (Dollars in thousands)  

Commercial

  $ 7,273   58.6 %   $ 6,117    55.0 %   $ 5,971   55.9 %

Real Estate Mortgage

            

One-four family residential

    398   7.8 %     335    8.1 %     327   9.8 %

Five or more family residential and commercial properties

    1,708   23.0 %     1,435    25.2 %     1,402   25.4 %

Real Estate Construction:

            

One-four family residential

    547   7.1 %     460    6.4 %     449   3.9 %

Five or more family residential and commercial properties

    41   1.8 %     34    3.3 %     34   2.8 %

Consumer

    138   1.7 %     115    2.0 %     112   2.2 %
                                    

Total allowance

  $ 10,105   100.0 %   $ 8,496    100.0 %   $ 8,295   100.0 %
                                    

(1) Represents the total of all outstanding loans in each category as a percent of total loans outstanding.

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

(4) Investment Securities Available For Sale

The amortized cost and fair values of investment securities available for sale at the dates indicated are as follows:

 

    

Amortized

cost

   Gross
unrealized
gains
   Gross
unrealized
losses
    Fair
value

December 31, 2006

          

U.S. Government agencies

   $ 18,539    $ 27    $ (224 )   $ 18,342

Mortgage backed and related securities:

          

Collateralized mortgage obligations and mortgage backed securities

     10,390      12      (325 )     10,077

Other related securities

     11,003      —        (298 )     10,705
                            

Totals

   $ 39,932    $ 39    $ (847 )   $ 39,124
                            

December 31, 2005

          

U.S. Government agencies

   $ 19,797    $ 12    $ (393 )   $ 19,416

Mortgage backed and related securities:

          

Collateralized mortgage obligations and mortgage backed securities

     12,105      22      (414 )     11,713

Other related securities

     11,003      —        (276 )     10,727
                            

Totals

   $ 42,905    $ 34    $ (1,083 )   $ 41,856
                            

Investments with unrealized losses as of December 31, 2006 are as follows:

 

     Less than 12 months   

12 months or

longer

   Total
     Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

U.S. Government agencies

   $ 815    $ 1    $ 14,170    $ 233    $ 14,985    $ 234

Mortgage backed and related securities

     730      8      20,366      630      21,096      638
                                         

Total temporarily impaired securities

   $ 1,545    $ 9    $ 34,536    $ 863    $ 36,081    $ 872
                                         

Investments with unrealized losses as of December 31, 2005 are as follows:

 

     Less than 12 months   

12 months or

longer

   Total
     Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

U.S. Government agencies

   $ 2,900    $ 32    $ 15,870    $ 375    $ 18,770    $ 407

Mortgage backed and related securities

     5,268      126      17,594      583      22,862      709
                                         

Total temporarily impaired securities

   $ 8,168    $ 158    $ 33,464    $ 958    $ 41,632    $ 1,116
                                         

 

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