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Taking stock in South Sound
Heritage banks on community Longtime South Sound institution fares well CHRIS CLOUGH, THE OLYMPIAN Originally published October 7, 2001
OLYMPIA -- Heritage Financial Corp.'s roots in South Sound date back to 1927.
Before the great stock market crash of 1929, before the Depression, before industry regulations were put in place to better protect consumers' money.
Back then, banks were a place to store cash, jewelry and gold, and Heritage was known as Thurston County Federal Savings & Loan. Banks made money loaning out assets, while trying to keep enough on hand for when people wanted to withdraw their money.
Banking before 1920 was not an overly complicated industry.
"In the old West, people could hang out their shingle and simply become a bank," said Donald Rhodes, chairman, president and CEO of Heritage Financial.
Times have changed, of course.
Today, Heritage boasts assets of about $586 million and last week declared a cash dividend of 10.5 cent per share, the 15th consecutive quarterly dividend since the company went public in January 1998.
Banks must meet strict government regulations regarding how much cash they keep on hand. There are accounting standards, a federal bank support network to provide stability and an array of customer services, including Internet banking.
But the basic business model remains much the same.
Banks, including Heritage Financial, earn profits loaning out their assets at a higher interest rate then they pay for access to the money, whether it's from depositors or the government.
Success for Heritage is two-pronged -- it's about assets and how assets are used.
A new strategy
Since 1927, Heritage has gone through several stages as a financial institution -- from a federal savings and loan, mutual savings bank, mutual holding company and finally a publicly traded corporation.
The company employs about 195 people while operating 12 Heritage Bank branches in South Sound and six Central Valley Bank branches in Eastern Washington. Its headquarters are in a four-story building that overlooks Capitol Lake and Heritage Park in downtown Olympia.
Along the way, 1994 was a crucial year for Heritage.
Rhodes, who came on board in 1989, and the board of directors decided to embark on a new strategy for what had been a thrift-style institution that relied almost entirely on mortgage lending.
"Primarily we wanted to diversify the services we provided beyond just real estate lending," Rhodes said. "Which, in turn, diversified revenue sources for the company."
To broaden its services, the strategy called for a conversion from a mutual bank to a publicly traded company -- with commercial lending becoming an equal priority to residential lending.
Rhodes said residential lending is more cyclical and that adding more commercial lending could smooth out pronounced downturns.
"By doing both, we are able to lower our dependence on any one type of lending," he said.
Do the two-step
Heritage entered into a two-step conversion that would lead to an initial public offering in January 1998. Several other Washington banks, including Banner Bank in Walla Walla and Riverview Community Bank in Camas, have gone through the same conversion process.
In 1994, Heritage made the conversion's first step -- moving from a mutual savings bank to a mutual holding company.
As a mutual savings bank, Heritage was, in a sense, owned by the depositors.
Changing to a mutual holding company allowed Heritage to issue stock.
"We always felt it was appropriate to convert to full stock at some point," Rhodes said. "The first step gave us the benefits of a stock-owned company while maintaining the control of a mutual bank."
Rhodes said that the interim step allowed Heritage to more easily attract top-notch commercial bank employees.
It also gave Heritage more capital.
About a third of the stock was purchased by about 200 depositors for $10 a share.
The remaining two thirds of stock was held by the newly formed Heritage Mutual Holding Co.
Heritage raised about $6 million in the step.
"It seemed like a lot of money at the time," Rhodes said. "The capital gave us the opportunity to change the culture of the bank's mindset from a thrift mentality to one that focuses on return to shareholders."
Hits the Nasdaq
In January 1998, Heritage completed the second step of the conversion with its initial public offering. The stock trades on the Nasdaq under the ticker symbol HFWA.
The move to a publicly traded company had to meet strict guidelines that included an independent appraisal to determine the value of the bank.
That value, incorporated with a target IPO share price, determined how many shares were sold.
Heritage issued 10 million shares at $10 a share. Under conversion guidelines, the depositors who bought shares in the 1994 step were entitled to the same percentage of ownership in the fully converted company. Thus, a third of the stock was issued to those 200 investors.
The balance of the shares were sold first to other depositors who wanted to invest, then to employees and thirdly to outside parties.
"Under the final tier of the offering, we could go out into our community to attract investors," Rhodes said. "As a byproduct, our stock is largely held by residents of the Pacific Northwest."
The proceeds from the offerings to depositors, employees and outsiders -- $63 million -- went to Heritage Financial Corp., giving the bank more capital to pursue its goal of generating more commercial business.
The strategy has borne fruit.
In June 1997, Heritage's loan portfolio included 71 percent real estate mortgages and 22 percent commercial loans.
At the end of March 2001, the segments were much more balanced, with commercial loans accounting for 49 percent of the portfolio and real estate mortgages at 43 percent. The other segments are construction and consumer loans.
"We have been successful at diversifying the balance sheet, which in turn lessens the risk of being dependent on any one source of revenue," Rhodes said.
"For example, residential real estate activity slowed dramatically during 1998 and 1999, but during the same time business lending activity was strong."
Commercial loan clients include small manufacturers, retailers, warehouse operators and an occasional restaurant, Rhodes said.
The IPO gave Heritage the means to acquire North Pacific Bank in June 1998 for $17.5 million in cash. North Pacific was a commercial bank with two branches in south Tacoma.
Over the mountains
In March 1999, Heritage merged with Washington Independent Bancshares Inc., which owned Central Valley Bank.
Central Valley is based in Toppenish and does business in Yakima and Ellensburg.
Before coming to Heritage, Rhodes had been hired to help several smaller banks in varying degrees of financial trouble. Central Valley was among them.
After getting Central Valley on the right path, he maintained ties with the bank and eventually Heritage decided to acquire it.
"Over the years, Central Valley was doing well, so the merger made sense," said Rhodes, Heritage's largest shareholder with 376,026 shares or 4.4 percent ownership as of March 9.
Heritage exchanged 1,058,009 shares for all of the Central Valley's outstanding stock in a deal worth about $10 million.
Diverse base
Heritage built its headquarters in the 1970s and occupies three of the building's four stories. The law firm of Connolly Tacon & Meserve leases one floor and has been a tenant since the building opened in 1974.
About of third of Heritage's 195 employees work at the 25,000-square-foot headquarters.
In 1999, Heritage built a new branch in Spanaway, replacing the one that opened there in the '70s and prompted the name change from Thurston County Federal Savings & Loan to Heritage Federal Savings & Loan.
The corporation has branches in five counties -- Thurston, Mason and Pierce in South Sound and Yakima and Kittitas counties east of the Cascades.
The counties have a range of industries that drive their economic engines. In Thurston County, it's largely state government. Pierce County is more manufacturing based, while Mason County still relies somewhat on natural resources.
The counties east of the Cascades are largely driven by agriculture.
"Again it's a case of diversity," Rhodes said. "Each county presents its own opportunities -- and its own challenges."
As for Thurston County, Heritage has played a vital role for the business community.
"They are a very proactive regional bank," said Dennis Matson, executive director of the Economic Development Council of Thurston County. "To have a healthy economy, you need to have community-based banks that are looking toward the business loan market."
Besides businesses, Matson said Heritage also has been supportive of community organizations.
Among the groups Heritage supports with donations are arts-related organizations such as the Olympia Symphony, The Washington Center for the Performing Arts and Harlequin Productions.
Rhodes said Heritage also has given money to help fund the Saint Martin's library, the St. Peter Hospital Foundation and the YMCA.
"My philosophy is that we try to support those activities that our employees and directors are interested in," Rhodes said.
Shareholders in mind
As a publicly traded corporation, the ultimate eye is on return to investors, and Heritage has adopted several means to increase that return.
Within the financial markets, Heritage has enacted an aggressive stock buyback program. It also has declared 15 consecutive quarterly dividends.
The buyback program was started in April 1999, the earliest date allowed after the merger with Central Valley Bank.
To date, about 3.3 million shares have been repurchased.
"Under the requirements of going public, we raised more capital than we have use for," said Ed Cameron, Heritage vice president and treasurer.
Given the possible non-operational uses of the capital -- acquiring other institutions, which Heritage did to some degree, and investing -- Heritage decided it was more prudent to return it to investors.
"We did all of those things, and still had excess," Cameron said. "By buying back stock, we return equity and increase our earnings per share."
Paul Miller, an analyst with Friedman Billings Ramsey investment bank in Arlington, Va., said it's a common practice among institutions such as Heritage.
"They are in line with most companies that convert," Miller said. "They end up overcapitalized, and there's no way they can safely grow into that much capital."
Heritage bought back thousands of shares when markets reopened after the Sept. 11 attacks and is about halfway through its latest 10 percent repurchasing program, Rhodes said.
"We've done about 400,000 shares out of 800,000 this phase," Rhodes said.
All told, about 3.7 million shares will have been repurchased when this part of the program is complete. Heritage's board of directors will then decide if further buybacks are necessary.
A new vision
Internally, the bank adopted Vision 2001 to streamline its operations and increase its profitability.
Heritage enlisted Alex Sheshunoff Management Services LP, a bank industry guru, to refine the company's banking practices.
"They specialize in community banks," Cameron said. "We brought their team in to look at what we do, create efficiencies it the way we do things and look for revenue opportunities we are missing or not taking full advantage of."
The $600,000 project from March to May involved looking at Heritage's work flow from top to bottom and back again.
In the end, Cameron said the bank will achieve significant expense savings and enhanced revenue, though about 11 positions were eliminated.
The program cost was a hit on second-quarter earnings, but Cameron said enough will happen this year "that we will recoup the cost. We're looking at it as a neutral expense."
The Vision 2001 program is part of Heritage's efforts to be regarded as a high performer within its industry, aiming for a 20 percent-plus return on equity. It now falls in the middle of the industry pack.
"It is our goal and intent to remain an independent bank rather than to sell or be merged with a larger bank" Rhodes said. "You have to earn that right, and that means improving return on investment."
After refining Heritage's mission for more than five years, Rhodes said the company will now focus on pursuing the mindset and operations of a commercial, community bank.
In its most recent quarterly report, for the second quarter ending June 30, Heritage announced net income of $1.28 million -- down from $1.47 million for the same quarter in 2000.
Excluding Vision 2001 expenses, projected net income would have been $1.58 million for the quarter.
Stockholders' equity as of June 30 was $79.8 million, down from $83 million at the start of the year. During that six months, Heritage repurchased $4.7 million shares of stock and declared $1.6 million in dividends.
Heritage's next earnings report is due the third week of this month, and investors could see more benefits from the 90-plus-year-old bank's efforts to redefine itself.
Security and Exchange Commission rules preclude Rhodes from disclosing specifics, but he offered this statement on the mid-October report:
"We expect that the benefits from the Vision 2001 project will be reflected in our third-quarter earnings announcement."
If past growth is any indication, you can bank on it.
The Olympian Copyright 2001 back to main Taking stock in South Sound index
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