HERITAGE FINANCIAL CORP /WA/ (HFWA) stock intrinsic value fair value estimate & owner earnings analysis

Heritage Financial Corporation owns Heritage Bank, a commercial community bank serving the Puget Sound region and southwest Washington and the Portland, Oregon metro area. On January 31, 2026 it completed the purchase of Olympic Bancorp, parent of Kitsap Bank (16 branches on the Kitsap Peninsula), paying 7,167,600 new Heritage shares (about $185 million). The combined bank has about $8.4 billion of assets, $5.75 billion of loans and $7.04 billion of deposits, 28% of them non-interest-bearing. It earns money the traditional way: lending to local businesses and property owners, funded by customer deposits, with modest fee income. About 65% of loans are commercial real estate, 43.6% of loans being investor-owned property, which is the main risk. How we measure earnings. We start from operating cash flow and strip out timing swings, stock compensation and the capital spending needed to keep branches and systems running. For a bank we also charge two costs that cash flow alone misses: loan-loss provisions (credit losses are the real cost of lending, even though the cash loss shows up elsewhere in the cash-flow statement) and the cost of the low-income-housing tax-credit investments whose tax savings are already in earnings ($24.7 million of amortization in 2025). On that basis, owner earnings per share before the merger were $1.60 (2017), $1.20 (2018, acquisition year), $2.23 (2019), $0.34 (2020, COVID reserve build), $3.00 (2021, reserve release; the two years average $1.67), $2.18 (2022), $1.91 (2023), $1.77 (2024) and $1.96 (2025). The median of 2019-2025, a window that spans the pandemic credit scare, near-zero rates and the 2022-2023 rate shock, is $1.96. Securities-sale losses from repositioning the bond portfolio in 2023-2025 ($12.2M, $22.7M, $10.7M) are treated as one-time; that the bank did it three years running is carried in the bear case. The combined bank. Olympic's standalone earnings were never separately disclosed, so we judge the merged business from its own results. Net income was $18.9 million in the first quarter of 2026 and $17.5 million in the second, after $5.2 million and $7.5 million of merger costs and small loan-loss reserve releases. Removing the merger costs and charging a normal provision, both quarters point to about $2.20 per share of owner earnings on the enlarged share count. The net interest margin of 3.99% is above Heritage's cycle average, so we set normal earning power at $2.10 per share, between the pre-merger median and the post-merger run rate. Owner earnings grew 10.6% in 2025 (from $1.77 to $1.96); our base case assumes year one of $2.20, 4.8% above the $2.10 level, and that step comes only from merger cost savings: the systems conversion is scheduled for the third quarter of 2026 and the company has put annual savings at $18.7 million by 2027, of which we credit about $8 million pre-tax still to come. Base case ($37.61 per share): owner earnings of $2.20 in year one and $2.26 from year two onward, flat, with no organic growth. Heritage's deposits fell from $6.39 billion in 2021 to $5.92 billion in 2025 before the deal, and its growth has come from large acquisitions (2018 and 2026) rather than a steady repeatable process, so no organic growth is credited. Beyond year ten the franchise is valued at the same flat level: a deposit-and-lending relationship base in operation since 1927, which has renewed itself through several credit cycles, is the named mechanism, but we add no growth to it. Beyond-year-ten value is about 56% of the estimate. Bull case ($42.01): the first-half 2026 run rate of $2.20 proves to be normal, the full cost savings arrive, and fixed-rate loans written at lower rates reprice upward as they mature, which management has pointed to, adding about $0.10 per share by year five, for $2.54 a year from year five onward. No credit event. Bear case ($26.75): the margin falls back to 2024 economics (about 10% lower earnings), only half the cost savings arrive (about $1.97 per share), and a regional commercial real estate downturn in years three to five costs 3% of loans (about $172 million before tax, $3.28 per share after tax). That is roughly what Heritage itself went through in 2008-2010, when provisions were $7.4 million and $19.4 million on about $800 million of loans and 2009 was a small loss. Deposits then run off at the 2021-2025 pace (about 1.9% a year) through year ten, leaving about $1.69 per share of lasting earning power. The bank's pre-provision earnings of roughly $110 million a year and $1.11 billion of equity absorb those losses without new capital, so no dilution is assumed. Debt. For a bank, deposits ($7.04 billion), Federal Home Loan Bank advances ($166 million, maturing in the third quarter of 2026) and $22.5 million of junior subordinated debentures are the raw material of the business, and the interest on them is an operating cost already charged in owner earnings. We value earnings after that interest directly and do not subtract these borrowings again, which would count them twice. So in every case the business value shown is already what is left for shareholders after depositors and lenders; the leverage risk is carried in the bear case through credit losses and deposit runoff. What changed since our previous estimate. We previously put the shares at $24.55 / $48.62 / $59.97. Three things moved the numbers: we now charge loan-loss provisions and the tax-credit investment cost against earnings, and correct the working-capital treatment, which lowers the earnings history; we no longer assume growth continuing indefinitely past year ten; and we now reflect the Olympic acquisition, which added about 21% more shares along with Kitsap Bank's earnings and cost savings. The bear case is higher because the combined bank's larger earnings base and cost savings cushion the same credit downturn. Margin-of-safety price. The margin-of-safety price is $25.50, a little below the bear case and about 32% below the base case. The margin reflects a commercial-real-estate-heavy loan book and a credit cycle that has hurt this bank before, set between a stable business and a cyclical one. At that price, base-case owner earnings imply a yield of about 9% a year before any move toward fair value. What would make this wrong: commercial real estate losses beyond Heritage's own 2008-2010 experience, a lasting fall in the margin below 2024 levels, or cost savings that do not arrive after the systems conversion. The acquired assets are still at provisional fair values, which can be revised until January 2027, and Olympic's pre-merger profit could not be tied out separately from the filings.