BUSINESS COMBINATION

On October 1, 2018, the Company completed the South Sound Merger and South Sound Bank was merged into the Bank. The primary reason for the acquisition was to expand the Company's presence along Washington State's economically important I-5 corridor.

Pursuant to the terms of the merger agreement, South Sound Bank shareholders received 0.746 of a share the Company's common stock and $5.68825 in cash per share of South Sound Bank common stock. The Company issued 904,826 shares of its common stock (valued at $28.27 million based on the Company's closing stock price on September 30, 2018 of $31.24 per share) and paid $6.90 million in cash in the transaction for total consideration paid of $35.17 million.

The South Sound Merger constitutes a business combination as defined by GAAP, which establishes principles and requirements for how the acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired and liabilities assumed. The Company was considered the acquirer in this transaction. Accordingly, the preliminary estimates of fair values of the acquired assets, including the identifiable intangible assets, and the assumed liabilities in the South Sound Merger were measured and recorded as of October 1, 2018. The excess of the total consideration paid over the fair value of the net assets acquired was allocated to goodwill. The South Sound Merger resulted in $8.97 million of goodwill. The goodwill arising from the transaction consists largely of the synergies and expected economies of scale from combining the operations of the Company and South Sound Bank. This goodwill is not deductible for tax purposes.

In most instances, determining the estimated fair values of the acquired assets and assumed liabilities requires the Company to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at the appropriate rate of interest. Differences may arise between contractually required payments and the expected cash flows at the acquisition date due to items such as estimated credit losses, prepayments or early withdrawal, and other factors. One of the most significant of those determinations relates to the valuation of acquired loans. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. In accordance with GAAP, there was no carry-over of South Sound Bank's previously established allowance for loan losses.

The following table summarizes the fair value of consideration paid, the preliminary estimated fair values of assets acquired and liabilities assumed as of the acquisition date, and the resulting preliminary goodwill relating to the transaction:



	At October 1, 2018
	Book Value		Fair Value Adjustment			Estimated Fair Value
	(Dollars in thousands)
Total merger consideration						$	35,170

Recognized amounts of identifiable assets acquired and liabilities assumed
Identifiable assets acquired:
Cash and cash equivalents	$	21,187	$	—		21,187
CDs held for investment	2,973		—			2,973
FHLB stock	205		—			205
Investment securities	24,913		(189		)	24,724
Loans receivable	123,627		(2,083		)	121,544
Premises and equipment	3,225		112			3,337
OREO	25		—			25
Accrued interest receivable	554		—			554
BOLI	2,629		—			2,629
CDI	—		2,483			2,483
MSRs	285		(4		)	281
Other assets	883		—			883
Total assets	180,506		319			180,825

Liabilities assumed:
Deposits	151,378		160			151,538
Other liabilities and accrued expenses	3,087		—			3,087
Total liabilities assumed	154,465		160			154,625
Total identifiable net assets acquired	$	26,041	$	159		26,200
Preliminary goodwill recognized						$	8,970

Fair values on the acquisition date are preliminary and represent management's best estimates based on available information and facts and circumstances in existence as of the filing date of this report. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation by March 31, 2019 when the valuation of tax-related matters is complete.

The acquired loan portfolio was valued using Level 3 inputs (see Note 9) and included the use of present value techniques, including cash flow estimates and incorporated assumptions that the Company believes marketplace participants would use in estimating fair values. Credit discounts were included in the determination of the fair value of the loans acquired; therefore, an allowance for loan losses was not recorded at the acquisition date. Acquired loans are evaluated upon acquisition and classified as either purchased credit-impaired ("PCI") or purchased non-credit-impaired. PCI loans reflect credit deterioration since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. The Company determined that PCI loans acquired in the South Sound Merger were insignificant.

For purchased non-credit-impaired loans, the difference between the fair value and unpaid principal balance of the loan at the acquisition date is amortized or accreted to interest income over the life of the loans. Any subsequent deterioration in credit quality is recognized by recording an allowance for loan losses.

CDI represents the future economic benefit of the potential cost savings from acquiring core deposits as part of a business combination compared to the cost of alternative funding sources. CDI is amortized to non-interest expense using an accelerated method based on an estimated runoff of related deposits over a period of ten years. CDI is evaluated for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable, with any changes in estimated useful life accounted for prospectively over the revised remaining life.

The operating results of the Company for the three months ended December 31, 2018 include the operating results produced by the net assets acquired in the South Sound Merger since the October 1, 2018 merger date. The table below presents the significant operating results of the acquired business since the October 1, 2018 merger date:



	Three Months Ended December 31, 2018
	(Dollars in thousands)
Interest income: Interest and fees on loans (1)	$	1,738
Interest income: Interest and dividends on investment securities and FHLB stock	201
Interest income: Other interest earning assets	100
Interest expense	(128		)
Provision for loan losses	—
Non-interest income	139
Non-interest expense (2)	(860		)
Net effect, pre-tax	$	1,190

(1) Includes the accretion of the fair value discount on the purchased loans of $87,000.

(2) Excludes certain compensation and employee benefits for management, and excludes certain other non-interest expenses that are impracticable to determine due to the integration of the operations for this merger. Also includes certain acquisition-related costs of $64,000 incurred by the Company.

For illustrative purposes only, the following table presents certain unaudited pro forma information for the three months ended December 31, 2018 and 2017. This unaudited estimated pro forma information was calculated as if South Sound Bank had been acquired as of the beginning of the fiscal year ended September 30, 2018. This unaudited pro forma information combines the historical results of South Sound Bank with the Company's consolidated historical results and includes certain adjustments reflecting the estimated impact of certain fair value adjustments for the respective periods. The pro forma information is not indicative of what would have occurred had the transaction occurred at the beginning of the fiscal year ended September 30, 2018. The unaudited pro forma information does not consider any changes to the provision for loan losses resulting from recording loans at fair value. Additionally, the Company expects to achieve further operating cost savings and other business synergies, including revenue growth as a result of the acquisition, which are not reflected in the pro forma amounts that follow. As a result, actual amounts would have differed from the unaudited pro forma information presented.



	Unaudited Pro Forma Three Months Ended December 31,
	2018		2017
	(Dollars in thousands except per share data)
Total revenues (net interest income plus non-interest income)	$	15,610	$	14,362
Net income	5,666		3,789
Basic net income per common share	0.68		0.46
Diluted net income per common share	0.67		0.45

During the three months ended December 31, 2018 and 2017, the Company incurred acquisition-related expenses of $64,000 and $41,000, respectively, related to the South Sound Merger, which are included in professional fees in the accompanying consolidated statement of income. South Sound Bank incurred acquisition-related expenses of $2,000 for the three months ended December 31, 2017 related to the South Sound Merger. These acquisition-related expenses incurred by the Company and South Sound Bank are not included in the unaudited pro forma information presented for the three months ended December 31, 2018 and 2017. The Company incurred acquisition-related expenses of $616,000 for the fiscal year ended September 30, 2018 related to the South Sound Merger, which were included in professional fees.

The Company expects to incur additional acquisition-related expenses of approximately $580,000 over the next two quarters. These expenses are related to the conversion of South Sound Bank's current core processing and ancillary information technology systems to the Company's new core processing system.