First Federal Bancshares (FFBI) 10-Q 2006 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

Commission file number 0-30753

FIRST FEDERAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Delaware	37-1397683
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

109 East Depot Street, Colchester, Illinois 62326

(Address of principal executive offices) (Zip Code)

(309) 776-3225

(Registrant’s telephone number, including area code)

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 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  ¨ Non-accelerated filer  x

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

As of November 6, 2006, the Registrant had outstanding 1,249,316 shares of common stock.

FIRST FEDERAL BANCSHARES, INC.

Form 10-Q Quarterly Report

Index

		Page
PART I - Financial Information
Item 1	Financial Statements	1
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3	Quantitative and Qualitative Disclosures About Market Risk	13
Item 4	Controls and Procedures	14
PART II - Other Information
Item 1	Legal Proceedings	15
Item 1A	Risk Factors	15
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	15
Item 3	Defaults Upon Senior Securities	15
Item 4	Submission of Matters to a Vote of Securities Holders	15
Item 5	Other Information	15
Item 6	Exhibits	16
SIGNATURES		18

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

First Federal Bancshares, Inc.

Consolidated Statements of Financial Condition

(in thousands of dollars, except share data)

(unaudited)

	September 30, 2006			December 31, 2005
ASSETS
Cash and cash equivalents	$	18,513		$	12,798
Time deposits in other financial institutions		196			196
Securities available-for-sale, at fair value		122,351			137,023
Loans receivable, net		188,070			178,551
Real estate owned, net		234			233
Federal Home Loan Bank stock, at cost		1,796			1,682
Premises and equipment, net		3,144			3,300
Goodwill		1,340			1,340
Core deposits and other intangibles		179			209
Accrued interest receivable		1,899			1,606
Other assets		2,101			2,364
TOTAL ASSETS	$	339,823		$	339,302
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits	$	294,327		$	291,228
Advances from borrowers for taxes and insurance		155			217
Federal Home Loan Bank advances		14,824			18,188
Subordinated debentures		7,217			7,217
Accrued interest payable		830			754
Other liabilities		550			383
Total liabilities		317,903			317,987
SHAREHOLDERS' EQUITY
Preferred stock, $.01 par value, 1,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $.01 par value, 4,000,000 shares authorized; 2,242,500 shares issued		22			22
Additional paid-in capital		23,293			23,166
Unearned ESOP shares		(717	)		(852	)
Unearned stock awards		—			(203	)
Treasury stock (Sept. 30- 993,111 shares, Dec. 31- 1,000,236 shares)		(29,801	)		(30,015	)
Retained earnings		31,694			31,751
Accumulated other comprehensive loss		(2,571	)		(2,554	)
Total shareholders' equity		21,920			21,315
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	339,823		$	339,302

See notes to consolidated financial statements.

1

First Federal Bancshares, Inc.

Consolidated Statements of Income

(in thousands of dollars, except share data)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Interest income
Loans	$	3,028		$	2,564		$	8,711		$	6,988
Securities		1,359			1,432			4,226			4,384
Other interest income		144			53			406			169
Total interest income		4,531			4,049			13,343			11,541
Interest expense
Deposits		2,560			1,893			7,223			5,221
Federal Home Loan Bank advances		162			170			561			303
Subordinated debentures		105			106			316			316
Total interest expense		2,827			2,169			8,100			5,840
Net interest income		1,704			1,880			5,243			5,701
Provision for loan losses		24			143			90			258
Net interest income after provision for loan losses		1,680			1,737			5,153			5,443
Noninterest income
Service charges on deposit accounts		155			126			367			322
Loan origination and servicing fees		71			71			206			199
Other fee income		85			69			269			189
Net gain (loss) on sale of securities		(20	)		(7	)		(9	)		222
Recovery of impairment loss		—			—			8			—
Other income		11			8			32			39
Total noninterest income		302			267			873			971
Noninterest expense
Compensation and benefits		1,077			1,130			3,374			3,305
Occupancy and equipment		147			146			450			425
Data processing		178			168			548			489
Federal insurance premiums		31			29			92			88
Advertising		26			36			106			116
Professional fees		80			58			255			214
Other noninterest expense		208			218			634			665
Total noninterest expense		1,747			1,785			5,459			5,302
Income before income taxes		235			219			567			1,112
Provision for income taxes		81			77			206			396
Net income	$	154		$	142		$	361		$	716
Earnings per share
Basic	$	.13		$	.13		$	.31		$	.62
Diluted	$	.13		$	.12		$	.30		$	.59
Weighted average shares - basic		1,167,592			1,130,709			1,156,689			1,149,044
Comprehensive income (loss)	$	1,579		$	(452	)	$	344		$	(335	)

See notes to consolidated financial statements.

2

First Federal Bancshares, Inc.

Consolidated Statements of Shareholders' Equity

Nine months ended September 30, 2006 and 2005

(in thousands of dollars, except share data)

(unaudited)

	Common Stock		Additional Paid-in Capital			Unearned ESOP Shares			Unearned Stock Awards			Treasury Stock			Retained Earnings			Accumulated Other Compre- hensive Loss			Total Share- holders' Equity
Balance at December 31, 2004	$	22	$	22,954		$	(1,032	)	$	(474	)	$	(28,185	)	$	31,393		$	(554	)	$	24,124
Purchase of 75,075 shares of treasury stock		—		—			—			—			(1,859	)		—			—			(1,859	)
ESOP shares earned		—		167			135			—			—			—			—			302
Options exercised (2,475 shares)		—		(32	)		—			—			75			—			—			43
Stock awards earned		—		—			—			203			—			—			—			203
Dividends declared ($.36 per share)		—		—			—			—			—			(420	)		—			(420	)
Comprehensive income
Net income		—		—			—			—			—			716			—			716
Unrealized loss on securities available- for- sale, net of reclassification and tax effects		—		—			—			—			—			—			(1,051	)		(1,051	)
Total comprehensive loss																						(335	)
Balance at September 30, 2005	$	22	$	23,089		$	(897	)	$	(271	)	$	(29,969	)	$	31,689		$	(1,605	)	$	22,058
Balance at December 31, 2005	$	22	$	23,166		$	(852	)	$	(203	)	$	(30,015	)	$	31,751		$	(2,554	)	$	21,315
Transferred to additional paid-in capital		—		(203	)		—			203			—			—			—			—
Purchase of 51 shares of treasury stock		—		—			—			—			(1	)		—			—			(1	)
ESOP shares earned		—		114			135			—			—			—			—			249
Options exercised (7,176 shares)		—		(99	)		—			—			215			—			—			116
Stock option expense		—		112			—			—			—			—			—			112
Stock awards earned		—		203			—			—			—			—			—			203
Dividends declared ($.36 per share)		—		—			—			—			—			(418	)		—			(418	)
Comprehensive income
Net income		—		—			—			—			—			361			—			361
Unrealized loss on securities available- for- sale, net of reclassification and tax effects		—		—			—			—			—			—			(17	)		(17	)
Total comprehensive income																						344
Balance at September 30, 2006	$	22	$	23,293		$	(717	)	$	—		$	(29,801	)	$	31,694		$	(2,571	)	$	21,920

See notes to consolidated financial statements.

3

First Federal Bancshares, Inc.

Consolidated Statements of Cash Flows

(in thousands of dollars)

(unaudited)

	Nine Months Ended September 30,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	361		$	716
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation		195			192
Net loss (gain) on sale of real estate owned		(7	)		1
Net amortization of premiums and discounts		10			109
ESOP compensation expense		249			302
Stock award compensation expense		203			203
Stock option expense		112			—
Amortization of intangible assets		30			30
Provision for loan losses		90			258
Deferred income taxes		66			91
Federal Home Loan Bank stock dividends		—			(62	)
Dividend reinvestments		(46	)		(717	)
Net loss (gain) on sale of securities		9			(222	)
Net changes in
Accrued interest receivable and other assets		(55	)		(253	)
Deferred loan fees		(36	)		(35	)
Accrued interest payable and other liabilities		243			303
Net cash from operating activities		1,424			916
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of securities available-for-sale		(10,998	)		(5,110	)
Principal paydowns on mortgage-backed securities		9,605			12,540
Purchase of Federal Home Loan Bank stock		(114	)		(42	)
Sale of Federal Home Loan Mortgage Corporation stock		226			239
Proceeds from sales of securities available-for-sale		15,725			5,398
Proceeds from maturities of securities available-for-sale		113			—
Purchase of loans		(15,319	)		(30,599	)
Sale of loans		2,311			1,619
Net decrease (increase) in loans receivable		3,345			(8,655	)
Proceeds from sale of real estate owned		96			169
Purchase of premises and equipment		(39	)		(71	)
Net cash from investing activities		4,951			(24,512	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		3,099			13,927
Net change in advances from borrowers for taxes and insurance		(62	)		(31	)
Advances from the Federal Home Loan Bank		7,200			13,227
Repayments of Federal Home Loan Bank advances		(10,564	)		(2,451	)
Purchase of treasury stock		(1	)		(1,859	)
Dividends paid		(448	)		(452	)
Exercise of options		108			36
Tax benefit from exercise of stock options		8			7
Net cash from financing activities		(660	)		22,404
Net change in cash and cash equivalents		5,715			(1,192	)
Cash and cash equivalents
Beginning of period		12,798			14,387
End of period	$	18,513		$	13,195
Supplemental disclosures of cash flow information
Cash paid during the period for
Interest	$	8,024		$	5,715
Taxes, net of refunds		(66	)		278
Transfers to real estate owned		90			778

See notes to consolidated financial statements.

4

FIRST FEDERAL BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

(table amounts in thousands of dollars, except share data)

Note 1 - Basis of Presentation

The accompanying interim consolidated financial statements have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain disclosures required by U.S. generally accepted accounting principles are not included herein. These interim consolidated statements should be read in conjunction with First Federal Bancshares, Inc.’s (“First Federal Bancshares” or the “Company”) Annual Report on Form 10-K for the year ended December 31, 2005. The December 31, 2005 consolidated balance sheet presented herein has been derived from the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2005, but does not include all disclosures required by U.S. generally accepted accounting principles.

Interim statements are subject to possible adjustment in connection with the annual audit of the Company for the year ending December 31, 2006. In the opinion of management of the Company, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the consolidated financial position and consolidated results of operations for the periods presented. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reported period. Actual results could differ from these estimates.

New Accounting Pronouncements: Effect of Newly Issued But Not Yet Effective Accounting Interpretation: In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” – an interpretation of FASB No. 109” (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation is effective for fiscal years beginning after December 31, 2006. The Company is currently evaluating the impact of the adoption of FIN 48, with respect to its results of operations, financial position and liquidity.

Note 2 – Earnings Per Share

Basic earnings per share for the three and nine months ended September 30, 2006 and 2005 were computed by dividing net income by the weighted average number of shares outstanding. Diluted earnings per share for the three and nine months ended September 30, 2006 and 2005 were computed by dividing net income by the weighted average number of shares outstanding, adjusted for the dilutive effect of the outstanding stock options and stock awards. Computations for basic and diluted earnings per share are provided in the following table.

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	For the three months Ended September 30,				For the nine months Ended September 30,
	2006		2005		2006		2005
	(in thousands, except per share data)
Basic
Net income	$	154	$	142	$	361	$	716
Weighted average common shares outstanding		1,168		1,131		1,157		1,149
Basic earnings per common share	$	.13	$	.13	$	.31	$	.62
Diluted
Net income	$	154	$	142	$	361	$	716
Weighted average common shares outstanding		1,168		1,131		1,157		1,149
Dilutive effect of stock options		29		50		29		58
Dilutive effect of stock awards		—		4		1		5
Diluted average common shares		1,197		1,185		1,187		1,212
Diluted earnings per common share	$	.13	$	.12	$	.30	$	.59

Note 3 – Stock-Based Compensation

The Company has a stock compensation plan under which it may issue stock options and restricted stock.

Under the 2001 Stock-Based Incentive Plan (the “Plan”), the Company’s Compensation Committee granted 224,250 shares of its Common Stock for Incentive and Non-Statutory stock options. All grants were made pursuant to the Plan prior to 2005. It is the Company’s intent that shares issued under the Plan would come from treasury shares.

Under the Plan, certain key employees have been granted options to purchase shares of the Company’s Common Stock at fair value at the date of the grant. All stock options have an exercise price that is at least equal to the fair market value of the Company’s stock on the date the options were granted. Options granted vest evenly over a five-year period and must be exercised within ten years from the date of grant.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share Based Payment.” The Company elected to utilize the modified prospective transition method, therefore, prior period results were not restated. Prior to the adoption of SFAS 123R, stock-based compensation expense related to stock options was not recognized in the results of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.”

SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values. For options with graded vesting, we value the stock option grants and recognize compensation expense as if each vesting portion of the award was a single award. Under the modified prospective method, unvested awards, awards that were granted, modified, or settled on or after January 1, 2006 are measured and accounted for in accordance with SFAS 123R. The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized.

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The following table summarizes stock option activity:

	Nine Months Ended September 30, 2006				Nine Months Ended September 30, 2005
	Options Shares		Weighted Average Price Per Share		Options Shares		Weighted Average Price Per Share
Outstanding at beginning of period	209,016		$	15.19	211,491		$	15.18
Granted	—			—	—			—
Exercised	(7,176	)		15.10	(2,475	)		14.37
Forfeited	—			—	—			—
Outstanding at end of period	201,840			15.20	209,016			15.19

The following table details stock options exercisable:

	September 30, 2006		December 31, 2005
	(dollars in thousands)
Stock options vested and currently exercisable:
Number		148,173		155,349
Weighted average exercise price	$	14.68	$	14.53
Weighted average remaining life (in years)		5.4		6.1

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes based stock option valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. Expected volatilities are based on historical volatility of the Company’s stock, and other factors. Expected dividends are based on dividend trends and the market price of the Company’s stock price at grant. The Company uses historical data to estimate option exercises and employee terminations within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. There were no grants during the three or nine months ended September 30, 2006 and 2005. Management has estimated a forfeiture rate of 7%. Estimated forfeitures will be reassessed in subsequent periods and may change based on new facts and circumstances.

The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The intrinsic value of options exercised during the three-month period and nine-month period ended September 30, 2006 was $35,000. The intrinsic value of stock options that were exercisable at September 30, 2006 was $784,000, while the intrinsic value of outstanding stock options was $963,000 at September 30, 2006. The Company recorded $34,000 in stock compensation expense during the three-month period and $112,000 for the nine-month period ended September 30, 2006. There were no options granted or modified during the three or nine-month periods ended September 30, 2006 and 2005.

Prior to 2006, the Company applied APB Opinion 25 and related Interpretations in accounting for its stock option plan. Accordingly, no compensation cost was recognized at the date of grant. As a result of adopting SFAS 123R on January 1, 2006, the Company’s diluted earnings per share was $.06 lower for the nine months ended September 30, 2006, than if the Company had continued to account for stock-based compensation under APB opinion No. 25 for stock option grants. As a result of the adoption of SFAS 123R, the Company’s

7

net income was $154,000 and $361,000, respectively, for the three and nine-month periods ended September 30, 2006, compared to $175,000 and $429,000 for the same respective periods had SFAS 123R not been adopted.

The following table illustrates the effect on operating results and per share information had the Company accounted for stock-based compensation in accordance with SFAS 123R for the three months and nine months ended September 30, 2005:

	Three Months Ended September 30, 2005		Nine Months Ended September 30, 2005
	(dollars in thousands, except per share data)
Net income, as reported	$	142	$	716
Deduct: Stock based compensation expense determined under the fair value based method, net of related tax effect		25		75
Pro forma net income	$	117	$	641
Earnings per share, as reported:
Basic	$	0.13	$	0.62
Diluted		0.12		0.59
Pro forma earnings per share:
Basic	$	0.10	$	0.56
Diluted		0.10	$	0.53

SFAS 123R requires the recognition of stock-based compensation for the number of awards that are ultimately expected to vest. Unrecognized stock option compensation expense related to unvested awards for the remainder of 2006 and beyond is estimated as follows:

Year	(in thousands)
October 2006 – December 2006	$	34
2007		19
2008		19
2009		17
Total	$	89

Pursuant to its 2001 Stock-Based Incentive Plan, the Company awarded 89,700 shares of restricted stock during 2001. These shares vest over a five-year period. The unamortized cost of shares not yet earned (vested) is reported as a reduction of shareholders' equity. Compensation expense for restricted stock awards totaled $68,000 for the three-month period and $203,000 for the nine-month period ended September 30, 2006. There were no shares granted or forfeited in the three or nine-month periods ended September 30, 2006.

Note 4 - Subsequent Events

On November 3, 2006, the Company and Heartland Bancorp, Inc. (“Heartland Bancorp”), the parent company of Heartland Bank and Trust Company, entered into an Agreement and Plan of Reorganization (the “Merger Agreement”) pursuant to which the Company will merge with a subsidiary of Heartland Bancorp. First Federal Bank will continue to operate as a subsidiary of Heartland Bancorp following the merger.

Under the terms of the Merger Agreement, stockholders of the Company will receive $23.00 in cash for each share of the Company common stock they own. Outstanding stock options will be cancelled in exchange for a payment of $23.00 less the option exercise price. The total value of the transaction is approximately $30.3 million. The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval by the shareholders of the Company. The transaction is currently expected to be completed in the first quarter of 2007.

In the event the merger is not consummated under certain circumstances, the Company has agreed to pay Heartland Bancorp a termination fee of $1,500,000.

Also on November 3, 2006, and in connection with the execution of the Merger Agreement, certain executive officers of the Company entered into employment agreements with the Company, to be effective only upon consummation of the merger (the “New Employment Agreements”), under which they will be employed as executive officers after the merger. The current employment agreements with the Company will be terminated in exchange for a lump sum cash payment. The lump sum cash payments to be made to these executives at the closing of the merger total $752,000. The New Employment Agreements have one-year terms. In addition, each New Employment Agreement contains provisions entitling each officer to be eligible for a performance bonus, vacation and a stock purchase opportunity, under which the officer will have the opportunity to purchase varying amounts of Class A non-voting common stock of Heartland Bancorp during the 60 day period immediately following the close of the merger. The New Employment Agreements also include a non-competition and a non-solicitation provision for a period of one-year following the officer’s termination of employment. Each New Employment Agreement provides for a payment equal to one-year’s base salary following a change in control and subsequent termination of employment.

8

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, as amended, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by use of the words such as "believe," "expect," "intend," "anticipate," "estimate," "project," or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on the operations and future prospects of the Company and its wholly-owned subsidiary include, but are not limited to, changes in: interest rates; general economic conditions; legislative/regulatory provisions; monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board; the quality or composition of the loan or investment portfolios; demand for loan products; deposit flows; competition; demand for financial services in the Company's market area; and accounting principles, policies, and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K (the “Form 10-K”) and this Quarterly Report on Form 10-Q under “Item 1A. Risk Factors.”

The following discussion compares the consolidated financial condition of First Federal Bancshares and its wholly owned subsidiary, First Federal Bank, at September 30, 2006 to its consolidated financial condition at December 31, 2005, and the consolidated results of its operations for the three-month and nine-month periods ended September 30, 2006 to the same periods in 2005. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included herein.

FINANCIAL CONDITION

Total assets were $339.8 million at September 30, 2006 and $339.3 million at December 31, 2005. During the nine months ended September 30, 2006, cash and cash equivalents increased $5.7 million to $18.5 million. Loans receivable increased $9.5 million to $188.1 million primarily as a result of loans and participations purchased totaling $15.3 million offset by loans and participations sold totaling $2.3 million. Securities available-for-sale decreased $14.6 million to $122.4 million primarily as a result of the sale of securities available-for-sale of $15.7 million and principal paydowns on mortgage-backed securities of $9.6 million, partially offset by purchases of securities available-for-sale of $11.0 million.

We have historically reviewed investment securities with significant declines in fair value for potential other-than-temporary impairment pursuant to the guidance set forth in Statement of Financial Accounting Standards 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115" and "SAB No. 59"). We have developed a methodology for conducting periodic impairment testing on marketable equity securities with dividends that adjust periodically based on market interest rate indices, such as the Shay Funds that we own. Management has concluded that there are no securities that are subject to other-than-temporary impairment issues.

The allowance for loan losses was $968,000 at September 30, 2006 and $971,000 at December 31, 2005. There were no impaired loans at either date. The allowance for loan losses represented .51% of total loans at September 30, 2006 and .54% at December 31, 2005, and 93.17% of non-performing loans at September 30, 2006 compared to 86.70% of non-performing loans at December 31, 2005. Non-performing assets totaled $1.3 million and $1.4 million at September 30, 2006 and December 31, 2005, respectively. The ratio of non-performing assets to total assets at September 30, 2006 was .39% compared to .40% at December 31, 2005.

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Total liabilities at September 30, 2006 were $317.9 million compared to $318.0 million at December 31, 2005. The decrease in total liabilities primarily reflects a $3.4 million decrease in Federal Home Loan Bank advances partially offset by an increase in customer deposits of $3.1 million.

Shareholders' equity at September 30, 2006 was $21.9 million compared to $21.3 million at December 31, 2005. The increase in equity is partially due to net income of $361,000 and $116,000 from the exercise of stock options. Other items affecting equity include ESOP and stock awards earned, dividends paid, and stock option expense associated with the adoption of FAS 123R.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2006 AND SEPTEMBER 30, 2005

Net income increased $12,000 to $154,000 for the quarter ended September 30, 2006 compared to the same period in 2005. The increase in net income was a result of an increase in noninterest income and decreases in the provision for loan losses and noninterest expense, partially offset by a decrease in net interest income due to a narrower interest rate spread.

Net interest income was $1.7 million for the quarter ended September 30, 2006 compared to $1.9 million for the same prior year period. The ratio of average interest-earning assets to average interest-bearing liabilities increased to 107.21% from 105.18% for the three-month periods, respectively. The net interest spread and the net interest margin decreased to 1.79% and 2.03%, respectively, for the quarter ended September 30, 2006 from 2.17% and 2.31%, respectively, for the same period in 2005. The decrease in the spread and margin was due to an increase in the rate of interest-bearing liabilities partially offset by an increase in the volume of interest-earning assets. The increase in the cost of funds exceeded the increase in the yield on interest-earning assets as interest-bearing liabilities repriced upward more quickly than interest-earning assets in reaction to the increasing short-term interest rate environment and flat yield curve. The average yield on interest-earning assets increased 42 basis points to 5.39% for the quarter ended September 30, 2006 from 4.97% for the same quarter in 2005, while the average cost of interest-bearing liabilities increased 81 basis points to 3.61% for the quarter ended September 30, 2006 from 2.80% for the same period in 2005.

The provision for loan losses was $24,000 for the quarter ended September 30, 2006 compared to $143,000 for the same period in 2005. The change was a result of lower net charge-offs in the current year period and a greater increase in commercial mortgages in the prior year period. Management considered the allowance for loan losses to be adequate during both periods.

On a quarterly basis, management of the Company meets to review the allowance for loan losses. Management classifies loans in compliance with regulatory classifications. Classified loans are individually reviewed to arrive at specific reserves for those loans. Once the specific portion of the allowance is calculated, management calculates a historical portion for each loan category based on loan loss history, peer data, current economic conditions and trends in the portfolio, including delinquencies and impairments, as well as changes in the composition of the loan portfolio. Although management believes that the allowance for loan losses reflected probable incurred losses on existing loans at September 30, 2006, there can be no assurance that such losses will not exceed estimated amounts. Future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions that may be beyond the Company’s control. The allowance for loan losses as of September 30, 2006 was maintained at a level that represents management’s best estimate of probable incurred losses inherent in the loan portfolio.

Noninterest income was $302,000 for the three-month period ended September 30, 2006 compared to $267,000 for the same period in 2005. The increase was primarily due to a $29,000 increase in service charges on deposit accounts, a $16,000 increase in other fee income and a slight increase in other income, partially offset by an increase of $13,000 in net loss on the sale of securities.

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During July 2006, the Company approved and executed the sale of its holdings in a mutual fund. The sale resulted in a net loss of $231,000, which was offset by a gain of $212,000 on the sale of 3,900 shares of FHLMC stock. Total proceeds of $9.1 million from the sale were used to fund approximately $8.0 million of commercial real estate loans, which further implements management’s strategic plan to increase loans as a percentage of assets.

Noninterest expense was $1.7 million for the quarter ended September 30, 2006 compared to $1.8 million for the same prior year period. Compensation and benefits expense decreased $53,000 primarily due to decreases in health insurance premiums, ESOP expense and compensation costs, partially offset by increases in retirement fund costs and stock option expense. In addition, decreases of $10,000 were experienced in both advertising and other noninterest expense. Professional fees increased $22,000 during the quarter in connection with the pending transaction with Heartland Bancorp as further discussed in “Note 4—Subsequent Events.” Data processing expense increased $10,000 compared to the same quarter in 2005 due to the expiration of discounts resulting from a change in data processors during 2003. Small increases also occurred in occupancy and equipment and federal insurance premiums.

The Company's income tax expense increased $4,000 to $81,000 for the quarter ended September 30, 2006 compared to $77,000 during the same period in 2005 primarily as a result of increased income. Income tax expense was approximately 35% of pretax income for both three-month periods.

RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND SEPTEMBER 30, 2005

Net income decreased $355,000 to $361,000 for the nine months ended September 30, 2006 compared to the same period in 2005. The primary factors for the decrease in net income were a decrease in net interest income due to a narrower interest rate spread, a decrease in noninterest income due to the absence of significant gains on the sale of securities in the current period and an increase in noninterest expense, partially offset by a decrease in the provision for loan losses.

Net interest income was $5.2 million for the nine-month period ended September 30, 2006 compared to $5.7 million for the same prior year period. The ratio of average interest-earning assets to average interest-bearing liabilities increased to 107.35% from 105.55% for the nine-month periods, respectively. The net interest spread and the net interest margin decreased to 1.83% and 2.06%, respectively, for the nine months ended September 30, 2006 from 2.26% and 2.40%, respectively, for the same period in 2005. The decrease in the spread and margin was primarily due to an increase in the average rate paid on interest-bearing liabilities partially offset by an increase in the volume of interest-earning assets. The increase in the cost of funds exceeded the increase in the yield on interest-earning assets as interest-bearing liabilities repriced upward more quickly than interest-earning assets in reaction to the increasing short-term interest rate environment and flat yield curve. The average yield on interest-earning assets increased 39 basis points to 5.24% for the nine months ended September 30, 2006 from 4.85% for the same quarter in 2005, while the average cost of interest-bearing liabilities increased 83 basis points to 3.42% for the nine months ended September 30, 2006 from 2.59% for the same period in 2005.

The provision for loan losses was $90,000 for the nine-month period ended September 30, 2006 compared to $258,000 for the same period in 2005. The change was a result of greater net charge-offs in the prior year period and a $436,000 decrease in commercial mortgage loans on “watch” status in the nine months ended September 30, 2006 compared to a $354,000 increase in the same prior year period. Management considered the allowance for loan losses to be adequate during both periods.

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Noninterest income was $873,000 for the nine months ended September 30, 2006 compared to $971,000 for the same period in 2005. Decreases in net gain on sale of securities of $231,000 and other income of $7,000 were partially offset by increases of $80,000 in other fee income, $45,000 in service charges on deposit accounts, $8,000 in recovery of impairment loss, and $7,000 in loan origination and servicing fees.

Noninterest expense was $5.5 million for the nine months ended September 30, 2006 compared to $5.3 million for the same prior year period. Compensation and benefits expense increased $69,000 due to increases in retirement fund costs and stock option expense, partially offset by decreases in health insurance premiums, ESOP expense, and compensation costs. Data processing expense increased $59,000 compared to the same period in 2005 due to the expiration of discounts resulting from a change in data processors during 2003. In addition, increases in professional fees, occupancy and equipment, and federal insurance premiums were partially offset by decreases in other noninterest expense and advertising.

The Company's income tax expense decreased $190,000 to $206,000 for the nine-month period ended September 30, 2006 compared to $396,000 during the same period in 2005 primarily as a result of decreased income. Income tax expense was approximately 36% of pretax income for both nine-month periods.

LIQUIDITY

The Company must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments, and to take advantage of investment opportunities. The Company invests excess funds in overnight deposits and other short-term interest-bearing assets to provide liquidity to meet these needs. At September 30, 2006, cash and cash equivalents totaled $18.5 million. At September 30, 2006, the Company had commitments to fund loans of $1.3 million. At the same time, certificates of deposit which are scheduled to mature in one year or less totaled $137.8 million. Management believes, based on past experience, that a significant portion of those deposits will remain with the Company. Based on the foregoing, in addition to the Company’s high level of core deposits and capital, the Company considers its liquidity and capital resources sufficient to meet its outstanding short-term and long-term needs. First Federal Bank has the ability to borrow funds at the Federal Home Loan Bank (FHLB). In the past, borrowed funds have been term advances and open lines of credit. At September 30, 2006 the Bank had $13.5 million in FHLB advances with an average weighted rate of 4.23% and tiered maturities from February 2007 through February 2016. In addition, advances totaling $1.3 million with an average weighted rate of 5.19% are scheduled for payments to amortize over a ten-year period, maturing in August and December 2015 and September 2016. Collateral used for these purposes are mortgage-backed securities issued by government sponsored agencies, namely, GNMA and FNMA, with a total value of $35.6 million, or 29.1% of total available-for-sale securities, and therefore does not significantly impact the Company’s liquidity. There were no open lines of credit at September 30, 2006.

CAPITAL RESOURCES

The Bank is subject to capital-to-asset requirements in accordance with bank regulations. The following table summarizes the Bank's regulatory capital requirements versus actual capital as of September 30, 2006:

	ACTUAL				MINIMUM REQUIRED				EXCESS
	AMOUNT		%		AMOUNT		%		AMOUNT		%
Core capital (to adjusted total assets)	$	25,701	7.59	%	$	13,541	4.00	%	$	12,160	3.59	%
Tangible capital (to adjusted total assets)		25,701	7.59			5,078	1.50			20,623	6.09
Risk-based capital (to risk-weighted assets)		25,993	15.48			13,430	8.00			12,563	7.48

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Qualitative Aspects of Market Risk.The Company's most significant form of market risk is interest rate risk. The principal objectives of the Company's interest rate risk management are to evaluate the interest rate risk inherent in certain balance sheet accounts, determine the level of risk appropriate given the Company's business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the Board of Director's approved guidelines. The Company has an Asset/Liability Committee, responsible for reviewing its asset/liability policies and interest rate risk position, which meets monthly and reports trends and interest rate risk position to the Board of Directors quarterly. The extent of the movement of interest rates is an uncertainty that could have a negative impact on the earnings of the Company.

The Company has used the following strategies to manage interest rate risk: (1) emphasizing the origination and purchase of adjustable-rate and balloon loans and not originating long-term, fixed-rate loans for retention in its loan portfolio; (2) emphasizing shorter term consumer loans; (3) introducing floating-rate commercial business loans tied to the prime rate; (4) maintaining a high quality securities portfolio that provides adequate liquidity and flexibility to take advantage of opportunities that may arise from fluctuations in market interest rates, the overall maturity of which is monitored in relation to the repricing of its loan portfolio; and (5) using Federal Home Loan Bank advances to better structure maturities of its interest rate sensitive liabilities. The Company currently does not participate in hedging programs, interest rate swaps or other activities involving the use of off-balance sheet derivative financial instruments.

Quantitative Aspects of Market Risk.The Company primarily utilizes an interest sensitivity analysis prepared by the Office of Thrift Supervision to review the level of interest rate risk of the Bank. This analysis measures interest rate risk by computing changes in the net portfolio value of the Bank's cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. Net portfolio value represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or decrease in market interest rates with no effect given to any steps that management might take to counter the effect of that interest rate movement. The following table, which is based on information provided to the Bank by the Office of Thrift Supervision, presents the change in the Bank's net portfolio value at September 30, 2006, the latest date for which information is available, that would occur upon an immediate change in interest rates based on Office of Thrift Supervision assumptions, but without giving effect to any steps that management might take to counteract that change. All model outputs associated with the –300 bp scenarios are not applicable because of the abnormally low prevailing interest rate environment.

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Change in Interest Rates in Basis Points (Rate Shock)	Net Portfolio Value						NPV as % of Portfolio Value of Assets
	Amount		$ Change		% Change		NPV Ratio		Basis Point Change
	(Dollars in thousands)
300	$	17,625	(12,432	)	(41	)%	5.46	%	(337	)bp
200		21,866	(8,190	)	(27	)	6.65		(218	)bp
100		26,186	(3,870	)	(13	)	7.83		(101	)bp
Static		30,056	—		—		8.83		—
(100)		33,396	3,340		11		9.67		83	bp
(200)		35,554	5,498		18		10.17		134	bp

The Office of Thrift Supervision uses certain assumptions in assessing the interest rate risk of savings associations. These assumptions relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others.

As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable rate mortgage loans, have features, which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, if interest rates change, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

ITEM 4: CONTROLS AND PROCEDURES

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Exchange Act. Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

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PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

Periodically, there have been various claims and lawsuits involving the Company, such as claims to enforce liens, condemnation proceedings on properties in which the Company holds security interest, claims involving the making and servicing of real property loans and other issues incident to the Company's business. In the opinion of management, after consultation with the Company's legal counsel, no significant loss is expected from any such pending claims or lawsuits. The Company is not a party to any material pending legal proceedings.

ITEM 1A. RISK FACTORS.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None

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

None

ITEM 5. OTHER INFORMATION.

None

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ITEM 6. EXHIBITS

2.1	Agreement and Plan of Reorganization, dated November 3, 2006, by and between Heartland Bancorp, Inc., Heartland Acquisition Corporation and First Federal Bancshares, Inc. (8)
3.1	Certificate of Incorporation of First Federal Bancshares, Inc. (1)
3.2	Bylaws of First Federal Bancshares, Inc. (2)
4.0	Specimen Stock Certificate of First Federal Bancshares, Inc. (1)
10.1*	Employment Agreement between First Federal Bancshares, Inc. and James J. Stebor (3)
10.2*	Employment Agreement between First Federal Bank and James J. Stebor (3)
10.3*	First Federal Bank Supplemental Executive Retirement Plan (3)
10.4*	First Federal Bank Employee Severance Compensation Plan (3)
10.5*	First Federal Bancshares, Inc. 2001 Stock-Based Incentive Plan (4)
10.6*	PFSB Bancorp, Inc. 2000 Stock-Based Incentive Plan (5)
10.7*	Form of NSO Award Agreement (6)
10.8*	Change in Control Agreement with Mark Tyrpin (7)
10.9	Employment Agreement, dated November 3, 2006, by and between James J. Stebor and First Federal Bank (8)
10.10	Employment Agreement, dated November 3, 2006, by and between Mark A. Tyrpin and First Federal Bank (8)
31.1	Rule 13a – 14(a)/15d – 14(a) Certification of the Chief Executive Officer.
31.2	Rule 13a – 14(a)/15d – 14(a) Certification of the Chief Financial Officer.
32.1	Section 1350 Certification of the Chief Executive Officer.
32.2	Section 1350 Certification of the Chief Financial Officer.

* Management contract or compensatory plan, contract or arrangement.

(1) Incorporated herein by reference from the Exhibits to Form SB-2, Registration Statement and amendments thereto, initially filed on May 5, 2000, Registration No. 333-36368.

(2) Incorporated herein by reference from the Exhibits to the Annual Report on Form 10-KSB, filed on March 28, 2002.

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(3) Incorporated herein by reference from the Exhibits to the Quarterly Report on Form 10-QSB filed on November 14, 2000.

(4) Incorporated herein by reference from the Exhibits to the Quarterly Report on Form 10-QSB filed on August 13, 2001.

(5) Incorporated by reference to PFSB Bancorp, Inc.’s Registration Statement on Form S-8 (SEC No. 333-35020) filed on April 18, 2000.

(6) Incorporated by reference from the Exhibits to the Annual Report on Form 10-K filed on March 31, 2005.

(7) Incorporated by reference from the Exhibits to the Annual Report on Form 10-K filed on March 30, 2006.

(8) Incorporated herein by reference from the Exhibits to the Current Report on Form 8-K filed on November 6, 2006.

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SIGNATURES

Pursuant to the requirements 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.

	FIRST FEDERAL BANCSHARES, INC.
Date: November 14, 2006	/s/ James J. Stebor
	James J. Stebor
	President and Chief Executive Officer
Date: November 14, 2006	/s/ Cathy D. Pendell
	Cathy D. Pendell
	Treasurer

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