In January 2004, Hills Bancorporation paid a dividend of $3,185,000 or $2.10 per share, a 10.53% increase from the $1.90 per share paid in January 2003. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2004 totaled $97,662,000. Under risk-based capital rules, the total amount of risk based capital is 13.98% of risk-adjusted assets, and is substantially in excess of required minimums.
The Company’s net income for the six months ended June 30, 2004 was $7.157 million compared to $7.508 million for the same period in 2003. The decrease of $351,000 was due primarily to four factors. The first of these factors was a $1.735 million increase in net interest income, second, a $1.485 million decrease in gain on sale of loans, third, a $568,000 increase in other income excluding the change in gain on sale of loans and finally an increase in other expenses of $1.532 million. The changes in the components of the net decrease are shown prior to a provision for income taxes.
Net interest income is the excess of the interest and fees received on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the first six months of 2004 was 3.57% compared to 3.47% in 2003 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 34% to make the interest earned on taxable and non-taxable assets more comparable. Total interest income decreased $254,000 for the first six months of 2004 compared to the same period in 2003. The volume of average earning assets is up $73.0 million while the tax-equivalent yield is down to 5.62% from 6.03% from the period ended June 30, 2003. Interest expense is $1.989 million less in 2004 than 2003 for the first six months of each year. The volume of average interest bearing liabilities is up $51.1 million while the yield paid is 2.41% in 2004 compared to 2.99% for 2003. The reduction of 58 basis points in interest costs accounts for the majority of the net interest margin improvement.
Net interest income on a tax equivalent basis for the six months ended changed in 2004 compared to 2003 as shown in the following table:
HILLS BANCORPORATION
Item 2. | Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued) |
Provision for Loan Losses
The provision for loan losses was $515,000 and $449,000 for the six months ended June 30, 2004 and 2003, respectively. The Company experienced net charge-offs for this time period in 2004 of $40,000 and net recoveries of $166,000 in 2003. The provision adjustment computed on a quarterly basis is a result of management’s determination of the quality of the loan portfolio and the adequacy of the allowance for loan losses. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the level of impaired loans which are all non-accrual and loans past due ninety days or more. In addition, management considers the credit quality of the loan portfolio based on review of problem and watch loans, including loans with historically higher credit risks (primarily agricultural loans).
The allowance for loan losses totaled $13,060,000 at June 30, 2004 compared to $12,585,000 at December 31, 2003. The allowance represented 1.38% and 1.43% of outstanding loans at June 30, 2004 and December 31, 2003, respectively. The allowance was based on management’s consideration of a number of factors, including loan concentrations, loans with higher credit risks (primarily agriculture loans and spec real estate construction) and overall increases in net loans outstanding. The methodology used in 2004 is consistent with the prior year.
Other Income
Net gain on sale of loans for the six months ended June 30, 2004 was $967,000 compared to $2,452,000 for the same period ended June 30, 2003. The decrease was expected, as net gain on sale of secondary market loans continued to drop significantly from the levels experienced in the first three quarters of 2003. The decrease in the volume of loans is due to the fact that many consumers had taken advantage of lower rates in 2003 to refinance loans and the absence of even lower rates since 2003.
Trust fees increased $163,000 in the first six months of 2004 compared to 2003 due to the increase in total assets under management. Approximately 51% of the trust assets are held in common stocks, and the asset growth has been fueled by higher stock prices over the last twelve months. For example, the Dow Jones Industrial Average is up just over 14% in the twelve months ended June 30, 2004. Other fees and charges increased to $2,203,000 in 2004 from $1,799,000 in 2003. Approximately $156,000 of the increased revenue from fees and charges is in ATM service fees, debit card fees and credit card merchant fees. In addition, rental revenue from a new tax credit real estate property added in January, 2004 was $300,000 higher in 2004 than in 2003.
Other Expenses
Total other expenses were $15.234 million and $13.702 million for the six months ended June 30, 2004 and 2003, respectively. The increase of $1.532 million included salaries and employee benefits which were $759,000 higher. The increase in direct salaries was $498,000 or 8.70%. The increase is due to salary adjustments for 2004 and an increase in the number of full-time equivalent employees. Increased employment resulted in part from the need to staff the Marion office that opened in February of 2003. Medical expenses of the Company’s self-funding plan increased by $143,000 for the six months from one year ago and are a result of higher medical costs and more employees in the plan.
Advertising and business development expenses were $787,000 for the six months ended June 30, 2004 compared to $670,000 for the six months ended June 30, 2003. The increase of $117,000 included primarily costs associated with the 100th Anniversary celebration of the Company’s subsidiary Bank in 2004.
Other expenses for the six month period presented are $3.008 million in 2004 compared to $2.532 million in 2003. Included in this expense line item are merchant card processing charges and ATM charges that were $162,000 higher in 2004 than 2003 because of the increased volume of activity. Also, expenses for the rental of tax credit real estate increased from $132,000 in the six months ended June 30, 2003 to $351,000 for the same period in 2004. The increase is due to the new property added in January of 2004.
Page 16 of 26
HILLS BANCORPORATION
Item 2. | Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued) |
Income Taxes
Income tax expense was $3,266,000 and $3,695,000 for the six months ended June 30, 2004 and 2003, respectively. The corresponding percentage of income taxes compared to income before income taxes is 31.33% in 2004 and 32.98% in 2003. The percentage in 2004 is lower due to higher income tax credits available from the tax credit real estate investments. The credits were $265,000 and $118,000 for the six months ended June 30, 2004 and 2003, respectively.
Discussion of operations for the three months ended June 30, 2004 and 2003.
Net Income
Net income decreased from $4,127,000 in 2003 to $3,795,000 in 2004. As discussed in the six month review of net income, the major factor was the gain on sale of secondary market loans decreasing from $1,587,000 in 2003 to $616,000 in 2004. Other significant changes in the income statement are increases in net interest income of $1,009,000 and $705,000 in other expenses.
Net Interest Income
Net interest income increased for the three month period ended June 30, 2004 by $1.009 million over the similar period in 2003. The net interest margin in 2004 improved to 3.62% compared to 3.45% in 2003. The increase in the volume of interest earning assets accounted for a significant portion of the net interest income improvement.
Details of the changes in net interest income are as follows:
| | Increase (Decrease) | |
| |
| |
| | Volume Changes | | Rate Changes | | Net Change | |
| |
| |
| |
| |
| | (Amount in thousands) | |
| | | |
Interest income: | | | | | | | |
| Loans, net | | | $ | 1,503 | | | | $ | (1,169 | ) | | | $ | 334 | | |
| Securitities | | | | 160 | | | | | (339 | ) | | | | (179 | ) | |
| Federal funds sold | | | | (107 | ) | | | | (3 | ) | | | | (110 | ) | |
| | |
|
| | | |
|
| | | |
|
| | |
| | | $ | 1,556 | | | | $ | (1,511 | ) | | | $ | 45 | | |
| | |
|
| | | |
|
| | | |
|
| | |
| | | | | | | | | | | | | | | | |
Interest expense: | | | | | | | | | | | | | | | | |
| Interest-bearing deposits | | | $ | (17 | ) | | | $ | (947 | ) | | | $ | (964 | ) | |
| Other borrowings | | | | (21 | ) | | | | 21 | | | | | — | | |
| | |
|
| | | |
|
| | | |
|
| | |
| | | $ | (38 | ) | | | $ | (926 | ) | | | $ | (964 | ) | |
| | |
|
| | | |
|
| | | |
|
| | |
| | | | | | | | | | | | | | | | |
Change in net interest income | | | $ | 1,594 | | | | $ | (585 | ) | | | $ | 1,009 | | |
| | |
|
| | | |
|
| | | |
|
| | |
Page 17 of 26
HILLS BANCORPORATION
Item 2. | Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued) |
Other Income
As explained in the preceding discussion of in the six months results, 2003 was an excellent year for loans sold on the secondary market. Interest rates were more favorable and the second quarter of 2003 had the highest level of gain on sale of loans since the Company began making sales on the secondary market over ten years ago. The total net gain was $1,587,000, which was $971,000 over the quarter ending June 30, 2004.
Other Expenses
Total expenses for the 2004 quarter compared to the 2003 quarter increased $705,000. Of the additional expenses, $375,000 represented salaries and employee benefits related to an increase in full and part time employees, coupled with normal year-end salary adjustments in 2004. The direct salary expense increase was $207,000. Medical claim and insurance expense increased $74,000 in 2004 compared to 2003.
Other expenses were $234,000 higher in 2004, with $189,000 of this increase relating to rental expenses on the tax credit real estate purchased in 2004. This was partially offset by an increase of $159,000 in rental income which is included in other fees and charges as part of other income.
Income Taxes
Income tax expense as a percentage of income before taxes decreased from 33.05% in 2003 to 31.76% in 2004. The decrease is due to additional tax credits available as a result of the new tax credit real estate investment in 2004.
Liquidity
The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Federal funds sold and investment securities available for sale comprised 16.75% of the Company’s total assets at June 30, 2004, compared to 19.66% at December 31, 2003.
The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of June 30, 2004, the Company had borrowed $167.6 million from the FHLB of Des Moines. The amount of advances from the FHLB of Des Moines is unchanged from December 31, 2003. These advances were used as a means of providing both long and short-term, fixed-rated funding for certain assets and managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $151 million at June 30, 2004.
As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and two lines of credit with two banks totaling $104 million. Those two lines of credit require the pledging of investment securities when drawn upon.
The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2004.
Page 18 of 26
HILLS BANCORPORATION
Market Risk Management
Market risk is the risk of loss arising from adverse changes in market prices and rates. The Company’s market risk is comprised primarily of interest rate risk resulting from its core banking activities of lending and deposit gathering. Interest rate risk measures the impact on earnings from changes in interest rates and the effect on current fair market values of the Company’s assets, liabilities and off-balance sheet contracts. The Company’s objective is to measure this risk and manage the balance sheet to avoid unacceptable potential for economic loss. Management continually develops and applies strategies to mitigate market risk, some of which are described below. Exposure to market risk is reviewed on a regular basis by the asset/liability committee at the bank. Management does not believe that the Company’s primary market risk exposures and how those exposures have been managed to date in 2004, changed significantly when compared to 2003.
Asset/Liability Management
The Company’s primary market risk exposure is to changes in interest rates. The Company’s asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company’s control, such as market interest rates and competition, may also have an impact on the Company’s interest income and interest expense. In the absence of other factors, the Company’s overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market rates increase over an extended period of time. The Company’s yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.
The Bank maintains an asset/liability committee, which meets at least quarterly to review the interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.
In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company’s operations, management has implemented an asset/liability program designed to mitigate the Company’s interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of passbook or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
Net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company’s interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company’s interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company’s net interest income.
Page 19 of 26
HILLS BANCORPORATION
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operations of the Company’s disclosure controls and procedures, and as defined in Exchange Act Rule 13a-15(e). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in enabling the Company’s periodic SEC filings within the required time period. There have been no changes in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Page 20 of 26
HILLS BANCORPORATION
PART II - OTHER INFORMATION
| Item 1. | |
| |
| No material legal proceedings are pending. |
| |
| Item 2. | |
| |
| There were no changes in securities. |
| |
| Item 3. | |
| |
| Hills Bancorporation has no senior securities. |
| |
| Item 4. | |
| | |
| (a) | The Annual Meeting of Shareholders was held on April 19, 2004. The results listed for the election of directors and the ratification of auditors are included in items (b) and (c) listed below. Note that the number of shares did not reflect the three-for-one stock split on April 13, 2004 with a record date of April 19, 2004. |
| | |
| (b) | The following individuals were elected to serve as directors of the Company for a three year term at the Annual Meeting. The results of the voting by individuals and those withholding authority are as follows: |
| | | For | | Withhold Authority | |
| | |
| |
| |
| 1. Michael E. Hodge | | | 1,226,475 | | | | 215 | | |
| 2. Richard W. Oberman | | | 1,225,828 | | | | 862 | | |
| 3. Sheldon E. Yoder, D.V.M. | | | 1,225,375 | | | | 1,315 | | |
| (c) | Ratification of KPMG LLP as the Company’s independent auditors for the fiscal year ending
December 31, 2004. |
| | For | | Against | | Abstain | |
| |
| |
| |
| |
| | | 1,210,421 | | | | 0 | | | | 16,269 | |
| | | | | | | | | | | | |
| Item 5. | |
| |
| None |
| |
| Item 6. | |
| |
| Exhibits |
| |
| 31 | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 |
| |
| 32 | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 |
| |
| Reports on Form 8-K |
| |
| No reports on Form 8-K have been filed during the quarter ended June 30, 2004. |
Page 21 of 26
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.
| | HILLS BANCORPORATION | |
| | | |
| | | |
| Date 8/5/04 | By | /s/ Dwight O. Seegmiller | |
| |
| |
| | Dwight O. Seegmiller, President and Chief Executive Officer | |
| | | |
| | | |
| Date 8/5/04 | By | /s/ James G. Pratt | |
| |
| |
| | James G. Pratt, Treasurer and Chief Financial Officer | |
Page 22 of 26
HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED JUNE 30, 2004
Exhibit
Number | | Description | | Page Number
In The Sequential
Numbering System
June 30, 2004 Form 10-Q |
| |
| |
|
31 | | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 | | 24- 25 of 26 |
| | | | |
32 | | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 | | 26 of 26 |
Page 23 of 26
