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 nine months of 2004 was 3.58% compared to 3.45% 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. The table below shows the change in average balances and average rates between years and the effect on the net interest income on a tax equivalent basis for the nine months ended 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 $1,117,000 and $123,000 for the nine months ended September 30, 2004 and 2003, respectively. The Company experienced net charge-offs for this time period in 2004 of $32,000 and net recoveries of $177,000 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 and 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 Company’s review of the portfolio at September 30, 2004 resulted in the level of potential problem loans increasing approximately $1 million from the December 31, 2003 balances. One year ago, for the nine months ended September 30, 2003, the loans identified for the loan loss review increased only $300,000.
The allowance for loan losses totaled $13,670,000 at September 30, 2004 compared to $12,585,000 at December 31, 2003. The allowance represented 1.39% and 1.43% of outstanding loans at September 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.
Net Gain on Sale of Loans
Net gain on sale of loans for the nine months ended September 30, 2004 was $1,259,000 compared to $3,972,000 for the same period ended September 30, 2003. The decreased fees in the secondary market were expected from the levels experienced in the first three quarters of 2003. The number of loans sold in 2004 was approximately 40% of the volume in 2003. Also, some discounting of fees occurred in 2004 to maintain market share. 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.
Other Income
Trust fees increased $219,000 in the first nine months of 2004 compared to 2003 due to the increase in total assets under management. Assets under management have increased $110.2 million in the last year to $674.8 million. Approximately 51% of the trust assets are held in common stocks, and the asset growth has been partially due to higher stock prices over the last twelve months. For example, the Dow Jones Industrial Average is up just over 6% in the twelve months ended September 30, 2004. Other fees and charges increased to $3,375,000 in 2004 from $2,802,000 in 2003. Approximately $292,000 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 tax credit real estate properties is $172,000 higher due to an additional property added in January 2004.
Page 17 of 29
HILLS BANCORPORATION
Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)
Other Expenses
Total other expenses were $23.0 million and $20.9 million for the nine months ended September 30, 2004 and 2003, respectively. This increase of $2.1 million includes salaries and employee benefits which were $982,000 higher. The increase in direct salaries was $562,000 or 6.41%. The increase is due to salary adjustments for 2004 and an increase in the average number of full-time equivalent employees. Medical expenses of the Company’s self-funding plan increased by $264,000 for the nine months from one year ago and are primarily the result of higher medical costs and more employees covered in the plan.
Occupancy and furniture and equipment expense increased $315,000 from one year ago to a total of $3,977,000. The change included an increase in depreciation expense on equipment of $156,000 due to a full year of depreciation for 2003 additions and new equipment added in 2004. Also, property taxes were $72,000 higher due to new construction of offices in the prior year at two locations and the full value of the improvements being assessed.
Advertising and business development expenses were $1,271,000 for the nine months ended September 30, 2004 compared to $1,021,000 for the nine months ended September 30, 2003. The increase of $250,000 included costs associated with the 100th Anniversary celebration of the Company’s subsidiary Bank in 2004 that were approximately $110,000. The balance of the increase was primarily in direct mail expense and product promotion. Both areas saw increased emphasis for 2004 in marketing retail deposits and home equity loans.
Other expenses for the nine month period presented are $4.5 million in 2004 compared to $3.9 million in 2003. Included in this expense category are merchant card processing charges, debit card processing and ATM charges that were $150,000 higher in 2004 than 2003 due to increased volume of activity. Also, expenses associated with the rental of tax credit real estate increased from $360,000 in the nine months ended September 30, 2003 to $595,000 for the same period in 2004. The increase is due to the addition in January of 2004 of the Iowa City Tax Credit Property.
Income Taxes
Income tax expense was $4,902,000 and $5,888,000 for the nine months ended September 30, 2004 and 2003, respectively. The corresponding percentage of income taxes compared to income before income taxes is 31.29% in 2004 and 33.24% in 2003. The percentage in 2004 is lower due to additional income tax credits available from the purchase in early 2004 of the Iowa City Tax Credit Property. The total tax credits were $395,000 and $175,000 for the nine months ended September 30, 2004 and 2003, respectively.
Page 18 of 29
HILLS BANCORPORATION
Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)
Discussion of operations for the three months ended September 30, 2004 and 2003.
Net Income
Net income decreased from $4,319,000 in 2003 to $3,607,000 in 2004. As discussed in the nine month review of net income, one of the major factors was the decrease in gain on sale of secondary market loans from $1,520,000 in 2003 to $292,000 in 2004. Net of income taxes, this would account for approximately an $810,000 decrease in net income. All the other significant differences net to an amount of less than $100,000. Those items include an increase in the net interest margin of $1,235,000; the provision for loan losses increasing by $927,000, a $252,000 increase in other income and a $600,000 increase in other expenses. Changes in each of these items occurred for reasons similar to those discussed in the nine month review of net income.
Net Interest Income
Net interest income increased for the three month period ended September 30, 2004 by $1.2 million from the similar period in 2003. The net interest margin in 2004 improved to 3.59% compared to 3.39% in 2003. The increase in the volume of interest earning assets accounted for a significant portion of the net interest income improvement along with savings on interest bearing liabilities.Net interest income on a tax-equivalent basis changes for the three months ended September 30, 2004 and 2003 are as follows:
| Change In
Average Balance
| | Change In
Average Rate
| | Increase (Decrease)
| |
|---|
Volume Changes
| | Rate Changes
| | Net Change
|
|---|
| (Amounts In Thousands) | |
|---|
| Interest income: | | | | | | | | | | | | | | | | | |
| Loans, net | | | $ | 107,605 | | | (0.29 | )% | $ | 1,657 | | $ | (661 | ) | $ | 996 | |
| Taxable securities | | | | (7,778 | ) | | (0.56 | ) | | (87 | ) | | (184 | ) | | (271 | ) |
| Nontaxable securities | | | | 9,757 | | | (0.33 | ) | | 137 | | | (62 | ) | | 75 | |
| Federal funds sold | | | | (33,509 | ) | | 1.13 | | | (66 | ) | | (1 | ) | | (67 | ) |
| | | |
| | | | |
| |
| |
| |
| | | | $ | 76,075 | | | | | $ | 1,641 | | $ | (908 | ) | $ | 733 | |
| | | |
| | | | |
| |
| |
| |
| Interest expense: | | |
| Interest-bearing demand deposits | | | $ | 13,925 | | | (0.26 | ) | $ | 26 | | $ | (93 | ) | $ | (67 | ) |
| Savings deposits | | | | 26,405 | | | (0.04 | ) | | 46 | | | (18 | ) | | 28 | |
| Time deposits | | | | (2,002 | ) | | (0.54 | ) | | (30 | ) | | (540 | ) | | (570 | ) |
| Federal funds purchased and securities | | |
| sold under agreements to repurchase | | | | 17,548 | | | (0.12 | ) | | 117 | | | (36 | ) | | 81 | |
| FHLB borrowings | | | | (31 | ) | | — | | | — | | | — | | | — | |
| | | |
| | | | |
| |
| |
| |
| | | | $ | 55,845 | | | | | $ | 159 | | $ | (687 | ) | $ | (528 | ) |
| | | |
| | | | |
| |
| |
| |
| Change in net interest income | | | | | | | | | $ | 1,482 | | $ | (221 | ) | $ | 1,261 | |
| | | | | | | | |
| |
| |
| |
A summary of the net interest spread and margin is as follows:
| | (Tax Equivalent Basis)
|
| 2004
|
| 2003
|
|
|---|
| | Yield on average interest-earning assets | | | 5.59 | % | | 5.72 | % |
| | Rate on average interest-bearing liabilities | | | 2.37 | | | 2.73 | |
| | | |
| |
| | Net interest spread | | | 3.22 | % | | 2.99 | % |
| | Effect of noninterest-bearing funds | | | 0.37 | | | 0.40 | |
| | | |
| |
| | Net interest margin (tax equivalent interest income
dividend by average interest-earning assets) | | | 3.59 | % | | 3.39 | % |
| | | |
| |
Page 19 of 29
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 $602,000 for the quarter ended September 30, 2004 compared to a reduction in the expense of $325,000 one year ago. As discussed in the results for the nine months, the allowance for loan losses was increased due to management’s analysis of the outstanding loans at September 30, 2004, which resulted in a higher level of problem loans.
Other Income
As explained in the preceding discussion of the nine months results, net gain on sale of loans was substantially less in 2004 as compared to 2003 which was an excellent year for loans sold on the secondary market. Interest rates were more favorable in 2003 and the third quarter of 2003 was the second highest level of gain on sale of loans since the Company started the program over ten years ago. The total gain on sale of loans in 2003 was $1,520,000, which was $1,228,000 more than the quarter ended September 30, 2004. Other income items for debit card fees and ATM service fees were up $96,000 for the quarter ended September 30, 2004, as compared to the same quarter of 2003.
Other Expenses
Total expenses for the 2004 quarter compared to the 2003 quarter increased $600,000. Of the additional expenses, $223,000 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 $65,000 and medical claims and insurance increased $121,000 in 2004 compared to 2003. Advertising and business development expenses increased $133,000 in comparing the quarters. As for the nine months, this included direct mail and product promotion items to assist in the retail growth of the Company. Other expenses were $143,000 higher in the 2004 quarter than in the comparable 2003 quarter, with $95,000 of this increase relating to increases in rental expenses on tax credit real estate. As a result of an increase in the volume of activity, credit card processing increased $77,000.
Income Taxes
Income tax expense as a percentage of income before taxes decreased from 33.66% in 2003 to 31.20% in 2004. The decrease is due to an additional $73,000 in tax credits available as a result of the new tax credit real estate investment in 2004.
Page 20 of 29
HILLS BANCORPORATION
Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)
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 16.10% of the Company’s total assets at September 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 September 30, 2004, the Company had borrowed $167.5 million from the FHLB of Des Moines. The amount of advances from the FHLB of Des Moines is $32,000 less than at December 31, 2003. These advances were used as a means of providing both long and short-term, fixed-rate funding for certain assets and managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $171 million at September 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 lines of credit with two banks totaling $106 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 September 30, 2004.
Page 21 of 29
HILLS BANCORPORATION
Item 3. Quantitative and Qualitative Disclosures About Market Risk
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 the manner in which 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, interest rates paid by the Company on the Company’s interest rate sensitive liabilities would re-price faster than interest rates received by the Company on 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 22 of 29
HILLS BANCORPORATION
Item 4. Controls and Procedures
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 recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. 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 23 of 29
HILLS BANCORPORATION
PART II – OTHER INFORMATION
| | No material legal proceedings are pending. |
| Item 2. | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities |
| | There were no changes in securities. |
| Item 3. | Defaults upon Senior Securities |
| | Hills Bancorporation has no senior securities. |
| Item 4. | Submission of Matters to a Vote of Security Holders |
| | No matters were submitted to a vote of security holders during the quarter ended September 30, 2004. |
| Item 6. | Exhibits and Reports on Form 8-K |
| 31 | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32 | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 |
| | A report on Form 8-K was filed on September 16, 2004, which reported that the Company’s Board of Directors elected James A. Nowak as a director of Hills Bancorporation and its wholly-owned subsidiary, Hills Bank and Trust Company on September 14, 2004. Mr. Nowak will serve on the audit committee of Hills Bancorporation beginning immediately and has been designated as the audit committee financial expert as defined in Rule 401(h) of Regulation S-K. |
Page 24 of 29
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: November 5, 2004
——————————
| | By: /s/ Dwight O. Seegmiller
—————————————————————— |
| | | Dwight O. Seegmiller, Director and President |
| | | |
| | | |
Date: November 5, 2004
——————————
| | By: /s/ James G. Pratt
—————————————————————— |
| | | James G. Pratt, Treasurer and Chief Accounting Officer |
Page 25 of 29
HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2004
Exhibit
Number | Description | Page Number
In The Sequential
Numbering System
September 30, 2004 Form 10-Q |
|---|
|
| | | | | | | |
| | 31 | | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 | | | 27- 28 of 29 |
| | | | | | | |
| | 32 | | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 | | | 29 of 29 |
| |
|
| | | | | | | |
Page 26 of 29
