| UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 |
| FORM 10-Q |
| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
| For the quarterly period ended June 30, 2006 |
| Commission file number: 0-12668 |
| Hills Bancorporation |
| Incorporated in Iowa | I.R.S. Employer Identification No. 42-1208067 |
| 131 MAIN STREET, HILLS, IOWA 52235 |
| Telephone number: (319) 679-2291 |
Indicate by checkmark 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. x Yes o No Indicate by checkmark 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. (Check one): Large accelerated filero Accelerated Filer x Non-accelerated filero Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso No x APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date. |
| CLASS | SHARES OUTSTANDING At July 31, 2006 | |
| Common Stock, no par value | 4,559,883 | |
Page 1 of 34 |
HILLS BANCORPORATION Part I |
Page 2 of 34 |
| HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Shares) |
| ASSETS | June 30, 2006 (Unaudited) | December 31, 2005 | |||||
| Cash and cash equivalents | $ | 27,143 | $ | 29,956 | |||
| Investment securities: | |||||||
| Available for sale at fair value (amortized cost June 30, 2006 $193,603; December 31, 2005 $199,673) | 188,679 | 196,786 | |||||
| Held to maturity at amortized cost (fair value June 30, 2006 $176; December 31, 2005 $225) | 170 | 215 | |||||
| Stock of Federal Home Loan Bank | 12,397 | 12,000 | |||||
| Loans held for sale | 8,093 | 702 | |||||
| Loans, net | 1,221,424 | 1,141,716 | |||||
| Property and equipment, net | 22,153 | 22,265 | |||||
| Tax credit real estate | 7,316 | 7,595 | |||||
| Accrued interest receivable | 9,422 | 8,619 | |||||
| Deferred income taxes | 8,437 | 6,819 | |||||
| Goodwill | 2,500 | 2,500 | |||||
| Other assets | 3,729 | 4,476 | |||||
| $ | 1,511,463 | $ | 1,433,649 | ||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||
| Liabilities | |||||||
| Noninterest-bearing deposits | $ | 142,432 | $ | 146,799 | |||
| Interest-bearing deposits | 930,428 | 889,615 | |||||
| Total deposits | $ | 1,072,860 | $ | 1,036,414 | |||
| Short-term borrowings | 67,787 | 34,537 | |||||
| Federal Home Loan Bank borrowings | 228,161 | 223,161 | |||||
| Accrued interest payable | 2,542 | 2,313 | |||||
| Other liabilities | 7,282 | 7,111 | |||||
| $ | 1,378,632 | $ | 1,303,536 | ||||
| Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP) | $ | 20,058 | $ | 20,634 | |||
| STOCKHOLDERS’ EQUITY | |||||||
| Capital stock, no par value; authorized 10,000,000 shares; issued June 30, 2006 4,565,260 shares; December 31, 2005 4,563,637 shares | $ | — | $ | — | |||
| Paid in capital | 12,090 | 11,970 | |||||
| Retained earnings | 124,033 | 119,989 | |||||
| Accumulated other comprehensive income (loss) | (3,041 | ) | (1,783 | ) | |||
| Treasury stock at cost (June 30, 2006 5,377 shares; December 31, 2005 1,400 shares) | (251 | ) | (63 | ) | |||
| $ | 132,831 | $ | 130,113 | ||||
| Less maximum cash obligation related to ESOP shares | 20,058 | 20,634 | |||||
| $ | 112,773 | $ | 109,479 | ||||
| $ | 1,511,463 | $ | 1,433,649 | ||||
| See Notes to Consolidated Financial Statements. |
Page 3 of 34 |
| HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (Amounts In Thousands, Except Per Share Amounts) |
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||
| Interest income: | ||||||||||||
| Loans, including fees | $ | 19,709 | $ | 16,209 | $ | 38,080 | $ | 31,393 | ||||
| Investment securities: | ||||||||||||
| Taxable | 1,150 | 1,230 | 2,290 | 2,459 | ||||||||
| Nontaxable | 715 | 659 | 1,422 | 1,303 | ||||||||
| Federal funds sold | 20 | 67 | 31 | 103 | ||||||||
| Total interest income | $ | 21,594 | $ | 18,165 | $ | 41,823 | $ | 35,258 | ||||
| Interest expense: | ||||||||||||
| Deposits | $ | 6,580 | $ | 4,672 | $ | 12,538 | $ | 8,724 | ||||
| Short-term borrowings | 783 | 228 | 1,200 | 307 | ||||||||
| FHLB borrowings | 2,814 | 2,360 | 5,603 | 4,600 | ||||||||
| Total interest expense | $ | 10,177 | $ | 7,260 | $ | 19,341 | $ | 13,631 | ||||
| Net interest income | $ | 11,417 | $ | 10,905 | $ | 22,482 | $ | 21,627 | ||||
| Provision for loan losses | 1,054 | 748 | 1,709 | 759 | ||||||||
| Net interest income after provision for loan losses | $ | 10,363 | $ | 10,157 | $ | 20,773 | $ | 20,868 | ||||
| Other income: | ||||||||||||
| Net gain on sale of loans | $ | 227 | $ | 306 | $ | 381 | $ | 544 | ||||
| Net losses on sale of investment securities | — | (234 | ) | — | (234 | ) | ||||||
| Trust fees | 870 | 726 | 1,713 | 1,459 | ||||||||
| Service charges and fees | 1,761 | 1,405 | 3,333 | 2,684 | ||||||||
| Rental revenue on tax credit real estate | 190 | 191 | 402 | 388 | ||||||||
| Other noninterest income | 724 | 574 | 1,398 | 1,182 | ||||||||
| $ | 3,772 | $ | 2,968 | $ | 7,227 | $ | 6,023 | |||||
| Other expenses: | ||||||||||||
| Salaries and employee benefits | $ | 4,625 | $ | 4,196 | $ | 9,102 | $ | 8,346 | ||||
| Occupancy | 543 | 526 | 1,096 | 1,061 | ||||||||
| Furniture and equipment | 824 | 850 | 1,613 | 1,685 | ||||||||
| Office supplies and postage | 359 | 344 | 648 | 650 | ||||||||
| Advertising and business development | 520 | 448 | 859 | 793 | ||||||||
| Outside services | 1,249 | 1,185 | 2,412 | 2,251 | ||||||||
| Rental expenses on tax credit real estate | 224 | 224 | 465 | 442 | ||||||||
| Other noninterest expense | 330 | 277 | 601 | 539 | ||||||||
| $ | 8,674 | $ | 8,050 | $ | 16,796 | $ | 15,767 | |||||
| Income before income taxes | $ | 5,461 | $ | 5,075 | $ | 11,204 | $ | 11,124 | ||||
| Federal and state income taxes | 1,671 | 1,518 | 3,465 | 3,424 | ||||||||
| Net income | $ | 3,790 | $ | 3,557 | $ | 7,739 | $ | 7,700 | ||||
| Earnings per share: | ||||||||||||
| Basic | $ | 0.83 | $ | 0.78 | $ | 1.70 | $ | 1.69 | ||||
| Diluted | 0.83 | 0.78 | 1.69 | 1.69 | ||||||||
| See Notes to Consolidated Financial Statements. |
Page 4 of 34 |
| HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts In Thousands) |
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||
| Net income | $ | 3,790 | $ | 3,557 | $ | 7,739 | $ | 7,700 | ||||
| Other comprehensive income (loss): | ||||||||||||
| Unrealized holding gains (losses) arising during the period, | $ | (1,347 | ) | $ | 1,442 | $ | (2,037 | ) | $ | (1,089 | ) | |
| Income tax effect of unrealized gains (losses) | 515 | (530 | ) | 779 | 407 | |||||||
| $ | (832 | ) | $ | 912 | $ | (1,258 | ) | $ | (682 | ) | ||
| Less: reclassification adjustment for losses included in net income, net of income taxes | — | 144 | — | 144 | ||||||||
| Other comprehensive income (loss) | (832 | ) | 1,056 | (1,258 | ) | (538 | ) | |||||
| Comprehensive income | $ | 2,958 | $ | 4,613 | $ | 6,481 | $ | 7,162 | ||||
| See Notes to Consolidated Financial Statements. |
Page 5 of 34 |
| HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts) |
| Paid In Capital | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Maximum Cash Obligation Related To ESOP Shares | Treasury Stock | Total | |||||||||||||
| Balance, December 31,2005 | $ | 11,970 | $ | 119,989 | $ | (1,783 | ) | $ | (20,634 | ) | $ | (63 | ) | $ | 109,479 | |||
| Issuance of 2,803 shares of common stock | 134 | — | — | — | — | 134 | ||||||||||||
| Forfeiture of 1,180 shares of common stock | (42 | ) | — | — | — | — | (42 | ) | ||||||||||
| Shared-based compensation | 28 | — | — | — | — | 28 | ||||||||||||
| Change related to ESOP shares | — | — | — | 576 | — | 576 | ||||||||||||
| Net income | — | 7,739 | — | — | — | 7,739 | ||||||||||||
| Cash dividends ($.81 per share) | — | (3,695 | ) | — | — | — | (3,695 | ) | ||||||||||
| Purchase of 3,977 shares of common stock | — | — | — | — | (188 | ) | (188 | ) | ||||||||||
| Other comprehensive income (loss) | — | — | (1,258 | ) | — | — | (1,258 | ) | ||||||||||
| Balance, June 30, 2006 | $ | 12,090 | $ | 124,033 | $ | (3,041 | ) | $ | (20,058 | ) | $ | (251 | ) | $ | 112,773 | |||
| Balance, December 31,2004 | $ | 11,364 | $ | 108,199 | $ | 576 | $ | (16,336 | ) | $ | — | $ | 103,803 | |||||
| Issuance of 3,517 shares of common stock | 134 | — | — | — | — | 134 | ||||||||||||
| Change related to ESOP shares | — | — | — | (1,064 | ) | — | (1,064 | ) | ||||||||||
| Net income | — | 7,700 | — | — | — | 7,700 | ||||||||||||
| Cash dividends ($.75 per share) | — | (3,413 | ) | — | — | — | (3,413 | ) | ||||||||||
| Other comprehensive income (loss) | — | — | (538 | ) | — | — | (538 | ) | ||||||||||
| Balance, June 30, 2005 | $ | 11,498 | $ | 112,486 | $ | 38 | $ | (17,400 | ) | $ | — | $ | 106,622 | |||||
| See Notes to Consolidated Financial Statements. |
Page 6 of 34 |
| HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Amounts In Thousands) |
| Six Months Ended June 30, | ||||||
| 2006 | 2005 | |||||
| Cash Flows from Operating Activities | ||||||
| Net income | $ | 7,739 | $ | 7,700 | ||
| Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities: | ||||||
| Depreciation | 1,170 | 1,255 | ||||
| Provision for loan losses | 1,709 | 759 | ||||
| Net losses on sale of investment securities | — | 234 | ||||
| Share-based compensation | 28 | — | ||||
| Compensation expensed through issuance of common stock | 134 | 134 | ||||
| Provision for deferred income taxes | (839 | ) | (247 | ) | ||
| Decrease in accrued interest receivable | (803 | ) | (748 | ) | ||
| Amortization of discount on investment securities, net | 287 | 495 | ||||
| Decrease in other assets | 747 | 12 | ||||
| Increase in accrued interest and other liabilities | 400 | 859 | ||||
| Loans originated for sale | (49,706 | ) | (54,267 | ) | ||
| Proceeds on sales of loans | 42,696 | 54,663 | ||||
| Net gain on sales of loans | (381 | ) | (544 | ) | ||
| Net cash and cash equivalents provided by operating activities | $ | 3,181 | $ | 10,305 | ||
| Cash Flows from Investing Activities Proceeds from maturities of investment securities: | ||||||
| Available for sale | $ | 15,460 | $ | 29,075 | ||
| Held to maturity | 45 | 4,310 | ||||
| Proceeds from sales of investment securities available for sale | — | 10,465 | ||||
| Purchases of investment securities available for sale | (10,074 | ) | (42,387 | ) | ||
| Loans made to customers, net of collections | (81,417 | ) | (61,633 | ) | ||
| Purchases of property and equipment | (1,058 | ) | (1,498 | ) | ||
| Investment in tax credit real estate, net | 279 | 190 | ||||
| Net cash used in investing activities | $ | (76,765 | ) | $ | (61,478 | ) |
| Cash Flows from Financing Activities | ||||||
| Net increase in deposits | $ | 36,446 | $ | 44,408 | ||
| Net increase (decrease) in short-term borrowings | 33,250 | (12,375 | ) | |||
| Borrowings from FHLB | 15,000 | 40,000 | ||||
| Payments on FHLB borrowings | (10,000 | ) | — | |||
| Forfeiture of common stock | (42 | ) | — | |||
| Purchase of treasury stock | (188 | ) | — | |||
| Dividends paid | (3,695 | ) | (3,413 | ) | ||
| Net cash provided by financing activities | $ | 70,771 | $ | 68,620 | ||
| (Continued) |
Page 7 of 34 |
| HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands) |
| Six Months Ended June 30, | |||||||
| 2006 | 2005 | ||||||
| Increase (decrease) in cash and cash equivalents | $ | (2,813 | ) | $ | 17,447 | ||
| Cash and cash equivalents: | |||||||
| Beginning of year | 29,956 | 23,008 | |||||
| End of period | $ | 27,143 | $ | 40,455 | |||
| Supplemental Disclosures Cash payments for: | |||||||
| Interest paid to depositors | $ | 12,309 | $ | 8,519 | |||
| Interest paid on other obligations | 6,803 | 4,907 | |||||
| Income taxes paid | 4,336 | 3,104 | |||||
| Noncash financing activities: | |||||||
| Increase (decrease) in maximum cash obligation related to ESOP shares | $ | (576 | ) | $ | 1,064 | ||
| See Notes to Consolidated Financial Statements. | |||||||
Page 8 of 34 |
HILLS BANCORPORATION |
| Note 1. | Basis of Presentation |
| The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X. These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown. Certain prior year amounts may be reclassified to conform to the current year presentation. | |
| Operating results for the six month period ended June 30, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2005 filed with the Securities Exchange Commission on March 10, 2006. |
| Note 2. | Earnings Per Share |
| Basic earnings per share amounts are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce the loss or increase the income per common share from continuing operations. | |
| The computation of basic and diluted earnings per share for the periods presented is as follows: | |
| Three months ended June 30, | Six months ended June 30, | ||||||||||||
| 2006 | 2005 | 2006 | 2005 | ||||||||||
| Common shares outstanding at the beginning of the period | 4,559,350 | 4,549,656 | 4,562,237 | 4,549,656 | |||||||||
| Weighted average number of net shares issued (redeemed) | 73 | 2,199 | (1,928 | ) | 1,257 | ||||||||
| Weighted average shares outstanding (basic) | 4,559,423 | 4,551,855 | 4,560,309 | 4,550,913 | |||||||||
| Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method | 27,373 | 18,521 | 27,493 | 18,888 | |||||||||
| Weighted average number of shares (diluted) | 4,586,796 | 4,570,376 | 4,587,802 | 4,569,801 | |||||||||
| Net income (In Thousands) | $ | 3,790 | $ | 3,557 | $ | 7,739 | $ | 7,700 | |||||
| Earnings per share: | |||||||||||||
| Basic | $ | 0.83 | $ | 0.78 | $ | 1.70 | $ | 1.69 | |||||
| Diluted | $ | 0.83 | $ | 0.78 | $ | 1.69 | $ | 1.69 | |||||
Page 9 of 34 |
HILLS BANCORPORATION Note 3. Recent Accounting Pronouncements As of January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004),Share-Based Payment (FAS 123R) which requires companies to recognize in compensation expense the grant-date fair value of stock awards issued to employees and directors. The Company adopted FAS 123R using the modified prospective transition method. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect the impact of FAS 123R. As a result of applying FAS 123R, the Company recognized share-based compensation expense of $28,400 for the six months ended June 30, 2006 (see Note 4.) As of January 1, 2006, the Company has elected to use the guidance issued by the FASB in Position FAS No. 123R-3,Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (“FSP FAS 123R-3”). FSP FAS 123R-3 provides a practical exception when a company transitions to the accounting requirements of FAS 123R. FAS 123R requires a company to calculate the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to adopting FAS 123R, termed the Additional Paid in Capital Pool (“APIC Pool”), assuming the company had been following the recognition provisions prescribed by FAS 123. The adoption of the FSP does not have an impact on the Company’s overall results of operations. In March 2004, the Emerging Issues Task Force (EITF) revisited EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application of Certain Investments. Effective with reporting periods beginning after June 15, 2004, companies carrying certain types of debt and equity securities at amounts higher than the securities’ fair market values would have to use more detailed criteria to evaluate whether to record a loss and would have to disclose additional information about unrealized losses. The FASB subsequently issued a staff position deferring the effective date of the measurement and recognition provisions of the revised EITF No. 03-1 until further implementation issues may be resolved. On November 3, 2005, the FASB issued a Staff Position (FSP) that addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in the FSP shall be applied to reporting periods beginning after December 15, 2005. Adoption of the new issuance did not have a material impact on the Company’s financial position and results of operations but the extent of any impact will vary due to the fact that the model, as issued, calls for many judgments and additional evidence gathering as such evidence exists at each securities valuation date. In December 2004, the FASB issued FASB Statement No. 153, Exchanges of Nonmonetary Assets, which eliminates an exception in APB 29 for recognizing nonmonetary exchanges of similar productive assets at fair value and replaces it with an exception for recognizing exchanges of nonmonetary assets at fair value that do not have commercial substance. This Statement is effective for the Company for nonmonetary asset exchanges occurring on or after January 1, 2006. The adoption of this Statement did not have a significant effect on the Company’s financial statements. In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections. Statement 154 establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting principle. The Company implemented the provisions of this statement as of January 1, 2006 and it did not have a significant effect on its financial statements. In July 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit based on the technical merits of the position. The provisions of FIN 48 are effective as of January 1, 2007. The adoption of the Interpretation will not have a significant effect on the Company’s financial statements. |
Page 10 of 34 |
HILLS BANCORPORATION Note 4. Employee Benefit Plans The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 198,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Directors may exercise options immediately and officers’ rights under the plan vest over a five-year period from the date of the grant. Prior to January 1, 2006, the Company accounted for the stock options under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees. On January 1, 2006, the Company adopted FAS 123R, which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors. The Company adopted FAS 123R using the modified prospective transition method. The Consolidated Financial Statements as of and for the three and six months ended June 30, 2006 reflect the impact of FAS 123R. In accordance with the modified prospective transition method, the Consolidated Financial Statements for prior periods have not been restated. Information concerning the issuance of stock options is presented in the following table: |
| Options | Weighted-Average | Weighted-Average Remaining Contractual Term (years) | Aggregate Intrinsic Value (In Thousands) | ||||||||
| Outstanding at June 30, 2006 | 62,619 | $ 26.69 | 5.34 | 1,671 | |||||||
| Options exercisable at June 30, 2006 | 44,019 | 25.27 | 4.78 | 1,112 | |||||||
The fair value of each option is estimated as of the date of grant using a Black-Scholes option pricing model. The expected lives of options granted incorporate historical employee exercise behavior. The risk-free rate for periods that coincide with the expected life of the options is based on the annual 10 year interest rate swap rate as published by the Federal Reserve Bank. Expected volatility is based on volatility levels of the Company’s peer’s common stock as the Company’s stock has limited trading activity. Expected dividend yield was based on historical dividend rates. At June 30, 2006, 117,956 shares were available for issuance under the plan. No stock options were granted or exercised during the six months ended June 30, 2006. As of June 30, 2006, there was $52,600 in unrecognized compensation cost for stock options granted under the plan. As of March 31, 2006, there was $70,000. This cost is expected to be recognized over a weighted-average period of 0.93 years. The results for the first two quarters of 2006 are not directly comparable to the same period in 2005. Prior to the adoption of FAS 123R, the Company applied the existing accounting rules under APB Opinion No. 25, which provided that no compensation expense was charged for options granted at an exercise price equal to the market value of the underlying common stock on the date of the grant. If the fair value recognition provisions of FAS 123R had been applied to stock-based compensation for the three and six months ended June 30, 2005, the Company’s pro forma net income and earnings per share would have been as follows: |
Page 11 of 34 |
HILLS BANCORPORATION Note 4. Employee Benefit Plans (continued) |
| Three months ended June 30, 2005 | Six months ended June 30, 2005 | |||||
| Net income: | ||||||
| As reported | $ | 3,557 | $ | 7,700 | ||
| Deduct total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects | (21 | ) | (42 | ) | ||
| Pro forma | $ | 3,536 | $ | 7,658 | ||
| Basic earnings per share: | ||||||
| As reported | $ | 0.78 | $ | 1.69 | ||
| Pro forma | $ | 0.78 | $ | 1.68 | ||
| Diluted earnings per share: | ||||||
| As reported | $ | 0.78 | $ | 1.69 | ||
| Pro forma | $ | 0.77 | $ | 1.68 | ||
Note 5. Stock Repurchase Program In July of 2005, the Company’s Board of Directors approved a stock repurchase program pursuant to which the Company may repurchase 750,000 shares of its common stock from time to time through December 31, 2009. Pursuant to this authorization, the Company has purchased 5,377 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2006. Of these 5,377 shares, 1,251 shares were purchased during the quarter ended June 30, 2006, at an average price per share of $47.64. Note 6. Commitments and Contingencies The Company’s subsidiary, Hills Bank and Trust (the “Bank”) is a party to financial instruments with off-balance–sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, credit card participations and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at June 30, 2006 and December 31, 2005 is as follows: |
| June 30, 2006 | December 31, 2005 | |||||
| (Amounts In Thousands) | ||||||
| Firm loan commitments and unused portion of lines of credit: | ||||||
| Home equity loans | $ | 17,043 | $ | 17,191 | ||
| Credit card participations | 27,127 | 24,934 | ||||
| Commercial, real estate and home construction | 90,547 | 86,301 | ||||
| Commercial lines | 90,146 | 61,510 | ||||
| Outstanding letters of credit | 10,172 | 12,374 | ||||
Page 12 of 34 |
| • | The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets. | |
| • | The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company. | |
| • | The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System. | |
| • | The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector. | |
| • The ability of the Company to obtain new customers and to retain existing customers. | |
| • | The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. | |
| • | Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers. | |
| • The ability of the Company to develop and maintain secure and reliable electronic systems. |
Page 13 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition |
| • | The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner. | |
| • | Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely. | |
| • | The economic impact of terrorist attacks and military actions. | |
| • | Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected. | |
| • The costs, effects and outcomes of existing or future litigation. | |
| • | Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. | |
| • | The ability of the Company to manage the risks associated with the foregoing as well as anticipated. |
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission. Critical Accounting Policies The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company’s allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company’s markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual loans in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the Management’s Discussion and Analysis of Financial Condition and Results of Operation that is included. Although management believes the levels of the allowance as of June 30, 2006 and December 31, 2005 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time. |
Page 14 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Overview The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona, Cedar Rapids and Marion, Iowa. At June 30, 2006, the Bank has twelve full service locations. The Bank has plans to open its second location in Washington County. The office will be located at 710 West 3rd Street in Wellman, Iowa and will be the thirteenth office of Hills Bank. Subject to bank regulatory approval, the Bank intends to remodel and expand the location, and intends to open this office in September of 2006. Net income for the six-month period ended June 30, 2006 was $7.74 million compared to $7.70 million for the same six months of 2005. Basic earnings per share increased to $1.70 for the six months ended June 30, 2006 compared to $1.69 for the same period in 2005. Diluted earnings per share was $1.69 for the six-month period in both 2005 and 2006. Return on average equity was 14.07% and return on average equity net of ESOP obligation was 11.88% for the six months ended June 30, 2006, compared to 14.87% and 12.79%, respectively, for the same period in 2005. Return on average assets was 1.06% in 2006 compared to 1.17% in 2005. Dividends of $.81 per share were paid in January 2006 to 1,499 shareholders. The 2006 dividend was an 8.0% increase over the prior year’s dividend of $.75 per share. The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earnings assets and the net interest margin percentage. The Bank achieved a net interest margin of 3.39% compared to 3.62% in 2005. The reduction in the margin percentage was expected because of recent changes in interest rates. Despite this reduction in net interest margin, net interest income has increased due to the higher volume of earnings assets as of June 30, 2006 compared to the same period in 2005. Highlights noted on the balance sheet as of June 30, 2006 for the Company included the following: |
| • | Total assets are over $1.5 billion, at $1.511 billion. |
| • | Net loans are $1.221 billion. |
| • | Loan growth of $87.1 million since December 31, 2005. |
| • | Deposit growth of $36.4 million since December 31, 2005. |
| • | Short-term borrowings increased $33.3 million since December 31, 2005. |
| A detailed discussion of the financial condition and results of operations follows this overview. | |
Page 15 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Financial Condition The asset growth for the six months ended June 30, 2006 of $77.8 million included a net loan increase of $79.7 million. Since December 31, 2005, the federal funds target rate has been raised by the Federal Reserve Open Market Committee from 4.25% to 5.25% with four increases of .25% each or a total of 1.00%. The upward movement of the federal funds target rate started on June 30, 2004 when the rate was 1.00% and has increased 17 times through June 30, 2006. Interest rates on loans are generally affected by these increases since interest rates for the U.S. Treasury market normally increase when the Federal Reserve Board raises the federal funds target rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. Loans secured by real estate accounted for $64.14 million or 73.64% of the increase in loans. Commercial loans increased $21.1 million to $112.6 million as of June 30, 2006, an increase of 23.11% since December 31, 2005. Increases in interest rates may at some point affect the loan demand and the economy, but at the current interest rate levels, demand for loans remains good. The overall economy in the Company’s principal place of business, Johnson and Linn Counties, remains good with unemployment levels that remain low. The tables below set forth the composition of the loan portfolio as of June 30, 2006 and December 31, 2005 (dollars in thousands), along with changes in the allowance for loan losses and non-performing loan information: |
| June 30, 2006 | December 31, 2005 | ||||||||||||
| Amount | Percent | Amount | Percent | ||||||||||
| (Amounts In Thousands) | (Amounts In Thousands) | ||||||||||||
| Agricultural | $ | 39,712 | 3.21 | % | $ | 43,730 | 3.78 | % | |||||
| Commercial and financial | 112,645 | 9.10 | 91,501 | 7.91 | |||||||||
| Real estate: | |||||||||||||
| Construction | 92,453 | 7.46 | 83,456 | 7.21 | |||||||||
| Mortgage | 961,333 | 77.62 | 906,188 | 78.32 | |||||||||
| Loans to individuals | 32,381 | 2.61 | 32,201 | 2.78 | |||||||||
| $ | 1,238,524 | 100.00 | % | $ | 1,157,076 | 100.00 | % | ||||||
| Less allowance for loan losses | 17,100 | 15,360 | |||||||||||
| $ | 1,221,424 | $ | 1,141,716 | ||||||||||
| The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring that, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment. |
Page 16 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Changes in the allowance for loan losses for the periods shown in the following table were as follows: |
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||
| 2006 | 2005 | 2006 | 2005 | |||||||||
| (Amounts In Thousands) | (Amounts In Thousands) | |||||||||||
| Balance, beginning | $ | 16,150 | $ | 13,750 | $ | 15,360 | $ | 13,790 | ||||
| Provision charged to expense | 1,054 | 748 | 1,709 | 759 | ||||||||
| Recoveries | 281 | 332 | 781 | 584 | ||||||||
| Loans charged off | (385 | ) | (460 | ) | (750 | ) | (763 | ) | ||||
| Balance, ending | $ | 17,100 | $ | 14,370 | $ | 17,100 | $ | 14,370 | ||||
| Non-performing loan information at June 30, 2006 and December 31, 2005, was as follows: |
| June 30, 2006 | December 31, 2005 | |||||
| (Amounts in thousands) | ||||||
| Non-accrual loans | $ | 845 | $ | 175 | ||
| Accruing loans past due ninety days or more | 3,118 | 1,910 | ||||
| Restructured loans | — | — | ||||
| Non-performing loans (includes non-accrual loans) | 16,854 | 16,602 | ||||
Page 17 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition The estimated fair value of the investment securities held by the Company decreased by $7.76 million from December 31, 2005 to June 30, 2006. Approximately $5.4 million of the decrease is due to the maturity of various U.S. Government agency securities in the past six month period which have not been replaced. In addition, the market value of securities available for sale has declined $2.0 million since December 31, 2005. The carrying values of investment securities for June 30, 2006 and December 31, 2005 are summarized in the following table (dollars in thousands): |
| June 30, 2006 | December 31, 2005 | |||||||||||
| Amount | Percent | Amount | Percent | |||||||||
| Securities available for sale | ||||||||||||
| U.S. Government agencies and corporations | $ | 110,350 | 58.49 | % | $ | 117,482 | 59.70 | % | ||||
| State and political subdivisions | 78,329 | 41.51 | 79,304 | 40.30 | ||||||||
| Total securities available for sale | $ | 188,679 | 100.00 | % | $ | 196,786 | 100.00 | % | ||||
| Securities held to maturity | ||||||||||||
| State and political subdivisions | $ | 170 | 100.00 | % | $ | 215 | 100.00 | % | ||||
Deposit growth was $36.4 million in the first six months of 2006. Repurchase agreements increased $12.5 million in the same period. These increases included $36.4 million of municipal deposits and $8.6 million of retail deposits. Short-term borrowings at December 31, 2005 included federal funds purchased that increased $20.7 million to $27.6 million as of June 30, 2006. The borrowings from the Federal Home Loan Bank (FHLB) were decreased by $10 million with the maturity in June 2006 of an advance with the interest rate of 4.09%. The Company borrowed an additional $15 million in June 2006 at a rate of 4.69% for ten years that is callable in one year. There were no federal funds sold as of June 30, 2006 or December 31, 2006. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth. Dividends and Equity In January 2006, Hills Bancorporation paid a dividend of $3,695,000 or $.81 per share, an 8.0% increase from the $.75 per share paid in January 2005. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2006 totaled $112.8 million. Under risk-based capital rules, the total amount of risk based capital of the Company as of June 30, 2006, was 13.38% of risk-adjusted assets, and is substantially in excess of the required minimum of 8.00%. Risk-based capital was 13.73% as of June 30, 2005 and 13.80% as of December 31, 2005, respectively. As of June 30, 2006, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s category. | ||||||||||||
Page 18 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the six months ended June 30, 2006 and 2005. Net Income Overview Net income increased $39,000 for the six months ended June 30, 2006 compared to the first six months of 2005. Total net income was $7,739,000 in 2006 and $7,700,000 in the comparable period in 2005. The changes in net income in 2006 from the first six months of 2005 are as follows and are discussed in detail in the following review of operations: |
| • | Net interest income increased by $855,000. |
| • | The provision for loan losses increased by $950,000. |
| • | Other income increased by $1,204,000. |
| • | Other expenses increased by $1,029,000. |
| • | Income taxes increased by $41,000. |
For the six-month periods ended June 30, 2006 and 2005, basic earnings per share were $1.70 and $1.69, respectively. Diluted earnings per share was $1.69 for both periods. Quarterly fluctuations in the Company’s net income continue to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average earnings assets. Net interest income of $22.5 million for the first six months of 2006 was derived from the Company’s $1.391 billion of average earning assets and its net interest margin of 3.39%. Average earning assets in the six months ending June 30, 2005 were $1.247 billion and the net interest margin was 3.63%. The margin compression was the result of the continued flattening of the yield curve and pricing pressure on short-term deposits. The reduction in the margin was expected and the overall net interest income has increased due to the higher volume of earning assets in 2006 compared to 2005. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.29% would have resulted approximately in a $690,000 decrease in income before income taxes in the six month period ending June 30, 2006. Similarly, an increase in the net interest margin of 10 basis points to 3.49% would have resulted in approximately a $690,000 increase in net interest income before taxes. The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.221 billion at June 30, 2006. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which include non-accrual loans) and loans past due 90 days or more. The provision for loan losses was $1,709,000 in 2006 compared to $759,000 in 2005. The increase in the provision for loan losses is the result of growth in the overall loan portfolio and an increase in problem and watch loans of $3.6 million. The amount of mortgage loans sold on the secondary market is the third factor that can cause fluctuations in net income. In the six months ended June 30, 2006 and 2005, the net gain on sale of loans was $381,000 and $544,000, respectively. The sale of loans is influenced by the real estate market and interest rates. The decrease in the gain on sale of loans was expected because many customers had taken advantage of lower interest rates in the prior three years to refinance loans. | |
Page 19 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the six months ended June 30, 2006 and 2005 (continued). Net Interest Income 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 2006 was 3.39% compared to 3.63% in 2005 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2006 compared to the comparable period in 2005 are shown in the following table: |
| Increase (Decrease) in Net Interest Income | ||||||||||||||||
| Change in Average Balance | Change in Average Rate | |||||||||||||||
| Volume Changes | Rate Changes | Net Change | ||||||||||||||
| (Amounts in Thousands) | ||||||||||||||||
| Interest income: | ||||||||||||||||
| Loans, net | $ | 157,221 | 0.32 | % | $ | 4,842 | $ | 1,845 | $ | 6,687 | ||||||
| Taxable securities | (13,689 | ) | 0.10 | (229 | ) | 60 | (169 | ) | ||||||||
| Nontaxable securities | 5,323 | 0.10 | 142 | 41 | 183 | |||||||||||
| Federal funds sold | (5,606 | ) | 1.21 | (81 | ) | 9 | (72 | ) | ||||||||
| $ | 143,249 | $ | 4,674 | $ | 1,955 | $ | 6,629 | |||||||||
| Interest expense: | ||||||||||||||||
| Interest-bearing demand deposits | $ | (4,655 | ) | 0.27 | $ | 14 | $ | (191 | ) | $ | (177 | ) | ||||
| Savings deposits | 8,119 | 0.63 | 25 | (926 | ) | (901 | ) | |||||||||
| Time deposits | 48,945 | 0.81 | (734 | ) | (2,002 | ) | (2,736 | ) | ||||||||
| Short-term borrowings | 28,056 | 2.08 | (320 | ) | (573 | ) | (893 | ) | ||||||||
| FHLB borrowings | 50,063 | (0.29 | ) | (1,332 | ) | 329 | (1,003 | ) | ||||||||
| $ | 130,528 | $ | (2,347 | ) | $ | (3,363 | ) | $ | (5,710 | ) | ||||||
| Change in net interest income | $ | 2,327 | $ | (1,408 | ) | $ | 919 | |||||||||
| A summary of the net interest spread and margin is as follows: |
| (Tax Equivalent Basis) | 2006 | 2005 | ||||||
| Yield on average interest-earning assets | 6.18 | % | 5.82 | % | ||||
| Rate on average interest-bearing liabilities | 3.27 | 2.58 | ||||||
| Net interest spread | 2.91 | % | 3.24 | % | ||||
| Effect of noninterest-bearing funds | 0.48 | 0.39 | ||||||
| Net interest margin (tax equivalent interest income divided by average interest-earning assets) | 3.39 | % | 3.63 | % | ||||
Page 20 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the six months ended June 30, 2006 and 2005 (continued). Provision for Loan Losses The provision for loan losses was $1,709,000 in 2006 compared to $759,000 in 2005, an increase of $950,000. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which include non-accrual loans) and loans past due ninety days or more. The provision for loan losses increased in the first six months of 2006 as a result of the growth in the overall loan portfolio and an increase in problem and watch loans of $3.6 million. In contrast, in the six months ended June 30, 2005, the watch and problem loans decreased by $10.0 million. While loan growth was substantial in both periods, $79.7 million in 2006 and $61.0 million in 2005, the provision expense was mitigated in 2005 by the improvement in the quality of the loan portfolio. In the first six months of 2006, management determined that there had been a deterioration in the quality of two commercial loans which increased the provision expense by $490,000. The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the six months ended June 30, 2006 and 2005, recoveries were $781,000 and $584,000, respectively; and charge-offs were $750,000 in 2006 and $763,000 in 2005. The allowance for loan losses totaled $17,100,000 at June 30, 2006 compared to $15,360,000 at December 31, 2005. The allowance represented 1.37% and 1.33% of outstanding loans at June 30, 2006 and December 31, 2005, respectively. The methodology used in 2006 is consistent with 2005. Net Gain on Sale of Loans Net gain on sale of loans for the six months ended June 30, 2006 was $381,000 compared to $544,000 for the comparable period ended June 30, 2005. The number of loans sold in 2006 was approximately 89% of the volume in 2005. The decrease in the volume of loans sold was expected because many consumers had taken advantage of lower interest rates in the prior three years. Other Income Other income, other than the net gain on sale of loans discussed above, increased by $1,367,000 for the six months ended June 30, 2006. Investment securities losses of $234,000 were recorded in 2005; there were no security sales recorded in 2006. Trust fees increased $254,000 in 2006 as a result of assets under management increasing from $708.6 million as of June 30, 2005 to $798.6 million as of June 30, 2006. Service charges and fees were up $649,000 from 2005 to 2006. $541,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and POS pin interchange fees increased during the same period by $152,000 due to volume of activity. Other noninterest income increased $216,000 as of June 30, 2006 compared to 2005. Included in this increase is a one-time $79,000 sales tax refund received in the second quarter of 2006 and a $53,000 rebate received in May 2006 related to the Bank’s participation in a credit card program. |
Page 21 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the six months ended June 30, 2006 and 2005 (continued). Other Expenses Other expenses increased $1,029,000 in 2006 to $16,796,000 from the same period in 2005. This increase of 6.53% included $756,000 in salaries and benefits. Direct salary expense was up $488,000, or 7.80%, due to annual pay adjustments and the addition of seven employees in 2006 as compared to 2005. Medical expense for employees’ health insurance increased $76,000 due to a premium increase of 12% for 2006. Advertising and business development expenses increased $66,000 as of June 30, 2006 compared to the same period in 2005. The increases are primarily the result of office promotions for the retail areas of the Bank. Outside services increased $161,000 from 2005 to $2.4 million in 2006. Outside services include professional fees, courier services and ATM fees and processing charges for the merchant credit card program, retail credit cards and other data processing services. The credit card, merchants’ card and debit card processing charges increased $47,000 due to the increase in the volume of activity. Fees to an outside consultant were up $30,000 in 2006 as the result of the sales tax audit that resulted in the $79,000 sales tax refund discussed above and expanded information security testing. Income Taxes Federal and state income tax expenses were $3,465,000 and $3,424,000 for the six months ended June 30, 2006 and 2005, respectively. Income taxes as a percentage of income before taxes were 30.93% in 2006 and 30.78% in 2005. The amount of tax credits in 2006 was $280,000 compared to $338,000 in 2005, as a result of one tax credit property ending its ten-year term for the credits. |
Page 22 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the three months ended June 30, 2006 and 2005. Net Income Net income increased to $3,790,000 for the three months ended June 30, 2006 from $3,557,000 for the same period in 2005, an increase of 6.55%. Earnings per share, both basic and diluted, increased for the three months ended June 30, 2006 compared to the same period in 2005. For the three-month period ended June 30, 2006, basic and diluted earnings per share were $0.83. For the three months ended June 30, 2005, basic and diluted earnings per share were $0.78. Return on average equity was 13.64% and return on average equity net of ESOP obligation was 11.50% for the three months ended June 30, 2006, compared to 13.59% and 11.68%, respectively, for the same period in 2005. Return on average assets was 1.02% in 2006 compared to 1.06% in 2005. Net Interest Income Net interest income increased for the three month period ended June 30, 2006 by $512,000 from the similar period in 2005. The net interest margin in 2006 was 3.37% compared to 3.57% in 2005. The decrease is primarily due to an increase in rates on core deposit accounts, including insured money market accounts and short-term certificates of deposits. These rates were increased due to the upward movement of the federal fund rates. Rates paid on repurchase agreements and federal funds borrowed also increased. The increase in the volume of interest earning assets accounted for a significant portion of the net interest income improvement. Net interest income changes on a tax-equivalent basis for the three months ended June 30, 2006 and 2005 are as follows: |
| Change in Average Balance | Change in Average Rate | Increase (Decrease) in Net Interest Income | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Volume Changes | Rate Changes | Net Change | |||||||||||||
| (Amounts in Thousands) | |||||||||||||||
| Interest income: | |||||||||||||||
| Loans, net | $ | 160,927 | 0.33 | % | $ | 2,506 | $ | 994 | $ | 3,500 | |||||
| Taxable securities | (14,829 | ) | 0.15 | (123 | ) | 43 | (80 | ) | |||||||
| Nontaxable securities | 5,237 | 0.09 | 70 | 16 | 86 | ||||||||||
| Federal funds sold | (7,103 | ) | 1.14 | (54 | ) | 7 | (47 | ) | |||||||
| $ | 144,232 | $ | 2,399 | $ | 1,060 | $ | 3,459 | ||||||||
| Interest expense: | |||||||||||||||
| Interest-bearing demand deposits | $ | (4,464 | ) | 0.29 | $ | 7 | $ | (113 | ) | $ | (106 | ) | |||
| Savings deposits | 17,813 | 0.55 | (13 | ) | (425 | ) | (438 | ) | |||||||
| Time deposits | 39,851 | 0.84 | (306 | ) | (1,058 | ) | (1,364 | ) | |||||||
| Short-term borrowings | 34,660 | 1.89 | (233 | ) | (322 | ) | (555 | ) | |||||||
| FHLB borrowings | 44,566 | (0.24 | ) | (590 | ) | 136 | (454 | ) | |||||||
| $ | 132,426 | $ | (1,135 | ) | $ | (1,782 | ) | $ | (2,917 | ) | |||||
| Change in net interest income | $ | 1,264 | $ | (722 | ) | $ | 542 | ||||||||
Page 23 of 34 |
HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the three months ended June 30, 2006 and 2005. A summary of the net interest spread and margin is as follows: |
| (Tax Equivalent Basis) | 2006 | 2005 | ||||||
|---|---|---|---|---|---|---|---|---|
| Yield on average interest-earning assets | 6.24 | % | 5.85 | % | ||||
| Rate on average interest-bearing liabilities | 3.36 | 2.69 | ||||||
| Net interest spread | 2.88 | % | 3.16 | % | ||||
| Effect of noninterest-bearing funds | 0.49 | 0.41 | ||||||
| Net interest margin (tax equivalent interest income divided by average interest-earning assets) | 3.37 | % | 3.57 | % | ||||
Provision for Loan Losses The provision for loan losses was $1,054,000 for the quarter ended June 30, 2006 compared to $748,000 for the comparable quarter in 2005, an increase of $306,000. As discussed in connection with the results of operations for the six months, the allowance for loan losses was increased due to management’s analysis of the outstanding loans at June 30, 2006. The provision for loan losses increased in the second quarter of 2006 as a result of the growth in the overall loan portfolio and an increase in loans classified as potential watch loans of $15.6 million. In contrast, in the three months ended June 30, 2005, the provision expense increased by $587,000 due to growth in watch and problem loans of $588,000. The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the three months ended June 30, 2006 and 2005, recoveries were $281,000 and $332,000, respectively; and charge-offs were $385,000 in 2006 and $460,000 in 2005. The allowance for loan losses totaled $17,100,000 at June 30, 2006 compared to $14,370,000 at June 30, 2005. The allowance represented 1.37% and 1.34% of outstanding loans at June 30, 2006 and June 30, 2005, respectively. Other Income Total other income was $3,772,000 and $2,968,000 for the three months ended June 30, 2006 and 2005. For the reason explained in the preceding discussion of the six month results, net gain on sale of loans was substantially less in 2006 as compared to 2005. Net gain on sale of loans decreased by $79,000 in the quarter ended June 30, 2006 as compared to the same quarter in 2005. The Trust Department fees for 2006 were $144,000 higher than 2005 due to the growth of assets under management. Investment securities losses of $234,000 were recorded in the second quarter of 2005; there were no security sales during the same period in 2006. Service charges and fees were up $356,000 in the three months ended June 30, 2006. $295,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and POS pin interchange fees increased $80,000 during the same period due to the volume of activity. Other noninterest income increased $150,000 in 2006. Included in this increase are the one-time $79,000 sales tax refund and the $53,000 rebate noted in the six month discussion above. |
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HILLS BANCORPORATION Item 2. Management’s Discussion and Analysis of Financial Condition Discussion of operations for the three months ended June 30, 2006 and 2005 (continued). Other Expenses Total expenses for the 2006 quarter compared to the 2005 quarter increased $624,000 to $8,674,000. Salaries and employee benefits increased $429,000 for the quarter ended June 30, 2006 compared to 2005. Direct salary expense was up $273,000, or 8.61%, due to annual pay adjustments and an additional seven employees in 2006 as compared to 2005. Advertising and business development expenses increased $72,000 in comparing the quarters. The increase is due to office promotions for the retail area of the Bank. As a result of an increase in the volume of activity, credit card and debit card processing charges increased $21,000 and these expenses are included in outside services expense. Outside services include professional fees that increased $48,000 over 2005. This increase included $30,000 paid to an outside consultant, as noted in the six month discussion above. Income Taxes Income tax expense as a percentage of income before taxes increased to 30.60% in 2006 from 29.91% in 2005. Income tax expense is $153,000 more in 2006 compared to 2005 primarily due to the $386,000 increase in income before income taxes. The amount of tax credits in the second quarter of 2006 was $140,000 compared to $169,000 in 2005. 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. There were no federal funds sold as of June 30, 2006 or December 31, 2005. Investment securities available for sale comprised 12.48% of the Company’s total assets at June 30, 2006, compared to 13.73% at December 31, 2005. 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, 2006, the Company had borrowed $228.2 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. This includes a new advance in June 2006 for $15 million. Also, a $10 million advance matured in June 2006. These advances were used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $178 million at June 30, 2006. As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and has lines of credit with two banks totaling $117 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, 2006. Contractual Obligations As of June 30, 2006, there had been no material changes in the Company’s contractual obligations from those disclosed in its Annual Report in Form 10-K for the year ended December 31, 2005. |
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| Period | Total number of shares purchased | Average price paid per share | Total number of shares purchased as part of publicly announced plans or programs | Maximum number of shares that may yet be purchased under the plans or programs (1) | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| April 1 to April 30 | 891 | $ | 47.50 | 5,017 | 744,983 | |||||||
| May 1 to May 31 | 110 | 48.00 | 5,127 | 744,873 | ||||||||
| June 1 to June 30 | 250 | 48.00 | 5,377 | 744,623 | ||||||||
| Total | 1,251 | $ | 47.64 | 5,377 | 744,623 | |||||||
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HILLS BANCORPORATION |
| (a) | The Annual Meeting of Shareholders was held on April 17, 2006. The results listed for the election of directors and the ratification of auditors are included in items (b) and (c) listed below. | |
| (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) | Willis M. Bywater | 3,112,657 | 34,258 | ||||||
| 2) | Thomas J. Gill, D.D.S | 3,138,102 | 8,813 | ||||||
| 3) | Donald H. Gringer | 3,117,667 | 29,248 | ||||||
| 4) | Dwight O. Seegmiller | 3,117,667 | 29,248 | ||||||
| (c) | Ratification of KPMG LLP as the Company’s independent auditors for the fiscal year ending December 31, 2006. | |
| For | Against | Abstain | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 3,118,874 | 2,366 | 25,675 | ||||||||
None Item 6. Exhibits and Reports on Form 8-K 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 |
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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: August 7, 2006 | By: /s/ Dwight O. Seegmiller | |
| Dwight O. Seegmiller, Director, President and Chief Executive Officer | ||
| Date: August 7, 2006 | By: /s/ James G. Pratt | |
| James G. Pratt, Secretary, Treasurer and Chief Accounting Officer | ||
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HILLS BANCORPORATION |
| Exhibit Number | Description | Page Number In The Sequential Numbering System June 30, 2006 Form 10-Q | ||
|---|---|---|---|---|
| 31 | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 | 32 - 33 of 34 | ||
| 32 | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 | 34 of 34 | ||
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