Net interest income is the excess of the interest and fees received on interest-earning 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 2006 was 3.35% compared to 3.58% 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 nine months ended in 2006 compared to the comparable period in 2005 are shown in the following table:
HILLS BANCORPORATION
Item 2. | Management’s Discussion and Analysis of Financial Condition |
| And Results of Operations (continued) |
Discussion of operations for the nine months ended September 30, 2006 and 2005 (continued). |
Provision for Loan Losses
The provision for loan losses was $2,142,000 in 2006 compared to $998,000 in 2005, an increase of $1,144,000. 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 nine months of 2006 as a result of the growth in the overall loan portfolio and an increase in problem and watch loans of $5.8 million. In contrast, in the nine months ended September 30, 2005, the watch and problem loans decreased by $5.5 million. While loan growth was substantial in both periods, $111.3 million in 2006 and $100.7 million in 2005, the provision expense was offset in 2005 by the improvement in the quality of the loan portfolio. The increase in the provision expense for 2006 is reflective of a point in time and not any group or type of loans for which estimated losses were higher than expected.
The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the nine months ended September 30, 2006 and 2005, recoveries were $1,117,000 and $1,031,000, respectively; and charge-offs were $1,139,000 in 2006 and $1,209,000 in 2005. The allowance for loan losses totaled $17,480,000 at September 30, 2006 compared to $15,360,000 at December 31, 2005. The allowance represented 1.38% and 1.33% of outstanding loans at September 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 nine months ended September 30, 2006 was $661,000 compared to $857,000 for the comparable period ended September 30, 2005. The number of loans sold in 2006 was approximately 87% of the volume in 2005.
Other Income
Other income, other than the net gain on sale of loans discussed above, increased by $1,747,000 for the nine months ended September 30, 2006. Investment securities losses of $234,000 were recorded in 2005; there were no security sales recorded in 2006. Trust fees increased $342,000 in 2006 as a result of assets under management increasing from $743.8 million as of September 30, 2005 to $823.7 million as of September 30, 2006. Service charges and fees were up $874,000 from 2005 to 2006. $680,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and Point of Sale (POS) pin interchange fees increased during the same period by $246,000 due to volume of activity. Other noninterest income increased $264,000 as of September 30, 2006 compared to 2005. Included in this increase was 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 22 of 36
HILLS BANCORPORATION
Item 2. | Management’s Discussion and Analysis of Financial Condition |
| And Results of Operations (continued) |
Discussion of operations for the nine months ended September 30, 2006 and 2005 (continued). |
Other Expenses
Other expenses increased $1,044,000 in 2006 to $25,312,000 from the same period in 2005. This increase of 4.30% included $1,043,000 in salaries and benefits. Direct salary expense was up $722,000, or 7.60%, due to annual pay adjustments and an increase of 5 employees since December 31, 2005. Medical expense for employees' health insurance increased $248,000 due to a premium increase of 12% for 2006 and a $105,000 reduction in medical expense in 2005 due primarily to a change in the Company’s medical plan from a self-insured plan to a full-premium plan. Employee compensation expense, which includes expense related to the officers’ deferred compensation plan, decreased $81,000 in 2006. In the first nine months of 2005, the appraised value of the Company’s common stock increased $8 per share to $45. The appraised value increased $2.50 to $49 during the same period in 2006. Beginning effective June 30, 2005 and as a result of the Company’s program to repurchase up to a total of 750,000 shares of the Company’s common stock, the Company obtains a quarterly independent appraisal of the shares of stock.
Occupancy expense increased $36,000 with property tax and utilities expenses increasing $25,000 and $15,000, respectively, in the first nine months of 2006 as compared to the same period in 2005. In 2006, furniture and equipment expense included $1,312,000 in depreciation compared to $1,445,000 in 2005, a decrease of $133,000. This decrease is partially offset by an increase in equipment and software maintenance contracts of $59,000 to $791,000.
Advertising and business development expenses decreased $94,000 as of September 30, 2006 compared to the same period in 2005. In 2005, the expenses included a $50,000 contribution to the American Red Cross to assist the victims of Hurricane Katrina. Also, expenses related to the Company’s credit card incentive program were $43,500 more in the first nine months of 2005 as compared to the same period in 2006.
Outside services increased $59,000 from 2005 to $3.6 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, merchant card and debit card processing charges increased $83,000 due to the increase in the volume of activity. Professional fees decreased $77,000 from 2005 to $1,043,000 as of September 30, 2006. The 2005 expenses included $140,000 in consulting fees for a new fee income strategy which are not included in 2006 expenses. This decline is offset by the increase in attorney’s fees of $47,000 for the nine months ended September 30, 2006 as compared to the same period in 2005. 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 $5,456,000 and $5,200,000 for the nine months ended September 30, 2006 and 2005, respectively. Income taxes as a percentage of income before taxes were 31.20% in 2006 and 30.83% in 2005. The amount of tax credits in 2006 was $420,000 compared to $507,000 in 2005, as a result of one tax credit property ending its ten-year term for the credits.
Page 23 of 36
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, 2006 and 2005. |
Net Income
Net income increased to $4,293,000 for the three months ended September 30, 2006 from $3,969,000 for the same period in 2005, an increase of 8.16%. Earnings per share, both basic and diluted, increased for the three months ended September 30, 2006 compared to the same period in 2005. For the three-month period ended September 30, 2006, basic earnings per share was $0.94 and diluted earnings per share was $0.93. For the three months ended September 30, 2005, basic earnings per share was $0.87 and diluted earnings per share was $0.86. Return on average equity was 14.88% and return on average equity net of ESOP obligation was 12.66% for the three months ended September 30, 2006, compared to 14.87% and 12.66%, respectively, for the same period in 2005. Return on average assets was 1.13% in 2006 compared to 1.15% in 2005.
Net Interest Income
Net interest income increased for the three month period ended September 30, 2006 by $401,000 from the similar period in 2005. The net interest margin in 2006 was 3.28% compared to 3.49% 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 September 30, 2006 and 2005 are as follows:
| Change in | | Change in | Increase (Decrease) in Net Interest Income
| |
|---|
| Average Balance
| | Average Rate
| Volume Changes
| | Rate Changes
| | Net Change
| |
|---|
| | | | | | | | | | | | | | | | | | |
| (Amounts in Thousands) | |
|---|
| | | | | | | | | | | | | | | | | | |
| Interest income: | | | | | | | | | | | | | | | | | |
| Loans, net | | | $ | 161,676 | | | 0.34 | % | $ | 2,573 | | $ | 1,065 | | $ | 3,638 | |
| Taxable securities | | | | (19,036 | ) | | 0.39 | | | (177 | ) | | 142 | | | (35 | ) |
| Nontaxable securities | | | | 4,877 | | | 0.01 | | | 65 | | | 4 | | | 69 | |
| Federal funds sold | | | | (11,794 | ) | | 1.72 | | | (102 | ) | | — | | | (102 | ) |
|
| | |
| |
| |
| |
| | | | $ | 135,723 | | | | | $ | 2,359 | | $ | 1,211 | | $ | 3,570 | |
|
| | |
| |
| |
| |
| | | | | | | | | | | | | | | | | | |
| Interest expense: | | | | | | | | | | | | | | | | | |
| Interest-bearing demand deposits | | | $ | (4,323 | ) | | 0.27 | | $ | 9 | | $ | (94 | ) | $ | (85 | ) |
| Savings deposits | | | | 10,638 | | | 0.64 | | | 39 | | | (509 | ) | | (470 | ) |
| Time deposits | | | | 32,995 | | | 0.88 | | | (269 | ) | | (1,149 | ) | | (1,418 | ) |
| Short-term borrowings | | | | 53,307 | | | 2.42 | | | (233 | ) | | (543 | ) | | (776 | ) |
| FHLB borrowings | | | | 32,926 | | | (0.06 | ) | | (423 | ) | | 37 | | | (386 | ) |
|
| | |
| |
| |
| |
| | | | $ | 125,543 | | | | | $ | (877 | ) | $ | (2,258 | ) | $ | (3,135 | ) |
|
| | |
| |
| |
| |
| Change in net interest income | | | | | | | | | $ | 1,482 | | $ | (1,047 | ) | $ | 435 | |
| | |
| |
| |
| |
Page 24 of 36
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, 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 | | | | 6.33 | % | | 5.91 | |
| | | | Rate on average interest-bearing liabilities | | | | 3.56 | | | 2.84 | |
| |
| |
| |
| | | | Net interest spread | | | | 2.77 | % | | 3.07 | |
| | | | Effect of noninterest-bearing funds | | | | 0.51 | | | 0.42 | |
| |
| |
| |
| | | | Net interest margin (tax equivalent interest income | | |
| | | | divided by average interest-earning assets) | | | | 3.28 | % | | 3.49 | |
| |
| |
| |
Provision for Loan Losses
The provision for loan losses was $433,000 for the quarter ended September 30, 2006 compared to $239,000 for the comparable quarter in 2005, an increase of $194,000. As discussed in connection with the results of operations for the nine months, the allowance for loan losses was increased due to management’s analysis of the outstanding loans at September 30, 2006. The provision for loan losses increased in the third quarter of 2006 as a result of the growth in the overall loan portfolio and an increase in loans classified as potential watch, watch and problem loans of $6.1 million. In contrast, in the three months ended September 30, 2005, the provision expense decreased by $363,000. Management’s analysis of outstanding loans as of September 30, 2005 indicated that the level of problem or watch loans considered in computing the provision adjustments had increased only $232,000 since June 30, 2005. In addition, net recoveries of loans were $1,000. These factors made a provision of $239,000 appropriate for the third quarter of 2005.
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 September 30, 2006 and 2005, recoveries were $336,000 and $447,000, respectively; and charge-offs were $389,000 in 2006 and $446,000 in 2005. The allowance for loan losses totaled $17,480,000 at September 30, 2006 compared to $14,610,000 at September 30, 2005. The allowance represented 1.38% and 1.31% of outstanding loans at September 30, 2006 and September 30, 2005, respectively.
Other Income
Total other income was $3,756,000 and $3,409,000 for the three months ended September 30, 2006 and 2005. For the reason explained in the preceding discussion of the nine 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 $33,000 in the quarter ended September 30, 2006 as compared to the same quarter in 2005. The Trust Department fees for 2006 were $88,000 higher than 2005 due to the growth of assets under management. Service charges and fees were up $225,000 in the three months ended September 30, 2006. $139,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and Point of Sale (POS) pin interchange fees increased $94,000 during the same period due to the volume of activity.
Page 25 of 36
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, 2006 and 2005 (continued). |
Other Expenses
Total expenses for the 2006 quarter compared to the 2005 quarter increased $15,000 to $8,516,000. Salaries and employee benefits increased $287,000 for the quarter ended September 30, 2006 compared to 2005. Direct salary expense was up $234,000, or 7.22%, due to annual pay adjustments. The decrease of $172,000 in compensation expense related to the officers’ deferred compensation plan is explained above in the discussion of operations for the nine months ended September 30, 2006. The increase in medical insurance expense of $172,000 is also discussed above.
In the third quarter of 2006, furniture and equipment expense included $437,000 of depreciation compared to $482,000 in 2005, a decrease of $45,000. This decrease is offset by an increase in equipment and software maintenance contracts of $41,000 to a total of $303,000 in 2006. This increase is due to purchases in 2006 and the resulting maintenance agreements.
Advertising and business development expenses decreased $160,000 in comparing the quarters. The decrease is due to several factors including the types of office promotions conducted by the retail areas of the bank. Also, as discussed in the nine month operations section above, the third quarter 2005 expenses included a $50,000 contribution to the American Red Cross and higher expenses related to the Company’s credit card incentive program. Expenses for the credit card program were $26,000 in the third quarter of 2006 compared to $81,000 in the same period of 2005, a decrease of $55,000.
Outside services decreased $102,000 from 2005 to $1,185,000 for the quarter ended September 30, 2006. As a result of an increase in the volume of activity, credit card, merchant card and debit card processing charges increased $36,000. Professional fees decreased $157,000 from 2005. Third quarter 2005 expenses included the $140,000 in consulting fees discussed above.
Income Taxes
Income tax expense as a percentage of income before taxes increased to 31.68% in 2006 from 30.91% in 2005. Income tax expense is $215,000 more in 2006 compared to 2005 primarily due to the $539,000 increase in income before income taxes. The amount of tax credits in the third quarter of 2006 was $140,000 compared to $169,000 in 2005.
Page 26 of 36
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. There were no federal funds sold as of September 30, 2006 or December 31, 2005. Investment securities available for sale comprised 12.08% of the Company’s total assets at September 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 September 30, 2006, the Company had borrowed $248.1 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. This includes three new advances in 2006 for a total of $45 million. Also, two $10 million advances matured in 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 $193 million at September 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 $98 million. Those two lines of credit require the pledging of investment securities when drawn upon. The Company’s short-term borrowings at December 31, 2005 included federal funds purchased of $6.8 million compared to $23.8 million as of September 30, 2006. 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, 2006.
Contractual Obligations
As of September 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.
Page 27 of 36
HILLS BANCORPORATION
Item 3. | Quantitative and Qualitative Disclosures |
Market Risk 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 interest rates increase over an extended period of time. Conversely, 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.
Asset/Liability Management
The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s 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 transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
The Bank model indicates that interest income should decline as interest rates increase, while net interest income should increase as interest rates decline. 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 28 of 36
HILLS BANCORPORATION
Item 4. | Controls and Procedures |
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 operation of the Company’s disclosure controls and procedures as defined in Exchange Act of 1934 Rule 13a-15(f). 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 during the first nine months of 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
Page 29 of 36
HILLS BANCORPORATION
PART II - OTHER INFORMATION
| No material legal proceedings are pending. |
There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended September 30, 2006:
| 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) | |
|---|
| |
| July 1 to July 31 | | | | 1,974 | | $ | 49.00 | | | 7,351 | | | 742,649 | |
| |
| August 1 to August 31 | | | | 2,680 | | | 49.00 | | | 10,031 | | | 739,969 | |
| |
| September 1 to September 30 | | | | 1,061 | | | 49.00 | | | 11,092 | | | 738,908 | |
| |
| Total | | | | 5,715 | | $ | 49.00 | | | 11,092 | | | 738,908 | |
| |
(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization, which was publicly announced on August 9, 2005, will expire on December 31, 2009. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.
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, 2006. |
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 |
Page 30 of 36
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.
Date: 11/7/06
| | By: /s/ Dwight O. Seegmiller
|
| | | Dwight O. Seegmiller, Director, President and Chief Executive Officer |
Date: 11/7/06
| | By: /s/ James G. Pratt
|
| | | James G. Pratt, Secretary, Treasurer and Chief Accounting Officer |
Page 31 of 36
HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2006
Page 32 of 36
