Net interest income is the excess of the interest and fees earned 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 2007 was 3.23% compared to 3.39% in 2006 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 2007 compared to the comparable period in 2006 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 six months ended June 30, 2007 and 2006 (continued)
Provision for Loan Losses
The provision for loan losses was $1,486,000 in 2007 compared to $1,709,000 in 2006, a decrease of $223,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. 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 impact of borrowers’ ability to repay, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risks (primarily agricultural and spec real estate construction loans).
The provision for loan losses was larger in 2006 due to loan growth of $87.1 million in the first six months compared to $15.4 million in loan growth in the same period in 2007. The decrease in provision expense due to less loan growth was offset by a larger increase in problem and watch loans in 2007. Problem and watch loans increased $27.4 million in the six-month period ended June 30, 2007 compared to an increase of $3.6 million during the same period in 2006. The increase in non-performing loans is due to the deterioration in the credit quality of four borrower relationships having an aggregate balance of approximately $19.2 million as of June 30, 2007. The Bank believes these loans are adequately collateralized by real estate.
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, 2007 and 2006, recoveries were $723,000 and $781,000, respectively; and charge-offs were $1,209,000 in 2007 and $750,000 in 2006. The allowance for loan losses totaled $18,850,000 at June 30, 2007 compared to $17,850,000 at December 31, 2006. The allowance represented 1.43% and 1.37% of outstanding loans at June 30, 2007 and December 31, 2006, respectively. The methodology used in 2007 is consistent with 2006.
Net Gain on Sale of Loans
Net gain on sale of loans for the six months ended June 30, 2007 was $527,000 compared to $381,000 for the comparable period ended June 30, 2006. Loans sold in the first six months of 2007 totaled $61.3 million compared to $49.7 million in the same period in 2006, an increase of 24%.
Other Income
Other income, other than the net gain on sale of loans discussed above, increased by $392,000 for the six months ended June 30, 2007. Trust fees increased $175,000 in 2007 as a result of assets under management increasing from $798.6 million as of June 30, 2006 to $927.2 million as of June 30, 2007. Service charges and fees were up $398,000 in 2007. $173,000 was the result of fee income strategies. Debit card and point of sale (POS) pin interchange fees increased during the same period by $198,000 due to volume of activity. Rental revenue on tax credit real estate decreased $96,000 for the six-month period ended June 30, 2007. This decrease was due to adjustments recorded upon receipt of the 2006 audited financial statements for the tax credit properties. Other noninterest income decreased $85,000 as of June 30, 2007 compared to 2006. Included in 2006 other income was a one-time $79,000 sales tax refund.
Page 20 of 35
HILLS BANCORPORATION
Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)
Discussion of operations for the six months ended June 30, 2007 and 2006 (continued)
Other Expenses
Other expenses increased $737,000 in 2007 to $17,533,000 from the same period in 2006. This increase of 4.39% included $546,000 in salaries and benefits. Direct salary expense was up $376,000, or 5.57%, due to annual pay adjustments and the addition of employees in 2007. Medical expense for employees’ health insurance increased $47,000 due to a premium increase of 6.90%. Furniture and equipment expense increased $110,000 in the six months ended June 30, 2007 compared to the same period in 2006. This variance is due to a $134,000 increase in software maintenance contract expense. Advertising and business development expenses decreased $44,000 as of June 30, 2007. The decrease is primarily the result of office promotions held in 2006 for the retail areas of the Bank.
Outside services increased $16,000 from 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 $54,000 due to the increase in the volume of activity. Professional fees decreased $53,000 in part due to fees of $30,000 paid to an outside consultant in 2006 for a sales tax audit and expanded information security testing.
Income Taxes
Federal and state income tax expenses were $3,604,000 and $3,465,000 for the six months ended June 30, 2007 and 2006, respectively. Income taxes as a percentage of income before taxes were 30.87% in 2007 and 30.93% in 2006. The amount of tax credits was $280,000 for the six month period for both 2007 and 2006.
Page 21 of 35
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 June 30, 2007 and 2006 |
Net Income
Net income increased to $4,067,000 for the three months ended June 30, 2007 from $3,790,000 for the same period in 2006, an increase of 7.31%. Earnings per share, both basic and diluted, increased for the three months ended June 30, 2007 compared to the same period in 2006. For the three-month period ended June 30, 2007, basic and diluted earnings per share were $0.90. For the three months ended June 30, 2006, basic and diluted earnings per share were $0.83. Return on average equity was 13.61% for the three months ended June 30, 2007 compared to 13.64%, for the same period in 2006. Return on average assets was 1.03% in 2007 and 2006.
Net Interest Income
Net interest income increased for the three month period ended June 30, 2007 by $195,000 from the similar period in 2006. The net interest margin in 2007 was 3.24% compared to 3.37% in 2006. 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, 2007 and 2006 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 | | | $ | 85,649 | | | 0.24 | % | $ | 1,404 | | $ | 785 | | $ | 2,189 | |
| Taxable securities | | | | (16,178 | ) | | 0.70 | | | (142 | ) | | 194 | | | 52 | |
| Nontaxable securities | | | | 6,129 | | | 0.05 | | | 83 | | | 11 | | | 94 | |
| Federal funds sold | | | | 9,550 | | | 0.83 | | | 98 | | | 24 | | | 122 | |
|
| | | |
| |
| |
| |
| | | | $ | 85,150 | | | | | $ | 1,443 | | $ | 1,014 | | $ | 2,457 | |
|
| | | |
| |
| |
| |
| Interest expense: | | |
| Interest-bearing demand deposits | | | $ | 20,301 | | | 0.59 | | $ | (47 | ) | $ | (242 | ) | $ | (289 | ) |
| Savings deposits | | | | (12,355 | ) | | 0.35 | | | 142 | | | (311 | ) | | (169 | ) |
| Time deposits | | | | 77,164 | | | 0.79 | | | (755 | ) | | (1,132 | ) | | (1,887 | ) |
| Short-term borrowings | | | | (24,761 | ) | | (0.22 | ) | | 335 | | | (36 | ) | | 299 | |
| FHLB borrowings | | | | 13,774 | | | — | | | (174 | ) | | 1 | | | (173 | ) |
|
| | | |
| |
| |
| |
| | | | $ | 74,123 | | | | | $ | (499 | ) | $ | (1,720 | ) | $ | (2,219 | ) |
|
| | | |
| |
| |
| |
| Change in net interest income | | | | | | | | | $ | 944 | | $ | (706 | ) | $ | 238 | |
| | |
| |
| |
| |
Page 22 of 35
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 June 30, 2007 and 2006 |
A summary of the net interest spread and margin is as follows:
| | (Tax Equivalent Basis) | | | | 2007 | | | 2006 | |
|---|
| |
| | |
| |
| |
| | | | | | | | | | |
| | Yield on average interest-earning assets | | | | 6.54 | % | | 6.24 | % |
| | Rate on average interest-bearing liabilities | | | | 3.86 | | | 3.36 | |
|
| |
| |
| | Net interest spread | | | | 2.68 | % | | 2.88 | % |
| | Effect of noninterest-bearing funds | | | | 0.56 | | | 0.49 | |
|
| |
| |
| | Net interest margin (tax equivalent interest income
divided by average interest-earning assets) | | | | 3.24 | % | | 3.37 | % |
|
| |
| |
Provision for Loan Losses
The provision for loan losses was $954,000 for the quarter ended June 30, 2007 compared to $1,054,000 for the comparable quarter in 2006, a decrease of $100,000. As discussed in connection with the results of operations for the six months, the allowance for loan losses was decreased due to management’s analysis of the outstanding loans at June 30, 2007. The provision for loan losses was larger in the three-month period ended June 30, 2006 due to loan growth of $53.3 million compared to loan growth of $9.7 million in the same period in 2007. In addition, loans classified as potential watch, watch or problem loans increased $13.2 million in the second quarter of 2006 compared to a decrease of $0.7 in these categories during the second quarter of 2007.
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, 2007 and 2006, recoveries were $259,000 and $281,000, respectively; and charge-offs were $773,000 in 2007 and $385,000 in 2006. The allowance for loan losses totaled $18,850,000 at June 30, 2007 compared to $17,100,000 at June 30, 2006. The allowance represented 1.43% and 1.37% of outstanding loans at June 30, 2007 and June 30, 2006, respectively.
Other Income
Total other income was $4,136,000 and $3,772,000 for the three months ended June 30, 2007 and 2006. Net gain on sale of loans increased by $99,000 in the quarter ended June 30, 2007 as compared to the same quarter in 2006 due to an increase in the volume of loans sold in 2007. The Trust Department fees for 2007 were $90,000 higher than 2006 due to the growth of assets under management. Service charges and fees were up $259,000 in the three months ended June 30, 2007. $131,000 was the result of fee income strategies. Debit card and point of sale (POS) pin interchange fees increased $105,000 during the same period due to the volume of activity. Other noninterest income decreased $84,000 in 2007. Included in the second quarter other income was the one-time $79,000 sales tax refund noted in the six month discussion above.
Other Expenses
Total expenses for the 2007 quarter compared to the 2006 quarter increased $247,000 to $8,921,000. Salaries and employee benefits increased $207,000 for the quarter ended June 30, 2007 compared to 2006. Direct salary expense was up $143,000, or 4.16%, due to annual pay adjustments and additional employees in 2007. Furniture and equipment expense increased $67,000 in the three months ended June 30, 2007 as compared to 2006. This variance was due to a $76,000 increase in software maintenance contract expense. Advertising and business development expenses decreased $66,000 in comparing the quarters. The decrease is due to office promotions held in 2006 for the retail area of the Bank.
Page 23 of 35
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 June 30, 2007 and 2006 (continued)
Outside services increased $23,000 from the second quarter of 2006. Credit card, merchants’ card and debit card processing charges increased $29,000 for the three-month period ended June 30, 2007 due to volume of card activity. Professional fees decreased $25,000 in 2007 in part due to the $30,000 in fees paid to an outside consultant in 2006, as noted in the six month discussion above.
Income Taxes
Income tax expense as a percentage of income before taxes increased to 30.75% in 2007 from 30.60% in 2006. Income tax expense was $135,000 more in 2007 compared to 2006 primarily due to the $412,000 increase in income before income taxes. The amount of tax credits was $140,000 in the second quarters of both 2007 and 2006.
Page 24 of 35
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 12.27% of the Company’s total assets at June 30, 2007, compared to 11.48% at December 31, 2006.
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, 2007, the Company had borrowed $245.4 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. This includes two new advances in June 2007, each for $15 million. Also, a $20 million advance matured in June 2007. 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 $189 million at June 30, 2007.
As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago. As of June 30, 2007, $8 million had been borrowed from the Federal Reserve Bank on a short-term basis. These funds were repaid by the Company on July 2, 2007. The Company also has lines of credit with two banks totaling $125 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, 2007.
As of June 30, 2007, investment securities with a carrying value of $53,015,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2006, investment securities with a carrying value of $59,063,000 were pledged.
Contractual Obligations
As of June 30, 2007, 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, 2006.
Page 25 of 35
HILLS BANCORPORATION
Item 3. Quantitative and Qualitative Disclosures About Market Risk
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 savings or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
Net 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.
Although there has been no material change in the Company’s assets and liability position since December 31, 2006, interest expense during the six months ended June 30, 2007 increased at a faster pace than the comparable increase in interest income. Correspondingly, the Company’s net interest margin decreased from 3.39% for the six months ended June 30, 2006 to 3.23% for the same period in 2007. As indicated elsewhere in this report, despite this decline in net interest margin, the Company’s net interest income increased in the six months ended June 30, 2007 as compared to the same period in 2006 due to an increase of approximately $100 million, or approximately 7.15%, in average earning assets.
Page 26 of 35
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 the Securities 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 six months of 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
Page 27 of 35
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, 2006.
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 June 30, 2007:
| |
| 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 | | | | 138 | | $ | 51.00 | | | 76,004 | | | 673,996 | |
| |
| May 1 to May 31 | | | | 4,720 | | | 52.00 | | | 80,724 | | | 669,276 | |
| |
| June 1 to June 30 | | | | 1,825 | | | 52.00 | | | 82,549 | | | 667,451 | |
| |
| Total | | | | 6,683 | | $ | 51.98 | | | 82,549 | | | 667,451 | |
| |
(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 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 and legal factors.
Item 3. | Defaults upon Senior Securities |
Hills Bancorporation has no senior securities.
Item 4. | Submission of Matters to a Vote of Security Holders |
The Annual Meeting of Shareholders was held on April 16, 2007. The only matter voted was for the election of directors. 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 | | Term |
|---|
| | 1. Michael S. Donovan | | | | 3,120,684 | | | 31,243 | | 1 year to 2009 |
| | 2. Michael E. Hodge | | | | 3,119,634 | | | 32,293 | | 2 years to 2010 |
| | 3. Richard W. Oberman | | | | 3,093,409 | | | 58,518 | | 2 years to 2010 |
| | 4. John W. Phelan | | | | 3,115,824 | | | 36,103 | | 2 years to 2010 |
| | 5. Sheldon E. Yoder, D.V.M. | | | | 3,120,684 | | | 31,243 | | 2 years to 2010 |
Page 28 of 35
HILLS BANCORPORATION
PART II - OTHER INFORMATION
(continued)
None
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 29 of 35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | HILLS BANCORPORATION |
|---|
| | | |
| Date: 8/7/07 | | By: /s/ Dwight O. Seegmiller |
| |
|
| | | Dwight O. Seegmiller, Director, President and Chief Executive Officer |
| | | |
| | | |
| Date: 8/7/07 | | By: /s/ James G. Pratt |
| |
|
| | | James G. Pratt, Secretary, Treasurer and Chief Accounting Officer |
Page 30 of 35
HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED JUNE 30, 2007
Page 31 of 35
