UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------------------- FORM 10-Q [Mark One] |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2004 |_| TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to __________ Commission File Number: 0-25509 First Federal Bankshares,Inc. (Exact name of registrant as specified in its charter) Delaware 42-1485449 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 329 Pierce Street, Sioux City, Iowa 51101 (Address of principal executive offices) Registrant's telephone number, including area code 712-277-0200 - -------------------------------------------------------------------------------- Former name, former address and former fiscal year, if changed since last report Indicate by check mark 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. Yes |X| No |_| Indicate by check mark whether the Registrant is an accelerated filer. Yes |_| No |X| Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at May 14, 2004 ----- --------------------------- (Common Stock, $.01 par value) 3,753,772 FIRST FEDERAL BANKSHARES, INC. INDEX Page ---- Part I. Financial Information Item 1. Financial Statements of First Federal Bankshares, Inc. and Subsidiaries (Unaudited) 1 Condensed Consolidated Balance Sheets at March 31, 2004 and June 30, 2003 1 Condensed Consolidated Statements of Operations for the three- and nine-month periods ended March 31, 2004 and 2003 2 Condensed Consolidated Statements of Changes in Stockholders' Equity for the nine-month periods ended March 31, 2004 and 2003 3 Condensed Consolidated Statements of Comprehensive Income for the three- and nine-month periods ended March 31, 2004 and 2003 4 Condensed Consolidated Statements of Cash Flows for the nine-month periods ended March 31, 2004 and 2003 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 Item 4. Controls and Procedures 22 Part II. Other Information 23 Item 1. Legal Proceedings 23 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 23 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 6. Exhibits and Reports on Form 8-K 23 Signatures 24 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS FIRST FEDERAL BANKSHARES, INC and SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) March 31, June 30, 2004 2003 ------------- ------------- Assets Cash and due from banks $ 21,505,254 $ 34,006,405 Interest-bearing deposits in other financial institutions 40,782,292 280,548 ------------- ------------- Cash and cash equivalents 62,287,546 34,286,953 ------------- ------------- Securities available-for-sale, at fair value (amortized cost of $59,020,441 and $77,392,727, respectively) 59,691,010 78,526,104 Securities held-to-maturity, at amortized cost (fair value of $26,570,669 and $45,659,510, respectively) 25,579,765 44,505,464 Loans receivable 430,515,085 419,882,438 Less: Allowance for loan losses 4,947,567 4,615,285 ------------- ------------- Net loans 425,567,518 415,267,153 ------------- ------------- Office property and equipment, net 13,403,610 13,165,804 Federal Home Loan Bank ("FHLB") stock, at cost 6,229,600 5,707,300 Accrued interest receivable 2,528,255 2,488,460 Refundable income taxes 94,372 -- Deferred tax asset 686,000 514,000 Goodwill (note 5) 18,523,607 18,523,607 Other assets 18,659,705 14,894,532 ------------- ------------- Total assets $ 633,250,988 $ 627,879,377 ============= ============= Liabilities Deposits $ 442,141,808 $ 448,944,039 Advances from FHLB and other borrowings 113,249,015 102,386,888 Advance payments by borrowers for taxes and insurance 489,440 1,458,955 Accrued taxes on income -- 346,167 Accrued interest payable 1,651,725 1,795,348 Accrued expenses and other liabilities 3,394,294 3,286,615 ------------- ------------- Total liabilities 560,926,282 558,218,012 ------------- ------------- Stockholders' equity Common stock, $.01 par value, 12,000,000 shares authorized; 4,934,262 and 4,896,857 shares issued at March 31, 2004 and June 30, 2003, respectively 49,343 48,969 Additional paid-in capital 37,003,715 36,537,133 Retained earnings, substantially restricted 51,415,564 47,900,781 Treasury stock, at cost, 1,148,990 and 1,088,466 shares at March 31, 2004 and June 30, 2003, respectively (15,449,468) (14,264,674) Accumulated other comprehensive income 419,569 710,378 Unearned Employee Stock Ownership Plan ("ESOP") shares (1,080,990) (1,185,700) Unearned Recognition and Retention Plan ("RRP") shares (33,027) (85,522) ------------- ------------- Total stockholders' equity 72,324,706 69,661,365 ------------- ------------- Total liabilities and stockholders' equity $ 633,250,988 $ 627,879,377 ============= ============= See notes to condensed consolidated financial statements. 1 FIRST FEDERAL BANKSHARES, INC. and SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three months Nine months ended March 31, ended March 31, ----------------------------- ----------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Interest income: Loans receivable $ 6,737,451 $ 7,031,157 $20,362,291 $22,418,585 Investment securities 877,833 1,378,144 2,968,493 4,612,144 Other interest-earning assets 13,628 30,585 24,275 41,533 ----------- ----------- ----------- ----------- Total interest income 7,628,912 8,439,886 23,355,059 27,072,262 ----------- ----------- ----------- ----------- Interest expense: Deposits 1,885,296 2,574,190 5,922,077 8,762,145 Advances from FHLB and other borrowings 1,220,862 1,222,914 3,766,105 3,807,420 ----------- ----------- ----------- ----------- Total interest expense 3,106,158 3,797,104 9,688,182 12,569,565 ----------- ----------- ----------- ----------- Net interest income 4,522,754 4,642,782 13,666,877 14,502,697 Provision for losses on loans 450,000 200,000 1,075,000 1,430,000 ----------- ----------- ----------- ----------- Net interest income after provision for losses on loans 4,072,754 4,442,782 12,591,877 13,072,697 ----------- ----------- ----------- ----------- Noninterest income: Service charges on deposit accounts 903,931 886,746 2,962,692 2,725,216 Service charges on loans 141,479 426,532 490,212 793,033 Gain on sale of loans 917,059 534,044 1,406,169 1,193,059 Gain on sale of real estate held for development 60,000 -- 60,000 18,561 (Loss) gain on sale of real estate owned (3,019) 35,960 (21,763) 65,639 Net gain (loss) on sale of securities -- 221,143 (64,797) 258,643 Net gain (loss) on sale of office property and equipment 36,499 (6,612) 69,917 (5,643) Real estate-related activities 318,848 409,244 1,007,512 1,132,259 Other income 384,751 420,452 1,247,779 1,298,392 ----------- ----------- ----------- ----------- Total noninterest income 2,759,548 2,927,509 7,157,721 7,479,159 ----------- ----------- ----------- ----------- Noninterest expense: Compensation and benefits (note 7) 2,744,260 2,576,695 7,639,316 7,529,845 Office property and equipment 667,527 726,472 1,902,608 2,024,145 Data processing expense 122,836 82,139 320,223 236,257 Advertising 55,129 60,509 255,131 296,729 Other expense 978,439 1,272,028 2,955,950 3,694,927 ----------- ----------- ----------- ----------- Total noninterest expense 4,568,191 4,717,843 13,073,228 13,781,903 ----------- ----------- ----------- ----------- Earnings before income taxes 2,264,111 2,652,448 6,676,370 6,769,953 Income taxes 751,000 870,000 2,211,000 2,263,000 ----------- ----------- ----------- ----------- Net earnings $ 1,513,111 $ 1,782,448 $ 4,465,370 $ 4,506,953 =========== =========== =========== =========== Earnings per share: (note 4) Basic earnings per share $ 0.41 $ 0.46 $ 1.23 $ 1.15 =========== =========== =========== =========== Diluted earnings per share $ 0.40 $ 0.45 $ 1.19 $ 1.12 =========== =========== =========== =========== Dividends declared per share $ 0.09 $ 0.08 $ 0.27 $ 0.24 =========== =========== =========== =========== See notes to condensed consolidated financial statements. 2 FIRST FEDERAL BANKSHARES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) Nine months ended March 31, 2004 2003 ------------------------------- Capital Stock Beginning of year balance $ 48,969 $ 48,711 Stock options exercised 374 210 - --------------------------------------------------------------------------------------------------------- End of period balance 49,343 48,921 - --------------------------------------------------------------------------------------------------------- Additional paid-in capital Beginning of year balance 36,537,133 36,247,480 Stock options exercised 345,854 161,240 RRP (forfeited) awarded, net (7,000) 9,050 Stock appreciation of allocated ESOP shares 127,728 41,661 - --------------------------------------------------------------------------------------------------------- End of period balance 37,003,715 36,459,431 - --------------------------------------------------------------------------------------------------------- Retained earnings, substantially restricted Beginning of year balance 47,900,781 43,542,299 Net earnings 4,465,370 4,506,953 Dividends paid on common stock (950,587) (950,790) - --------------------------------------------------------------------------------------------------------- End of period balance 51,415,564 47,098,462 - --------------------------------------------------------------------------------------------------------- Treasury stock, at cost Beginning of year balance (14,264,674) (7,577,646) RRP (forfeited) awarded, net (25,200) (1,800) Treasury stock purchased (1,159,594) (4,213,803) - --------------------------------------------------------------------------------------------------------- End of period balance (15,449,468) (11,793,249) - --------------------------------------------------------------------------------------------------------- Accumulated other comprehensive income Beginning of year balance 710,378 490,458 Net change in unrealized gains on securities available-for-sale, net of tax expense (331,437) 266,178 Less: reclassification adjustment for net realized (losses) gains included in net income, net of tax expense (40,628) 162,169 - --------------------------------------------------------------------------------------------------------- End of period balance 419,569 594,467 - --------------------------------------------------------------------------------------------------------- Unearned ESOP shares Beginning of year balance (1,185,700) (1,330,000) ESOP shares allocated 104,710 108,800 - --------------------------------------------------------------------------------------------------------- End of period balance (1,080,990) (1,221,200) - --------------------------------------------------------------------------------------------------------- Unearned recognition and retention plan shares Beginning of year balance (85,522) (158,507) RRP forfeited (awarded), net 14,981 (7,250) Amortization of RRP expense 37,514 60,783 - --------------------------------------------------------------------------------------------------------- End of period balance (33,027) (104,974) - --------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------- Total stockholders' equity $ 72,324,706 $ 71,081,858 ========================================================================================================= See notes to condensed consolidated financial statements. 3 FIRST FEDERAL BANKSHARES, INC. and SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) Three Months Ended Nine months ended March 31, March 31, -------------------------- -------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Net earnings $ 1,513,111 $ 1,782,448 $ 4,465,370 $ 4,506,953 Other comprehensive income (loss): Unrealized holding gains (losses) arising during the period, net of tax 179,564 14,351 (331,437) 266,178 Less: reclassification adjustment for net realized gains (losses) included in net income, net of tax expense -- 138,657 (40,628) 162,169 ----------- ----------- ----------- ----------- Other comprehensive income (loss), net of tax 179,564 (124,306) (290,809) 104,009 ----------- ----------- ----------- ----------- Comprehensive income $ 1,692,675 $ 1,658,142 $ 4,174,561 $ 4,610,962 =========== =========== =========== =========== 4 FIRST FEDERAL BANKSHARES, INC. and SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine months ended March 31, Cash flows from operating activities: 2004 2003 ------------ ------------ Net earnings $ 4,465,370 $ 4,506,953 Adjustments to reconcile net earnings to net cash provided by operating activities: Loans originated for sale to investors (28,950,060) (47,917,013) Proceeds from sale of loans originated for sale 30,188,546 47,979,698 Provision for loan losses 1,075,000 1,430,000 Depreciation and amortization 1,060,752 1,408,083 Net gain on sale of loans (1,406,169) (1,193,059) Net loss (gain) on sale of securities available-for-sale 64,797 (258,643) Net gain on sale of real estate held for development (60,000) (18,561) Net loss (gain) on sale of real estate owned 21,763 (65,639) Net (gain) loss on sale of office property and equipment (69,917) 5,643 Net loan fees deferred 45,993 183,993 Amortization of premiums and discounts on loans and securities 219,489 116,356 (Increase) decrease in accrued interest receivable (39,795) 131,132 Increase in other assets (356,256) (2,453,332) Decrease in accrued interest payable (143,623) (1,127,138) Increase in accrued expenses and other liabilities 107,678 1,557,570 (Decrease) increase in accrued taxes on income (313,387) 171,208 ------------ ------------ Net cash provided by operating activities 5,910,181 4,457,251 ------------ ------------ Cash flows from investing activities: Purchase of securities held-to-maturity -- (1,125,682) Proceeds from maturities of securities held-to-maturity 18,856,176 14,099,343 Proceeds from sale of securities available-for-sale 13,585,515 26,171,473 Purchase of securities available-for-sale (8,209,971) (38,748,085) Proceeds from maturities of securities available-for-sale 12,610,800 10,610,326 Purchase of bank owned life insurance (2,555,755) -- Purchase of Federal Home Loan Bank Stock (522,300) (669,500) Loans purchased (23,661,000) (9,787,000) Proceeds from sale of loans 37,370,941 2,357,433 (Increase) decrease in loans receivable (25,306,388) 26,302,200 Proceeds from sale of office property and equipment 108,912 1,040 Purchase of office property and equipment (1,084,819) (359,800) Proceeds from sale of foreclosed real estate 144,555 449,101 Proceeds from sale of real estate held for development 702,302 54,298 Net expenditures on real estate held for development (1,274,983) (125,763) ------------ ------------ Net cash provided by investing activities 20,763,985 29,229,384 ------------ ------------ Cash flows from financing activities: Decrease in deposits (6,802,231) (20,180,496) Proceeds from FHLB advances and other borrowings 25,249,015 50,167,000 Repayment of FHLB advances and other borrowings (14,386,888) (45,443,549) Net decrease in advances from borrowers for taxes and insurance (969,515) (886,157) Issuance of common stock, net 346,227 161,450 Repurchase of common stock (1,159,594) (4,213,803) Cash dividends paid (950,587) (950,790) ------------ ------------ Net cash provided by (used in) financing activities 1,326,427 (21,346,345) ------------ ------------ Net increase in cash and cash equivalents 28,000,593 12,340,290 Cash and cash equivalents at beginning of period 34,286,953 23,217,221 ------------ ------------ Cash and cash equivalents at end of period $ 62,287,546 $ 35,557,511 ============ ============ Supplemental disclosures: Cash paid for interest $ 9,831,805 $ 13,696,703 ============ ============ Cash paid for income taxes $ 2,651,039 $ 2,091,792 ============ ============ See notes to condensed consolidated financial statements. 5 FIRST FEDERAL BANKSHARES, INC. and SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of presentation The condensed consolidated balance sheet information for June 30, 2003 was derived from the audited Consolidated Balance Sheets of First Federal Bankshares, Inc. (the "Company") at June 30, 2003. The condensed consolidated financial statements as of and for the three months and nine months ended March 31, 2004 and 2003 are unaudited. In the opinion of management of the Company these financial statements reflect all adjustments, consisting only of normal recurring accruals necessary to present fairly these condensed consolidated financial statements. The results of operations for the interim periods are not necessarily indicative of results that may be expected for an entire year. Certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. Certain amounts previously reported have been reclassified to conform to the presentation in these condensed consolidated financial statements. These reclassifications did not affect previously reported net income or retained earnings. The Company's critical accounting policies relate to the allowance for loan losses and accounting for intangible assets. A description of the Company's critical accounting policy related to intangible assets is summarized in Note 5 of these interim financial statements. With regard to the Company's critical accounting policy related to the allowance for loan losses, the Company has established a systematic method of periodically reviewing the credit quality of the loan portfolio in order to establish an allowance for losses on loans. The allowance for losses on loans is based on management's current judgments about the credit quality of individual loans and segments of the loan portfolio. The allowance for losses on loans is established through a provision for loan losses based on management's evaluation of the risk inherent in the loan portfolio, and considers all known internal and external factors that affect loan collectibility as of the reporting date. Such evaluation, which includes a review of all loans on which full collectability may not be reasonably assured, considers among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience, management's knowledge of inherent risks in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. This evaluation involves a high degree of complexity and requires management to make subjective judgments that often require assumptions or estimates about uncertain matters. A summary of significant accounting policies followed by the Company is set forth in Note 1 of the Company's 2003 Annual Report to Stockholders and is incorporated herein by reference. The Company's critical accounting policies and their application are periodically reviewed by the Audit Committee and the full Board of Directors. 6 2. Organization The Company is the holding company for First Federal Bank (the "Bank"). The Company owns 100% of the Bank's common stock. Currently, the Company engages in no other significant activities beyond its ownership of the Bank's common stock. 3. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 4. Earnings per share The following information was used in the computation of net earnings per common share on both a basic and diluted basis for the periods presented. Three months ended Nine months ended March 31, March 31, 2004 2003 2004 2003 -------------------------- -------------------------- Basic earnings per share computation: Net earnings $1,513,111 $1,782,448 $4,465,370 $4,506,953 Weighted average common shares outstanding 3,654,457 3,837,324 3,643,980 3,931,839 ---------- ---------- ---------- ---------- Basic earnings per share $ 0.41 $ 0.46 $ 1.23 $ 1.15 ========== ========== ========== ========== Diluted earnings per share computation: Net earnings $1,513,111 $1,782,448 $4,465,370 $4,506,953 Weighted average common shares outstanding - basic 3,654,457 3,837,324 3,643,980 3,931,839 Incremental option shares using treasury stock method 105,589 92,089 112,190 87,341 ---------- ---------- ---------- ---------- Weighted average diluted shares outstanding 3,760,046 3,929,413 3,756,170 4,019,180 ---------- ---------- ---------- ---------- Diluted earnings per share $ 0.40 $ 0.45 $ 1.19 $ 1.12 ========== ========== ========== ========== 5. Intangible assets The gross carrying amount of intangible assets subject to amortization and the associated accumulated amortization at March 31, 2004, is presented in the table below. Amortization expense for intangible assets was $11,547 and $104,640, respectively, for the three months ended March 31, 2004 and 2003 and $40,827 and $321,880, respectively, for the nine months ended March 31, 2004 and 2003. 7 March 31, 2004 -------------- Gross carrying accumulated amount amortization ------ ------------ Intangible assets: Core deposit premium $ 690,140 $ 464,497 Mortgage servicing rights 268,379 -- --------- --------- Total $ 958,519 $ 464,497 ========= ========= Unamortized intangible assets $ 494,022 ========= Projections of amortization expense are based on existing asset balances and the existing interest rate environment as of March 31, 2004. What the Company actually experiences may be significantly different depending upon changes in market interest rates and market conditions. The following table shows the estimated future amortization expense for amortizing intangible assets: Core deposit Mortgage servicing premium rights ------- ------ Three months ended June 30, 2004 $ 11,547 $ 6,841 Years ended June 30, 2005 45,396 34,831 2006 44,604 40,361 2007 44,604 35,983 2008 44,604 30,536 2009 34,888 25,611 thereafter -- 94,216 6. Dividends On January 15, 2004 the Company declared a cash dividend on its common stock, payable on February 27, 2004 to stockholders of record as of February 13, 2004, equal to $0.09 per share. Dividends totaling $330,332 were paid to stockholders on February 27, 2004. On April 15, 2004 the Company declared a cash dividend on its common stock, payable on May 28, 2004 to stockholders of record as of May 14, 2004 equal to $0.09 per share. The Company expects to pay approximately $327,800 to stockholders on May 28, 2004. 7. Stock Options At March 31, 2004, the Company had two stock-based employee compensation plans, which are described more fully in Note 11 of the Company's 2003 Annual Report to Stockholders. The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for its stock options in the condensed consolidated financial statements. The following table illustrates the effect on net income and earnings per share 8 if the Company had applied the fair value recognition provisions of SFAS 123, Accounting for Stock-based Compensation, to stock-based employee compensation. Three months ended Nine months ended March 31, March 31, 2004 2003 2004 2003 ----------------------------- ----------------------------- Net income, as reported $ 1,513,111 $ 1,782,448 $ 4,465,370 $ 4,506,953 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (28,706) (18,681) (65,786) (52,256) ----------- ----------- ----------- ----------- Pro forma net income $ 1,484,405 $ 1,763,767 $ 4,399,584 $ 4,454,697 =========== =========== =========== =========== Earnings per share: Basic - as reported $ 0.41 $ 0.46 $ 1.23 $ 1.15 Basic - pro forma $ 0.41 $ 0.46 $ 1.21 $ 1.13 =========== =========== =========== =========== Diluted - as reported $ 0.40 $ 0.45 $ 1.19 $ 1.12 Diluted - pro forma $ 0.39 $ 0.45 $ 1.17 $ 1.11 =========== =========== =========== =========== The fair value of each option grant has been estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the periods presented: dividend yield of 1.62% to 3.41%; expected volatility of 22.76% to 26.44%; risk free interest rate of 3.86% to 6.63%; and expected life of 7.5 years. 8. Effect of New Accounting Standards In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. FIN 46 establishes accounting guidance for consolidation by business enterprises of variable interest entities ("VIE") that function to support the activities of the primary beneficiary. Prior to the implementation of FIN 46, VIE were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003. For existing VIE, the implementation date of FIN 46 is the first fiscal year or interim period beginning after June 15, 2003. The Company's adoption of FIN 46 in connection with its consolidated financial statements beginning July 1, 2003 was not material as the Company does not presently have any VIE. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, ("SFAS 149"). SFAS 149 amends Statement 133 for certain items. The Company adopted SFAS 149 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS 150"). SFAS 150 established standards for how an issuer classifies and measures 9 certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or asset in some circumstances). The Company adopted SFAS 150 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations. In December 2003, the Accounting Standards Executive Committee issued Statement of Position ("SOP") 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP applies to all loans acquired in a transfer, including those acquired in the acquisition of a bank or a branch, and provides that such loans be accounted for at fair value with no allowance for loan losses, or other valuation allowance, permitted at the time of acquisition. The difference between cash flows expected at the acquisition date and the investment in the loan should be recognized as interest income over the life of the loan. If contractually required payments for principal and interest are less than expected cash flows, this amount should not be recognized as a yield adjustment, a loss accrual, or a valuation allowance. The SOP is effective for the Company's fiscal year beginning July 1, 2005. No significant impact is expected on the consolidated financial statements at the time of adoption. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-looking statements This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and is including this statement for the purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the Company's future activities and operating results include, but are not limited to, changes in: interest rates, general economic conditions, legislative and regulatory changes, U.S. monetary and fiscal policies, demand for products and services, deposit flows, competition and accounting policies, principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Overview During the quarter ended March 31, 2004 the Company sold $37.1 million of fixed-rate residential loans with 15-year terms in order to mitigate future interest rate risk in a potential rising market interest rate environment. The net gain on these loans totaled $791,000. The mortgage servicing asset recorded as a result of this sale totaled $268,000. The loan sale will negatively impact the Company's net interest margin in the short term since the loans sold had an average yield of 4.92%, while the proceeds of the sale were received and invested in a historically low market interest rate 10 environment. However, the interest rate risk associated with keeping these longer-term fixed-rate loans in an increasing interest rate environment was viewed as more unfavorable to the Company than the short-term margin compression resulting from the sale. Management expects to re-deploy the loan sale proceeds into higher-yielding loans over the next six to twelve months. The extended low market interest rate environment contributed to a decrease in the Company's net interest margin when compared to the prior year and also when compared to its fiscal year plan. The Company's yield on interest-earning assets is generally decreasing at a faster rate than the cost of interest-bearing liabilities, although the Company has mitigated a portion of this compression by adjustments to the mix of both interest-earning assets and interest-bearing liabilities. Financial condition Total assets increased by $5.4 million, or 0.9%, to $633.3 million at March 31, 2004 from $627.9 million at June 30, 2003. Cash and cash equivalents increased by $28.0 million, or 81.7%, to $62.3 million at March 31, 2004 from $34.3 million at June 30, 2003. The increase in cash and cash equivalents resulted from the sale of $37.1 million of fixed-rate residential loans in March 2004. Proceeds from maturities and sales of investment securities totaled $45.1 million for the nine months ended March 31, 2004 while purchases of investment securities for the same period totaled $8.2 million. The net proceeds of $36.9 million from investment securities activities partially funded an increase in loans receivable. Loans receivable increased by $10.6 million, or 2.5%, to $430.5 million at March 31, 2004 from $419.9 million at June 30, 2003 even after the loan sale. FHLB Stock increased by $522,000, or 9.2%, to $6.2 million at March 31, 2004 from $5.7 million at June 30, 2003 due to FHLB stock purchase requirements related to outstanding advance balances. Deposits decreased by $6.8 million, or 1.5%, to $442.1 million at March 31, 2004 from $448.9 million at June 30, 2003. The Company is generally not a market rate leader for term deposits. In response to historically low market interest rates, deposit customers have withdrawn funds from matured time deposits and transferred those funds to more liquid accounts. The Company offers premium rates to customers with multiple relationships in order to retain existing deposits and attract new customers. Periodically, the Company offers premium rates on select products in order to generate and retain deposits and to meet certain asset/liability management objectives. Offsetting the decrease in the balance of deposits was an increase in FHLB advances as the Company acquired fixed-rate fixed-term advances at generally lower rates than comparable-term retail certificates of deposit. FHLB advances and other borrowings increased by $10.8 million, or 10.6%, to $113.2 million at March 31, 2004 from $102.4 million at June 30, 2003. Total stockholders' equity increased by $2.6 million, or 3.8%, to $72.3 million at March 31, 2004 from $69.7 million at June 30, 2003. The Company repurchased 54,500 shares of its common stock during the nine months ended March 31, 2004 at a cost of $1.2 million. A repurchase program announced in August 2003 provided for the repurchase of up to 377,000 shares, or approximately 10% of the then outstanding shares, in open market purchases. At March 31, 2004 up to 367,000 shares may yet be purchased under this program. The Company's management believes that stock repurchases are an appropriate deployment of a portion of the Company's capital that enhances shareholder value when the Company's common stock is repurchased at an 11 appropriate price. With capital levels in excess of regulatory requirements, as demonstrated in the capital table included later in this report, and a basic core surplus of liquid assets in excess of short term liabilities that totals $58.7 million, or 9.36%, at March 31, 2004, the Company believes it can implement these repurchase programs without adversely affecting its capital or liquidity positions or its ability to pay future dividends. In addition, stock repurchase programs may reduce price volatility and enhance the liquidity of the Company's common stock, which is generally advantageous for shareholders. Earnings totaled $1.5 million and $4.5 million, respectively, for the three months and nine months ended March 31, 2004. Excluding dividends on unallocated Employee Stock Ownership Plan ("ESOP") shares, dividends declared during the nine months ended March 31, 2004 totaled $950,587. Asset quality Non-performing assets totaled $5.5 million, or 0.87% of total assets at March 31, 2004 and $5.1 million, or 0.81% of total assets at June 30, 2003. The allowance for loan losses is increased by the provision for loan losses charged to operations and reduced by net charge-offs. Management establishes the allowance for loan losses through a process that begins with estimates of probable loss inherent in the portfolio based on various statistical analyses. These analyses consider historical and projected default rates and loss severities; internal risk ratings; and geographic, industry and other environmental factors. In establishing the allowance for loan losses, management also considers the Company's current business strategy and credit processes, including compliance with established guidelines for credit limits, credit approvals, loan underwriting criteria and loan workout procedures. The policy of the Company is to segment the allowance to correspond to the various types of loans in the loan portfolio according to the underlying collateral, which corresponds to the respective levels of quantified and inherent risk. The initial assessment takes into consideration non-performing loans and the valuation of the collateral supporting each loan. Non-performing loans are risk-rated generally on a case-by-case basis based on qualitative and quantitative factors that include, but are not limited to, collateral type and estimated value, financial statement analysis, specific economic factors, cash flow analysis, delinquency history and loan workout situations and progress. Based upon this analysis, a quantified risk factor is assigned to each non-performing loan. This results in an allocation to the overall allowance for the corresponding type and severity of each non-performing loan. Performing loans are also reviewed by collateral type, with similar risk factors being assigned. These risk factors take into consideration, among other matters, the borrower's ability to pay and the Company's past loan loss experience with each type of loan. The assigned risk factors result in allocations to the allowance corresponding to the risk-rated portfolio of performing loans. In order to determine its overall adequacy, the allowance for loan losses is reviewed by management on a monthly basis. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary, based on changes in economic and local market conditions 12 beyond management's control. In addition, various regulatory agencies periodically review the Company's loan loss allowance as an integral part of the examination process. Accordingly, the Company may be required to take certain charge-offs and/or recognize additions to the allowance based on the judgment of regulators as determined by information provided to them during their examinations. Based on relevant and presently available information, management believes that the current allowance for loan losses represents all known and inherent losses in the Company's portfolio that are both probable and reasonably estimable. Following are tables presenting (a) a summary of the allowance for loan losses and (b) non-performing asset balances for or at the periods or dates indicated. (a) Summary of the allowance for loan losses Three months ended Nine months ended March 31, March 31, 2004 2003 2004 2003 ----------------------------- ----------------------------- Balance at beginning of period $ 4,862,531 $ 4,660,178 $ 4,615,285 $ 4,583,897 Provision for losses 450,000 200,000 1,075,000 1,430,000 Charge-offs (395,285) (372,560) (808,698) (1,744,696) Recoveries 30,321 92,156 65,980 310,573 ----------- ----------- ----------- ----------- Balance at end of period $ 4,947,567 $ 4,579,774 $ 4,947,567 $ 4,579,774 =========== =========== =========== =========== (b) Non-performing assets March 31, 2004 June 30, 2003 -------------- ------------- (Dollars in thousands) Loans accounted for on a non-accrual basis: One-to-four family $ 1,053 $ 335 Multi-family residential -- 2,426 Commercial real estate 1,278 628 Commercial business 812 -- Consumer 362 302 ---------- ---------- Total $ 3,505 $ 3,691 ---------- ---------- Loans 90 days past due and still accruing (1): One-to-four family $ 1,313 $ 997 Multi-family residential -- -- Commercial real estate -- -- Commercial business -- -- Consumer -- -- ---------- ---------- Total $ 1,313 $ 997 ---------- ---------- Total non-performing loans $ 4,818 $ 4,688 ---------- ---------- Other non-performing assets (2) $ 717 $ 412 ---------- ---------- Total non-performing assets $ 5,535 $ 5,100 ========== ========== Restructured loans not included in other non-performing categories above (3) $ 3,121 $ 3,005 ========== ========== Non-performing loans as a % of total loans 1.12% 1.13% Non-performing loans as a % of total assets 0.76% 0.75% Non-performing assets as a % of total assets 0.87% 0.81% 13 - ---------- (1) Delinquent FHA/VA guaranteed loans and delinquent loans with past due interest that, in the opinion of management, is collectable, are not placed on non- accrual. (2) Represents the net book value of real property acquired through foreclosure or deed in lieu of foreclosure and the net book value of repossessed automobiles, boats and trailers. Other non-performing assets are carried at the lower of cost or fair market value less estimated disposal costs. (3) Restructured loans have had amounts added to the principal balance and/or the terms of the debt modified. Modification terms include payment extensions, interest only payments and longer amortization periods, among other possible concessions that would not normally be considered. Capital The Office of Thrift Supervision (the "OTS") requires that the Bank meet minimum tangible, leverage (core) and risk-based capital requirements. As of March 31, 2004 the Bank was in compliance with all regulatory capital requirements. Capital levels in excess of regulatory requirements enabled the Bank to pay dividends to the Company in order to fund common stock repurchases. The Bank's required, actual and excess capital levels as of March 31, 2004 were as follows: Excess of Actual Over Required % of Actual % of Regulatory Amount Assets Amount Assets Requirement ------ ------ ------ ------ ----------- (Dollars in thousands) Tangible Capital $ 9,168 1.5% $46,589 7.62% $37,421 Tier 1 leverage (core) 18,336 3.0% 46,589 7.62% 28,253 Risk-based Capital 33,609 8.0% 51,237 12.20% 17,628 Liquidity The Company is required by OTS regulation to maintain sufficient liquidity to assure its safe and sound operation. Liquid assets include cash, certain time deposits, banker's acceptances and specified United States government, state or federal agency obligations. The Company's liquidity position is sufficient to enable the Company to deploy a portion of such liquidity for stock repurchases. The Company adjusts its liquid assets in order to meet funding needs for deposit outflows, payment of real estate taxes from escrowed funds, when applicable, loan commitments and capital strategies. The Company also adjusts liquidity as appropriate to meet its asset/liability objectives. 14 Effect of new accounting standards In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. FIN 46 establishes accounting guidance for consolidation by business enterprises of variable interest entities ("VIE") that function to support the activities of the primary beneficiary. Prior to the implementation of FIN 46, VIE were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003. For existing VIE, the implementation date of FIN 46 is the first fiscal year or interim period beginning after June 15, 2003. The Company's adoption of FIN 46 in connection with its consolidated financial statements beginning July 1, 2003 was not material as the Company does not presently have any VIE. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, ("SFAS 149"). SFAS 149 amends Statement 133 for certain items. The Company adopted SFAS 149 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS 150"). SFAS 150 established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or asset in some circumstances). The Company adopted SFAS 150 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations. In December 2003, the Accounting Standards Executive Committee issued Statement of Position ("SOP") 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP applies to all loans acquired in a transfer, including those acquired in the acquisition of a bank or a branch, and provides that such loans be accounted for at fair value with no allowance for loan losses, or other valuation allowance, permitted at the time of acquisition. The difference between cash flows expected at the acquisition date and the investment in the loan should be recognized as interest income over the life of the loan. If contractually required payments for principal and interest are less than expected cash flows, this amount should not be recognized as a yield adjustment, a loss accrual, or a valuation allowance. The SOP is effective for the Company's fiscal year beginning July 1, 2005. No significant impact is expected on the consolidated financial statements at the time of adoption. COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED March 31, 2004 and 2003 General. Net earnings for the three months ended March 31, 2004 totaled $1.5 million, or basic and diluted earnings per share of $0.41 and $0.40, respectively. Net earnings for the three months ended March 31, 2003 totaled $1.8 million, or basic and diluted earnings per share of $0.46 and $0.45, respectively. 15 Interest Income. Interest income decreased by $811,000, or 9.6%, to $7.6 million for the three months ended March 31, 2004 from $8.4 million for the three months ended March 31, 2003. The average yield on interest-earning assets decreased by 47 basis points to 5.53% for the three months ended March 31, 2004 from 6.00% for the three months ended March 31, 2003. The average balance of interest-earning assets decreased by $3.2 million, or 0.6%, to $559.5 million for the three months ended March 31, 2004 from $562.7 million for the three months ended March 31, 2003. Interest income on loans receivable decreased by $294,000, or 4.2%, to $6.7 million for the three months ended March 31, 2004 from $7.0 million for the three months ended March 31, 2003. The decrease in interest income on loans was primarily due to a decrease in the average yield on loans. The average yield on loans receivable decreased by 90 basis points to 5.90% for the three months ended March 31, 2004 from 6.80% for the three months ended March 31, 2003. The decrease in the average yield on loans was due to refinancing activity and to interest rate reductions for adjustable-rate loans in the generally lower market interest rate environment during the current year period. Partially offsetting the decrease in interest income due to lower yields was an increase in the average balance of loans receivable. The average balance of loans receivable increased by $45.3 million, or 11.0%, to $459.0 million for the three months ended March 31, 2004 from $413.7 million or the three months ended March 31, 2003. The increase in the average balance of loans receivable was primarily funded by proceeds from the maturity and sale of investment securities. The sale of $37.1 million of residential loans occurred at the end of March and therefore had minimal effect on the average balance of loans for the three months ended March 31, 2004. Interest income on investment securities decreased by $500,000, or 36.3%, to $878,000 for the three months ended March 31, 2004 from $1.4 million for the three months ended March 31, 2003. The decrease in interest income on investment securities was primarily due to a decrease in the average balance. The average balance of investment securities decreased by $43.1 million, or 31.5% to $93.9 million for the three months ended March 31, 2004 from $137.0 million for the three months ended March 31, 2003. In addition, the average tax-equivalent yield on investment securities decreased by 21 basis points to 4.01% for the three months ended March 31, 2004 from 4.22% for the three months ended March 31, 2003 in the generally lower market interest rate environment. Interest Expense. Interest expense decreased by $691,000, or 18.2%, to $3.1 million for the three months ended March 31, 2004 from $3.8 million for the three months ended March 31, 2003 primarily due to a decrease in the average cost of interest-bearing liabilities. The average cost of interest-bearing liabilities decreased by 42 basis points to 2.43% for the nine months ended March 31, 2004 from 2.85% for the nine months ended March 31, 2003. Interest on deposits decreased by $689,000, or 26.8%, to $1.9 million for the three months ended March 31, 2004 from $2.6 million for the three months ended March 31, 2003. The average cost of deposits decreased by 51 basis points to 1.90% for the three months ended March 31, 2004 from 2.41% for the three months ended March 31, 2003. The decrease in the average cost of deposits was due to changes in the mix of deposit types and to the generally lower market interest rate environment during the three months ended March 31, 2004. The average balance of non-interest-bearing deposits increased by $16.0 million, or 74.6%, to $37.4 million for the three months ended March 31, 2004 from 16 $21.4 million for the three months ended March 31, 2003 while the average balance of generally higher-rate fixed-term time deposits decreased by $12.6 million between the same periods. Also contributing to the decrease in interest on deposits was a decrease in the average balance of interest-bearing deposits. The average balance of interest-bearing deposits decreased by $29.6 million, or 6.9%, to $398.4 million for the three months ended March 31, 2004 from $428.0 million for the three months ended March 31, 2003. Interest on FHLB advances and other borrowings totaled $1.2 million for each of the three month periods ended March 31, 2004 and 2003. The average cost of borrowings decreased by 40 basis points to 4.25% for the three months ended March 31, 2004 from 4.65% for the three months ended March 31, 2003. Offsetting the decrease in the average cost of borrowings was an increase in the average balance of borrowings. The average balance of borrowings increased by $10.3 million, or 9.8%, to $115.5 million for the three months ended March 31, 2004 from $105.2 million for the three months ended March 31, 2003. Net Interest Income. Net interest income before provision for losses on loans decreased by $120,000, or 2.6%, to $4.5 million for the three months ended March 31, 2004 from $4.6 million for the three months ended March 31, 2003 primarily due to lower yields on interest-earning assets in the extended historically low market interest rate environment. The Company maintained a net interest margin of 3.26% for the each of the three months ended March 31, 2004 and 2003 largely due to the shift in the mix of interest-earning assets between loans receivable and investments securities and the shift in interest-bearing liabilities between non-interest-earning deposits and time deposits as described above. Provision for Losses on Loans. Provision for losses on loans totaled $450,000 for the three months ended March 31, 2004 and $200,000 for the three months ended March 31, 2003. During the three months ended March 31, 2004 and 2003 the Company recorded net charge-offs totaling $365,000 and $280,000, respectively. For more information on asset quality see "Asset Quality" in Management's Discussion and Analysis of Financial Condition. Noninterest Income. Noninterest income decreased by $168,000, or 5.7%, to $2.8 million for the three months ended March 31, 2004 from $2.9 million for the three months ended March 31, 2003. The decrease in noninterest income was largely due to decreases in service charges on loans. Service charges on loans decreased by $285,000, or 66.8%, to $142,000 for the three months ended March 31, 2004, from $427,000 for the three months ended March 31, 2003. The decrease in service charges on loans was primarily due to a decrease of $248,000 in penalty income related to commercial loan prepayments. The decrease in noninterest income was also partly due to a gain of $221,000 on the sale of securities that was recorded during the three months ended March 31, 2003. No gain on the sale of securities was recorded for the same period of the current fiscal year. Partly offsetting the decreases in noninterest income was an increase in gain on sale of loans. Gain on sale of loans increased by $383,000, or 71.7%, to $917,000 for the three months ended March 31, 2004 from $534,000 for the three months ended March 31, 2003. The increase in gain on sale of loans was due to the sale of $37.1 million of fixed-rate 15-year residential mortgages in order to mitigate interest rate risk. The net gain on the sale of these loans in March 2004 totaled $791,000. During the three months ended March 31, 2003 the Company recorded a gain of $165,000 on the sale of its credit 17 card portfolio. Gains from the Company's ongoing origination and concurrent sale of fixed rate mortgages to investors decreased by $243,000 for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003 due to a slowdown in mortgage origination activity, particularly refinancing, after an extended period of low market interest rates. Real estate-related income generated by the Company's subsidiaries was also affected by the slowdown in mortgage activity. Income from real estate-related activities decreased by $90,000, or 22.1%, to $319,000 for the three months ended March 31, 2004 from $409,000 for the three months ended March 31, 2003. Noninterest expense. Largely offsetting the decrease in noninterest income was a decrease in noninterest expense. Noninterest expense decreased by $150,000, or 3.2%, to $4.6 million for the three months ended March 31, 2004 from $4.7 million, for the three months ended March 31, 2003. The decrease in noninterest expense was partly due to a decrease in amortization expense for mortgage servicing assets. Such amortization expense totaled $90,000 for the three months ended March 31, 2003, while no expense was recorded for the three months ended March 31, 2004 since these assets had been fully amortized. The Company will commence amortization of the mortgage servicing asset related to the March 2004 loan sale during the next fiscal quarter that ends on June 30, 2004. (See "Note 5.Intangible assets" in the Notes to Condensed Consolidated Financial Statements.) The decrease in noninterest expense was also due to a decrease of $74,000 in valuation adjustments on other real estate owned for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003. Additionally, office property and equipment expense decreased by $59,000, or 8.1%, for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003. Partly offsetting the decreases in noninterest expense was an increase in compensation and benefits expense. Compensation and benefits expense increased by $168,000, or 6.5%, to $2.7 million for the three months ended March 31, 2004 from $2.6 million for the three months ended March 31, 2003 largely due to annual salary increases in January 2004. Net earnings and income tax expense. Net earnings before income taxes decreased by $388,000, or 14.6%, to $2.3 million for the three months ended March 31, 2004 from $2.7 million for the three months ended March 31, 2003 primarily due to the decrease in net interest income and the increase in provision for loan losses. Income tax expense totaled $751,000, or an effective tax rate of 33.2%, and $870,000, or an effective tax rate of 32.8%, respectively, for the three months ended March 31, 2004 and 2003. COMPARISON OF THE RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED March 31, 2004 and 2003 General. Net earnings totaled $4.5 million for each of the nine month periods ended March 31, 2004 and 2003. Basic and diluted earnings per share were $1.23 and $1.19, respectively, and $1.15 and $1.12, respectively, for the nine months ended March 31, 2004 and 2003. Interest Income. Interest income decreased by $3.7 million, or 13.7%, to $23.4 million for the nine months ended March 31, 2004 from $27.1 million for the nine months ended March 31, 2003. The decrease in interest income was due to decreases in both the average yield and the average balance of interest-earning assets. The average yield on interest-earning assets decreased by 77 basis points to 5.59% for the nine months ended March 31, 18 2004 from 6.36% for the nine months ended March 31, 2003, primarily due to lower yields on interest-earning assets in the continued low market interest rate environment. In addition, the average balance of interest-earning assets decreased by $7.0 million, or 1.2%, to $560.3 million for the nine months ended March 31, 2004 from $567.3 million for the nine months ended March 31, 2003. Interest income on loans decreased by $2.0 million, or 9.2%, to $20.4 million for the nine months ended March 31, 2004 from $22.4 million for the nine months ended March 31, 2003. The decrease in interest income on loans was primarily due to a decrease in the average yield on loans. The average yield on loans decreased by 115 basis points to 6.02% for the nine months ended March 31, 2004 from 7.17% for the nine months ended March 31, 2003. The decrease in the average yield on loans was due to refinancing activity, current loan production in a low interest rate environment and interest rate reductions for adjustable-rate loans in the generally lower market interest rate environment during the current year period. Partially offsetting the decrease in interest income due to lower yields was an increase in the average balance of loans. The average balance of loans increased by $33.5 million, or 8.1%, to $450.2 million for the nine months ended March 31, 2004 from $416.7 million for the nine months ended March 31, 2003. The increase in the average balance of loans was primarily funded by proceeds from the maturity and sale of investment securities. Interest income on investment securities decreased by $1.6 million, or 35.6%, to $3.0 million for the nine months ended March 31, 2004 from $4.6 million for the nine months ended March 31, 2003. The decrease in interest income on investment securities was primarily due to a decrease in the average balance. The average balance of investment securities decreased by $39.7 million, or 27.3% to $105.7 million for the nine months ended March 31, 2004 from $145.4 million for the nine months ended March 31, 2003. In addition, the average tax-equivalent yield on investment securities decreased by 41 basis points to 3.98% for the nine months ended March 31, 2004 from 4.39% for the nine months ended March 31, 2003 in the generally lower market interest rate environment. Interest Expense. Interest expense decreased by $2.9 million, or 22.9%, to $9.7 million for the nine months ended March 31, 2004 from $12.6 million for the nine months ended March 31, 2003. The decrease in interest expense was primarily due to a decrease in interest on deposits. Interest on deposits decreased by $2.9 million, or 32.4%, to $5.9 million for the nine months ended March 31, 2004 from $8.8 million for the nine months ended March 31, 2003. The average cost of deposits decreased by 76 basis points to 1.95% for the nine months ended March 31, 2004 from 2.71% for the nine months ended March 31, 2003. The decrease in the average cost of deposits was due to changes in the mix of deposit types and to the generally lower market interest rate environment during the nine months ended March 31, 2004. Also contributing to the decrease in interest on deposits was a decrease in the average balance of interest-bearing deposits. The average balance of interest-bearing deposits decreased by $27.9 million, or 6.5%, to $403.3 million for the nine months ended March 31, 2004 from $431.2 million for the nine months ended March 31, 2003. In addition, the Company lowered rates on deposit products and increased its use of wholesale funding from the FHLB with generally lower interest costs than term deposits. Interest on FHLB advances and other borrowings totaled $3.8 million for each of the nine months ended March 31, 2004 and 2003. The average cost of borrowings decreased by 52 basis points to 4.23% for the nine months ended 19 March 31, 2004 from 4.75% for the nine months ended March 31, 2003. Offsetting the decrease in the average cost of borrowings was an increase in the average balance of borrowings. The average balance of borrowings increased by $11.7 million, or 10.9%, to $118.5 million for the nine months ended March 31, 2004 from $106.8 million for the nine months ended March 31, 2003. Net Interest Income. Net interest income before provision for losses on loans decreased by $836,000, or 5.8%, to $13.7 million for the nine months ended March 31, 2004 from $14.5 million for the nine months ended March 31, 2003 primarily due to a decrease in the Company's net interest margin. The Company's net interest margin decreased by 10 basis points to 3.27% for the nine months ended March 31, 2004 from 3.37% for the nine months ended March 31, 2003. Changes in the mix of interest-earning assets and interest-bearing liabilities partially mitigated the compression of the net interest margin in the continued low interest rate environment. An increase in the average balance of loans was offset by a decrease in the average balance of relatively lower-yielding investment securities. In addition, a decrease in the average balance of time deposits was partially offset by an increase in the average balance of non-interest-bearing deposit accounts. Provision for Losses on Loans. Provision for losses on loans decreased by $355,000, or 24.8% to $1.1 million for the nine months ended March 31, 2004 from $1.4 million for the nine months ended March 31, 2003. During the nine months ended March 31, 2004 and 2003 the Company recorded net charge-offs totaling $743,000 and $1.4 million, respectively. For more information on asset quality see "Asset Quality" in Management's Discussion and Analysis of Financial Condition. Noninterest Income. Noninterest income decreased by $321,000, or 4.3%, to $7.2 million for the nine months ended March 31, 2004 from $7.5 million for the nine months ended March 31, 2003. The decrease in noninterest income was largely due to a net loss on sale of securities that totaled $65,000 for the nine months ended March 31, 2004. In comparison, the Company recorded a gain of $259,000 on the sale of securities for the nine months ended March 31, 2003. The decrease in noninterest income was also due to a decrease in service charges on loans. Service charges on loans decreased by $303,000, or 38.2%, to $490,000 for the nine months ended March 31, 2004, from $793,000 for the three months ended March 31, 2003. The decrease in service charges on loans was largely due to a decrease of $263,000 in penalty income related to commercial loan prepayments. In addition, fees on loans serviced by the Company for other investors decreased by $82,000 for the nine months ended March 31, 2004 as compared to same period of the prior fiscal year due to lower principal balances serviced after substantial refinancing activity in the extended low interest rate environment. Partially offsetting these decreases in noninterest income was an increase in service charges on deposit accounts that totaled $237,000 for the nine months ended March 31, 2004 as compared to the nine months ended March 31, 2003. The increase in service charges on deposit accounts was primarily due to an increase in overdraft activities on retail accounts and the resulting service fees assessed. In addition, the restructuring of the Company's checking and savings accounts included a more favorable service charge schedule. Also offsetting the decreases in noninterest income was an increase in gain on sale of loans. Gain on sale of loans increased by $213,000, or 17.9%, to $1.4 million for the nine months ended March 31, 2004 from $1.2 million for 20 the nine months ended March 31, 2003. The increase in gain on sale of loans was partly due to a $791,000 gain on the sale of $37.1 million of fixed-rate 15-year residential mortgages in March 2004. During the nine months ended March 31, 2003 the Company recorded a gain of $165,000 on the sale of its credit card portfolio. Gains from the Company's ongoing origination and concurrent sale of fixed rate mortgages to investors decreased by $412,000 for the nine months ended March 31, 2004 as compared to the nine months ended March 31, 2003 due to a slowdown in mortgage origination activity, particularly refinancing, after an extended period of low market interest rates. Real estate-related income generated by the Company's subsidiaries was also affected by the slowdown in mortgage activity. Income from real estate-related activities decreased by $125,000, or 11.0%, to $1.0 million for the three months ended March 31, 2004 from $1.1 million for the three months ended March 31, 2003. Noninterest expense. More than offsetting the decrease in noninterest income was a decrease in noninterest expense. Noninterest expense decreased by $709,000, or 5.1%, to $13.1 million for the nine months ended March 31, 2004 from $13.8 million for the nine months ended March 31, 2003 primarily due to a decrease in other noninterest expense. The decrease in other noninterest expense was partly due to a decrease in expense for the amortization of mortgage servicing assets. Such amortization expense totaled $270,000 for the nine months ended March 31, 2003, while no expense was recorded for the nine months ended March 31, 2004 since these assets had been fully amortized. Amortization of the mortgage servicing asset created by the March 2004 loan sale did not commence until April 2004. Other noninterest expense also decreased due to a decrease of $72,000 in recruiting expense; a decrease of $117,000 in per account service fee expense due to the elimination of special features attached to eligible retail transaction accounts that had been provided by a third party vendor; and, a decrease of $125,000 in valuation adjustments on other real estate owned properties and repossessed assets for the nine months ended March 31, 2004 as compared to the nine months ended March 31, 2003. Additionally, advertising expense decreased by $42,000, or 14.0%, to $255,000 for the nine months ended March 31, 2004 from $297,000 for the nine months ended March 31, 2003. Partly offsetting the decreases in noninterest expense was an increase in compensation and benefits expense. Compensation and benefits expense increased by $109,000, or 1.5%, to $7.6 million for the nine months ended March 31, 2004 from $7.5 million for the nine months ended March 31, 2003 largely due to annual salary increases in January 2004. Net earnings and income tax expense. Net earnings before income taxes decreased by $94,000, or 1.4%, to $6.7 million for the nine months ended March 31, 2004 from $6.8 million for the nine months ended March 31, 2003. Income tax expense totaled $2.2 million, or an effective tax rate of 33.1%, and $2.3 million, or an effective tax rate of 33.4%, respectively, for the nine months ended March 31, 2004 and 2003. 21 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss arising from adverse changes in market prices and interest rates. The Company's market risk is primarily comprised of interest rate risk resulting from its core banking activities of lending and deposit taking. Interest rate risk is the risk that changes in market interest rates might adversely affect the Company's net interest income or the economic value of its portfolio of assets, liabilities and off-balance-sheet contracts. Management continually develops and applies strategies to mitigate this risk. During the three months ended March 31, 2004 the Company sold $37.1 million of 15-year fixed-rate residential loans with an average yield of 4.92% in anticipation of a potential increase in market interest rates that could erode the market value of those loans. The Company primarily relies on the OTS Net Portfolio Value Model (the "Model") to measure its susceptibility to interest rate changes. For various assumed hypothetical changes in market interest rates, the Model estimates the current economic value of each type of asset, liability and off-balance-sheet contract. The present value of expected net cash flows from existing assets minus the present value of expected net cash flows from existing liabilities plus or minus the present value of expected net cash flows from existing off-balance-sheet contracts results in a net portfolio value ("NPV") estimate. An analysis of the changes in NPV in the event of hypothetical changes in interest rates is presented in the Form 10-K filed by the Company for the fiscal year ended June 30, 2003. The Company's NPV ratio after a 200 basis point rate-shock was 6.91% and 6.79%, respectively, at December 31, 2003 and June 30, 2003 as measured by the OTS Model. Management expects to see an improvement in the Company's primary market risk exposures at March 31, 2004 as compared to December 31, 2003 and June 30, 2003 due to the sale of the residential loans mentioned above and the investment of the proceeds in short-term liquid assets. However, the Company's primary market risk exposure has not yet been quantified at March 31, 2004, and the complexity of the Model makes it difficult to accurately predict results. ITEM 4. CONTROLS AND PROCEDURES Under the supervision and with the participation of the Company's management, including its Chief Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e)and 15d-15(e)under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. There has been no change in the Company's internal control over financial reporting in connection with the quarterly evaluation that occurred during the Company's last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings There are various claims and lawsuits in which the Registrant is periodically involved incidental to the Registrant's business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits. Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities. The Company did not purchase any shares of its common stock during the three months ended March 31, 2004. On August 21, 2003 the Company announced that its Board of Directors had authorized a stock repurchase program pursuant to which the Company intends to repurchase up to 377,000 shares, or 10% of its issued and outstanding shares of common stock. Under this stock repurchase program 367,000 shares may yet be purchased as of March 31, 2004. The expiration date of the program is August 21, 2004. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the period covered by this report. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 31.1 Certification of Chief Executive Officer Pursuant to Section 302 Exhibit 31.2 Certification of Chief Financial Officer Pursuant to Section 302 Exhibit 32 Statement Pursuant to Section 906 (b) Reports on Form 8-K A report on Form 8-K was filed on January 21, 2004. The event reported was the Company's announcement of results of operations for the three months and six months ended December 31, 2003 and declaration of a dividend in a press release dated January 20, 2004. 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed by the undersigned thereunto duly authorized. FIRST FEDERAL BANKSHARES, INC. DATE: May 14, 2004 BY: /s/ Barry E. Backhaus --------------------------------- Barry E. Backhaus President and Chief Executive Officer DATE: May 14, 2004 BY: /s/ Colin D. Anderson --------------------------------- Colin D. Anderson Senior Vice President and Chief Financial Officer 24