SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For quarterly period ended June 30, 2002 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For transition period __________ to __________ Commission File Number: 0-24724 HEARTLAND FINANCIAL USA, INC. (Exact name of Registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 42-1405748 (I.R.S. employer identification number) 1398 Central Avenue, Dubuque, Iowa 52001 (Address of principal executive offices)(Zip Code) (563) 589-2100 (Registrant's telephone number, including area code) 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 the number of shares outstanding of each of the classes of Registrant's common stock as of the latest practicable date: As of August 13, 2002, the Registrant had outstanding 9,819,470 shares of common stock, $1.00 par value per share. HEARTLAND FINANCIAL USA, INC. Form 10-Q Quarterly Report Table of Contents Part I Item 1. Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk Part II Item 1. Legal Proceedings Item 2. Changes in Securities Item 3. Defaults Upon Senior Securities Item 4. Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K Form 10-Q Signature Page HEARTLAND FINANCIAL USA, INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data) 6/30/02 12/31/01 (Unaudited) ----------- ---------- ASSETS Cash and due from banks $ 39,336 $ 45,738 Federal funds sold and other short- term investments 35,551 47,812 ---------- ---------- Cash and cash equivalents 74,887 93,550 Time deposits in other financial institutions 1,642 564 Securities: Trading, at fair value 1,230 1,528 Available for sale, at fair value (cost of $337,899 for 2002 and $318,342 for 2001) 345,177 323,689 Loans and leases: Held for sale 15,450 26,967 Held to maturity 1,099,589 1,078,238 Allowance for loan and lease losses (15,409) (14,660) ---------- ---------- Loans and leases, net 1,099,630 1,090,545 Assets under operating leases 32,057 35,427 Premises, furniture and equipment, net 33,176 31,482 Other real estate, net 108 130 Goodwill, net 9,507 9,507 Core deposit premium and other intangibles, net 10,986 11,198 Other assets 43,838 46,444 ---------- ---------- TOTAL ASSETS $1,652,238 $1,644,064 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Deposits: Demand $ 153,791 $ 160,742 Savings 496,862 493,374 Time 577,424 551,043 ---------- ---------- Total deposits 1,228,077 1,205,159 Short-term borrowings 143,890 160,703 Other borrowings 136,321 143,789 Accrued expenses and other liabilities 29,226 27,323 ---------- ---------- TOTAL LIABILITIES 1,537,514 1,536,974 ---------- ---------- STOCKHOLDERS' EQUITY: Preferred stock (par value $1 per share; authorized, 184,000 shares, none issued or outstanding) - - Series A Junior Participating preferred stock (par value $1 per share; authorized, 16,000 shares, none issued or outstanding) - - Common stock (par value $1 per share; authorized, 16,000,000 shares and 12,000,000 at June 30, 2002, and December 31, 2001, respectively; issued 9,905,783 shares at June 30, 2002, and December 31, 2001) 9,906 9,906 Capital surplus 16,784 18,116 Retained earnings 84,866 79,107 Accumulated other comprehensive income 4,364 3,565 Treasury stock at cost (85,107 shares at June 30, 2002, and 226,031 shares at December 31, 2001) (1,196) (3,604) ---------- ---------- TOTAL STOCKHOLDERS' EQUITY 114,724 107,090 ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,652,238 $1,644,064 ========== ========== See accompanying notes to consolidated financial statements. HEARTLAND FINANCIAL USA, INC. CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (Dollars in thousands, except per share data) Three Months Ended Six Months Ended 6/30/02 6/30/01 6/30/02 6/30/01 ------- ------- ------- ------- INTEREST INCOME: Interest and fees on loans and leases $ 21,134 $ 23,383 $ 42,107 $ 46,795 Interest on securities: Taxable 3,188 3,600 6,382 6,720 Nontaxable 672 473 1,144 944 Interest on federal funds sold 67 568 172 1,257 Interest on interest bearing deposits in other financial institutions 37 43 140 91 -------- -------- -------- -------- TOTAL INTEREST INCOME 25,098 28,067 49,945 55,807 -------- -------- -------- -------- INTEREST EXPENSE: Interest on deposits 8,024 12,159 16,413 24,635 Interest on short-term borrowings 695 1,677 1,375 3,625 Interest on other borrowings 2,096 2,100 4,305 4,154 -------- -------- -------- -------- TOTAL INTEREST EXPENSE 10,815 15,936 22,093 32,414 -------- -------- -------- -------- NET INTEREST INCOME 14,283 12,131 27,852 23,393 Provision for loan and lease losses 616 1,123 1,601 1,844 -------- -------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES 13,667 11,008 26,251 21,549 -------- -------- -------- -------- NONINTEREST INCOME: Service charges and fees 2,217 1,554 4,150 3,015 Trust fees 904 778 1,736 1,544 Brokerage commissions 203 167 330 293 Insurance commissions 160 178 377 429 Securities gains, net 75 352 156 924 Gain (loss) on trading account securities (214) 46 (242) (179) Rental income on operating leases 3,674 3,795 7,530 7,649 Gain on sale of loans 522 523 1,529 916 Impairment loss on mortgage servicing rights (326) - (326) - Other noninterest income 91 169 538 397 -------- -------- -------- -------- TOTAL NONINTEREST INCOME 7,306 7,562 15,778 14,988 -------- -------- -------- -------- NONINTEREST EXPENSES: Salaries and employee benefits 6,923 6,328 13,908 12,538 Occupancy 777 782 1,554 1,607 Furniture and equipment 831 778 1,649 1,584 Depreciation on equipment under operating leases 2,879 2,874 5,909 5,792 Outside services 1,116 871 1,997 1,624 FDIC deposit insurance assessment 53 52 106 103 Advertising 387 407 839 786 Goodwill amortization - 135 - 270 Core deposit and other intangibles amortization 253 283 507 566 Other noninterst expenses 2,204 2,003 4,312 3,916 -------- -------- -------- -------- TOTAL NONINTEREST EXPENSES 15,423 14,513 30,781 28,786 -------- -------- -------- -------- INCOME BEFORE INCOME TAXES 5,550 4,057 11,248 7,751 Income taxes 1,639 1,243 3,524 2,481 -------- -------- -------- -------- NET INCOME $ 3,911 $ 2,814 $ 7,724 $ 5,270 ======== ======== ======== ======== EARNINGS PER COMMON SHARE-BASIC $ 0.40 $ 0.29 $ 0.79 $ 0.55 EARNINGS PER COMMON SHARE-DILUTED $ 0.40 $ 0.29 $ 0.79 $ 0.54 CASH DIVIDENDS DECLARED PER COMMON SHARE $ 0.10 $ 0.09 $ 0.20 $ 0.18 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (Unaudited) (Dollars in thousands, except per share data) Common Capital Retained Stock Surplus Earnings ------- ------- --------- Balance at January 1, 2001 $ 9,906 $18,812 $ 71,253 Net income - - 5,270 Unrealized gain (loss) on securities available for sale - - - Reclassification adjustment for gains realized in net income - - - Income taxes - - - Comprehensive income Cash dividends declared: Common, $.18 per share - - (1,729) Purchase of 26,634 treasury shares - - - ------- ------- -------- Balance at June 30, 2001 $ 9,906 $18,812 $ 74,794 ======= ======= ======== Balance at January 1, 2002 $ 9,906 $18,116 $ 79,107 Net income - - 7,724 Unrealized gain (loss) on securities available for sale - - - Unrealized gain (loss) on derivatives arising during the period - - - Reclassification adjustment for gains realized in net income - - - Income taxes - - - Comprehensive income Cash dividends declared: Common, $.20 per share - - (1,965) Purchase of 76,705 treasury shares - - - Issuance of 217,629 treasury shares - (1,332) - ------- ------- -------- Balance at June 30, 2002 $ 9,906 $16,784 $ 84,866 ======= ======= ======== Accumulated Other Comprehensive Treasury Income (Loss) Stock Total ------------- -------- ----- Balance at January 1, 2001 $ 1,301 $(5,126) $ 96,146 Net income - - 5,270 Unrealized gain (loss) on securities available for sale 2,025 - 2,025 Reclassification adjustment for gains realized in net income 924 - 924 Income taxes (1,003) - (1,003) -------- Comprehensive income 7,216 Cash dividends declared: Common, $.18 per share - - (1,729) Purchase of 26,634 treasury shares - (331) (331) ------- ------- -------- Balance at June 30, 2001 $ 3,247 $(5,457) $101,302 ======= ======= ======== Balance at January 1, 2002 $ 3,565 $(3,604) $107,090 Net income - - 7,724 Unrealized gain (loss) on securities available for sale 1,939 - 1,939 Unrealized gain (loss) on derivatives arising during the period (572) - (572) Reclassification adjustment for gains realized in net income (156) - (156) Income taxes (412) - (412) -------- Comprehensive income 8,523 Cash dividends declared: Common, $.20 per share - - (1,965) Purchase of 76,705 treasury shares - (1,060) (1,060) Issuance of 217,629 treasury shares - 3,468 2,136 ------- ------- -------- Balance at June 30, 2002 $ 4,364 $(1,196) $114,724 ======= ======= ======== See accompanying notes to consolidated financial statements. HEARTLAND FINANCIAL USA, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Dollars in thousands) Six Months Ended 6/30/02 6/30/01 ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 7,724 $ 5,270 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 8,021 8,214 Provision for loan and lease losses 1,601 1,844 Provision for income taxes in excess of payments 2,971 1,889 Net amortization of premium on securities 2,543 87 Securities gains, net (156) (924) Decrease (increase) in trading account securities 298 (1,475) Loans originated for sale (70,779) (78,126) Proceeds on sales of loans 83,825 52,418 Net gain on sales of loans (1,529) (916) Decrease (increase) in accrued interest receivable (708) 414 Increase in accrued interest payable 120 570 Other, net (530) (446) --------- --------- NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES 33,401 (11,181) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of time deposits in other financial institutions (1,068) - Proceeds on maturities of time deposits in other financial institutions 4 959 Proceeds from the sale of securities available for sale 20,889 29,090 Proceeds from the maturity of and principal paydowns on securities available for sale 84,178 25,894 Purchase of securities available for sale (126,362) (99,382) Net increase in loans and leases (21,567) (14,447) Increase in assets under operating leases (2,539) (6,241) Capital expenditures (3,307) (2,555) Proceeds on sale of OREO and other repossessed assets 273 420 --------- --------- NET CASH USED BY INVESTING ACTIVITIES (49,499) (66,262) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase (decrease) in demand deposits and savings accounts (3,463) 33,379 Net increase in time deposit accounts 26,381 33,968 Net increase (decrease) in short-term borrowings (16,813) 12,759 Proceeds from other borrowings 7,683 30,880 Repayments of other borrowings (15,151) (14,379) Purchase of treasury stock (1,060) (331) Proceeds from issuance of treasury stock 1,823 - Dividends (1,965) (1,729) --------- --------- NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES (2,565) 94,547 --------- --------- Net decrease in cash and cash equivalents (18,663) 17,104 Cash and cash equivalents at beginning of year 93,550 84,687 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 74,887 $101,791 ========= ========= Supplemental disclosures: Cash paid for income/franchise taxes $ 332 $ 605 ========= ========= Cash paid for interest $ 21,973 $ 31,844 ========= ========= Securities held to maturity transferred to securities available for sale $ - $ 2,154 ========= ========= See accompanying notes to consolidated financial statements. HEARTLAND FINANCIAL USA, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: BASIS OF PRESENTATION The interim unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and accompanying notes to the financial statements for the fiscal year ended December 31, 2001, included in Heartland Financial USA, Inc.'s (the "Company") Form 10-K filed with the Securities and Exchange Commission on March 29, 2002. Accordingly, footnote disclosure which would substantially duplicate the disclosure contained in the audited consolidated financial statements has been omitted. The financial information of the Company included herein is prepared pursuant to the rules and regulations for reporting on Form 10-Q. Such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of results for the interim periods. The results of the interim periods ended June 30, 2002, are not necessarily indicative of the results expected for the year ending December 31, 2002. Basic earnings per share is determined using net income and weighted average common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average common shares and assumed incremental common shares issued. Amounts used in the determination of basic and diluted earnings per share for the three and six month periods ended June 30, 2002 and 2001, are shown in the tables below: Three Months Ended 6/30/02 6/30/01 ------- ------- Net Income (000's) $ 3,911 $ 2,814 ======= ======= Weighted average common shares outstanding for basic earnings per share (000's) 9,809 9,601 Assumed incremental common shares issued upon exercise of stock options (000's) 64 94 ------- ------- Weighted average common shares for diluted earnings per share (000's) 9,873 9,695 ======= ======= Six Months Ended 6/30/02 6/30/01 ------- ------- Net Income (000's) $ 7,724 $ 5,270 ======= ======= Weighted average common shares outstanding for basic earnings per share (000's) 9,770 9,601 Assumed incremental common shares issued upon exercise of stock options (000's) 62 99 ------- ------- Weighted average common shares for diluted earnings per share (000's) 9,832 9,700 ======= ======= NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Goodwill and Other Intangible Assets - Goodwill represents the excess of the purchase price of acquired subsidiaries' net assets over their fair value. On July 1, 2001, the Company adopted FASB Statement ("FAS") No. 142, "Goodwill and Other Intangible Assets". During the transition period from July 1, 2001, through December 31, 2001, substantially all the Company's goodwill associated with business combinations completed prior to July 1, 2001, continued to be amortized over periods of 15 to 25 years on the straight-line basis. Effective January 1, 2002, all goodwill amortization was discontinued. Effective January 1, 2002, goodwill will be assessed at least annually for impairment by applying a fair-value-based test using discounted cash flows. The Company completed its initial goodwill impairment assessment and did not have any transitional impairment charge. Subsequent assessments will be performed in the fourth quarter of each year and any resulting impairment will be recognized as a charge to noninterest expense unless related to discontinued operations. Core deposit intangibles are amortized over ten years on an accelerated basis. Other intangible assets consist of the excess purchase price of acquired branch net assets over their fair value that will continue to be amortized over 15 years on the straight-line basis in accordance with the provisions of FAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions". The Company reviews intangible assets whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. If impairment is indicated through an analysis of undiscounted cash flows, the asset is written down to the extent that the carrying value exceeds its fair value. NOTE 3: "ADJUSTED" EARNINGS - FAS NO. 142 TRANSITIONAL DISCLOSURE The table below reconciles reported earnings for the three and six months periods ended June 30, 2001, to "adjusted" earnings, which exclude goodwill amortization. Three Months Ended June 30, 2002 Three Months Ended June 30, 2001 --------- -------------------------------- Reported Reported Goodwill "Adjusted" Earnings Earnings Amort. Earnings --------- -------- -------- ----------- Income before income taxes (000's) $ 5,550 $ 4,057 $ 135 $ 4,192 Income taxes (000's) 1,639 1,243 - 1,243 --------- -------- -------- ----------- Net income (000's) $ 3,911 $ 2,814 $ 135 $ 2,949 ========= ======== ======== =========== Earnings per common share - basic $ .40 $ .29 $ .01 $ .31 ========= ======== ======== =========== Earnings per common share - diluted $ .40 $ .29 $ .01 $ .30 ========= ======== ======== =========== Six Months Ended June 30, 2002 Six Months Ended June 30, 2001 --------- -------------------------------- Reported Reported Goodwill "Adjusted" Earnings Earnings Amort. Earnings --------- -------- -------- ----------- Income before income taxes (000's) $ 11,248 $ 7,751 $ 269 $ 8,020 Income taxes (000's) 3,524 2,481 - 2,481 --------- -------- -------- ----------- Net income (000's) $ 7,724 $ 5,270 $ 269 $ 5,539 ========= ======== ======== =========== Earnings per common share - basic $ .79 $ .55 $ .03 $ .58 ========= ======== ======== =========== Earnings per common share - diluted $ .79 $ .54 $ .03 $ .57 ========= ======== ======== =========== NOTE 4: CORE DEPOSIT PREMIUM AND OTHER INTANGIBLE ASSETS The gross carrying amount of intangible assets and the associated accumulated amortization at June 30, 2002, is presented in the table below. June 30, 2002 ---------------------- Gross Carrying Accumulated Amount Amortization -------- ------------ Intangible assets: Core deposit premium (000's) $ 4,492 $ 1,808 Mortgage servicing rights (000's) 2,733 713 Other intangible assets (000's) 7,799 1,517 ------- ------- Total (000's) $15,024 $ 4,038 ======= ======= Unamortized intangible assets (000's) $10,986 ======= Projections of amortization expense for mortgage servicing rights are based on existing asset balances and the existing interest rate environment as of June 30, 2002. What the Company actually experiences may be significantly different depending upon changes in mortgage interest rates and market conditions. The following table shows the estimated future amortization expense for amortized intangibles assets: Core Mortgage Deposit Servicing Premium Rights Other Total --------- -------- ------- --------- Six months ended December 31, 2002 (000's) $ 247 $ 317 $ 260 $ 824 Year Ended December 31, 2003 (000's) $ 404 $ 486 $ 520 $ 1,410 2004 (000's) 353 405 520 1,278 2005 (000's) 353 324 520 1,197 2006 (000's) 353 243 520 1,116 2007 (000's) 353 162 520 1,035 NOTE 5: OTHER BORROWINGS On June 27, 2002, the Company completed an offering of $5.0 million of variable rate cumulative capital securities representing undivided beneficial interests in Heartland Financial Capital Trust II. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from the Company. The proceeds are being used for general corporate purposes. Interest is payable quarterly on March 30, June 30, September 30 and December 30 of each year. The debentures will mature and the capital securities must be redeemed on June 30, 2032. The Company has the option to shorten the maturity date to a date not earlier than June 30, 2007. The Company may not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. Deferred issuance costs related to this offering will be included in other assets and amortized on a straight-line basis over the life of the debentures. NOTE 6: STOCKHOLDERS' RIGHTS PLAN On June 7, 2002, the Company adopted a stockholders' rights plan (the "Rights Plan"). Under the terms of the Rights Plan, on June 26, 2002, the Board of Directors distributed one purchase right for each share of common stock outstanding as of June 24, 2002. Upon becoming exercisable, each right entitles the registered holder thereof, under certain limited circumstances, to purchase one-thousandth of a share of Series A Junior Participating preferred stock at an exercise price of $85.00. Rights do not become exercisable until ten business days after any person or group has acquired, commenced, or announced its intention to commence a tender or exchange offer to acquire 15% or more of the Company's common stock. If the rights become exercisable, holders of each right, other than the acquiror, upon payment of the exercise price, will have the right to purchase the Company's common stock (in lieu of preferred shares) having a value equal to two times the exercise price. If the Company is acquired in a merger, share exchange or other business combination or 50% or more of its consolidated assets or earning power are sold, rights holders, other than the acquiring or adverse person or group, will be entitled to purchase the acquiror's shares at a similar discount. If the rights become exercisable, the Company may also exchange rights, other than those held by the acquiring or adverse person or group, in whole or in part, at an exchange ratio of one share of the Company's common stock per right held. Rights are redeemable by the Company at any time until they are exercisable at the exchange rate of $.01 per right. Issuance of the rights has no immediate dilutive effect, does not currently affect reported earnings per share, is not taxable to the Company or its shareholders, and will not change the way in which the Company's shares are traded. The rights expire on June 7, 2012. In connection with the Rights Plan, the Company designated 16,000 shares, par value $1.00 per share, of Series A Junior Participating preferred stock. These shares, if issued, will be entitled to receive quarterly dividends and a liquidation preference. There are no shares issued and outstanding and the Company does not anticipate issuing any shares of Series A Junior Participating preferred stock except as may be required under the Rights Plan. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SAFE HARBOR STATEMENT This report (including information incorporated by reference) contains, and future oral and written statements of Heartland and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of Heartland. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of Heartland's management and on information currently available to management, are generally identifiable by the use of words such as "believe", "expect", "anticipate", "plan", "intend", "estimate", "may", "will", "would", "could", "should" or other similar expressions. Additionally, all statements in this document, including forward- looking statements, speak only as of the date they are made, and Heartland undertakes no obligation to update any statement in light of new information or future events. Heartland'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 operations and future prospects of Heartland and its subsidiaries include, but are not limited to, the following: - The strength of the United States economy in general and the strength of the local economies in which Heartland conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of Heartland's assets. - The economic impact of the terrorist attacks that occurred on September 11th, as well as any future threats and attacks, and the response of the United States to any such threats and attacks. - The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters. - The effects of changes in interest rates (including the effects of changes in the rate of prepayments of Heartland's assets) and the policies of the Board of Governors of the Federal Reserve System. - The ability of Heartland to compete with other financial institutions as effectively as Heartland currently intends due to increases in competitive pressures in the financial services sector. - The inability of Heartland to obtain new customers and to retain existing customers. - The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. - Technological changes implemented by Heartland and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to Heartland and its customers. - The ability of Heartland to develop and maintain secure and reliable electronic systems. - The ability of Heartland to retain key executives and employees and the difficulty that Heartland may experience in replacing key executives and employees in an effective manner. - Consumer spending and saving habits which may change in a manner that affects Heartland's business adversely. - Business combinations and the integration of acquired businesses may be more difficult or expensive than expected. - The costs, effects and outcomes of existing or future litigation. - Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. - The ability of Heartland to manage the risks associated with the foregoing as well as anticipated. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning Heartland and its business, including other factors that could materially affect Heartland's financial results, is included in Heartland's filings with the Securities and Exchange Commission. GENERAL Heartland's results of operations depend primarily on net interest income, which is the difference between interest income from interest earning assets and interest expense on interest bearing liabilities. Noninterest income, which includes service charges, fees and gains on loans, rental income on operating leases and trust income, also affects Heartland's results of operations. Heartland's principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy and equipment costs, depreciation on equipment under operating leases and provision for loan and lease losses. Earnings for the second quarter of 2002 improved by $1.097 million or 39% over the same quarter the previous year, despite a challenging economy. Net income totaled $3.911 million, or $.40 on a diluted earnings per common share basis, compared to $2.814 million, or $.29 on a diluted earnings per common share basis, during the same quarter in 2001. Return on common equity was 13.98% and return on assets was .96% for the second quarter of 2002. For the same period in 2001, return on equity was 11.32% and return on assets was .73%. Contributing to the improved earnings during the second quarter of 2002 was the $2.152 million or 18% growth in net interest income due primarily to growth in earning assets. Average earning assets went from $1.385 billion during the second quarter of 2001 to $1.462 billion during the same quarter in 2002, a change of $77 million or 6%. Exclusive of securities gains and losses, including trading account securities gains and losses, and a valuation adjustment on mortgage servicing rights, noninterest income experienced a $607 thousand or 8% increase. Heartland's adoption of the provisions of Statement of Financial Accounting Standards ("FAS") No. 142, Goodwill and Other Intangible Assets, on January 1, 2002, discontinued the amortization of $9.507 million in unamortized goodwill. The amount of amortization expense recorded during the second quarter of 2001 on this goodwill was $135 thousand ($.01 on a diluted per common share basis). For the six-month period ended on June 30, 2001, amortization expense on this goodwill was $269 thousand ($.03 on a diluted per common share basis). For the six-month period ended on June 30, 2002, net income increased $2.454 million or 47% when compared to the same period in 2001. Net income totaled $7.724 million, or $.79 on a diluted per common share basis, compared to $5.270 million, or $.54 on a diluted per common share basis, during the same period in 2001. Return on common equity was 14.08% and return on assets was .95% for the six-month period in 2002 compared to 10.79% and .70%, respectively, for the same period in 2001. Again, the largest contributor to the improved earnings during the first six months of 2002 was the $4.459 million or 19% growth in net interest income. Average earning assets went from $1.353 billion during the first six months of 2001 to $1.460 billion during the same period in 2002, a change of $107 million or 8%. Exclusive of securities gains and losses, including trading account securities gains and losses, and a valuation adjustment on mortgage servicing rights, noninterest income experienced a $1.947 million or 14% increase. In addition to gains on sale of loans, the other noninterest income category to reflect significant improvement was service charges and fees. Noninterest expense was held to a $1.995 million or 7% increase. Total assets remained stable at June 30, 2002, increasing by less than 1% since year-end 2001. Loans and leases were $1.115 billion and deposits were $1.228 billion at the end of the second quarter, an increase of 1% and 2%, respectively, since year-end 2001. Loan growth was slowed due to paydowns experienced in the mortgage loan portfolio as customers continued to refinance their mortgage loans into fifteen- and thirty-year fixed rate loans, which Heartland usually sells into the secondary market. Some of this slowed growth was offset by an increase in the commercial loan portfolio, which grew $41.612 million or 6% during the first six months. NET INTEREST INCOME Net interest margin, expressed as a percentage of average earning assets, was 4.02% during the second quarter of 2002 compared to 3.86% for the first quarter of 2002 and 3.60% for the second quarter of 2001. Heartland manages its balance sheet to minimize the effect a change in interest rates has on its net interest margin. The utilization of floors on Heartland's commercial loan portfolio has had a positive impact on the net interest margin as the affect of downward rates was minimized. If rates begin to edge upward, Heartland will not see a corresponding increase in its interest income until rates have moved above the floors in place on these loans. To offset the impact of these floors on the net interest margin if rates move upward, funding in the three- to five-year maturities has been locked in. During the last half of 2001, Heartland elected to obtain additional Federal Home Loan Bank advances to lock in historically low rates in anticipation of fixed-rate commercial loan growth and the replacement of maturing advances during the first half of 2002. On a tax-equivalent basis, interest income as a percentage of average earning assets went from 8.21% during the second quarter of 2001 to 6.99% during the second quarter of 2002, a decline of 122 basis points. Interest expense as a percentage of average earning assets went from 4.62% during the second quarter of 2001 to 2.97% for the same quarter in 2002, a decline of 164 basis points. For the three and six month periods ended June 30, 2002, interest income decreased $3.0 million or 11% and $5.9 million or 11%, respectively, when compared to the same periods in 2001. These decreases were primarily attributable to the dramatic decline in rates. During 2001, national prime decreased from 9.50% to 8.00% during the first quarter and from 8.00% to 6.75% during the second quarter. During the first and second quarters of 2002, national prime remained unchanged at 4.75%. Additionally, the significant amount of refinance activity experienced on mortgage loans during the fourth quarter of 2001 reduced the amount of interest income realized in Heartland's mortgage-backed securities portfolio. For the three and six month periods ended June 30, 2002, interest expense decreased $5.1 million or 32% and $10.3 million or 32%, respectively, when compared to the same periods in 2001. The decline in interest expense outpaced the decline in interest income primarily as a result of the decline in rates and the maturity of higher-rate certificates of deposit accounts. Management continues to focus efforts on improving the mix of its funding sources to minimize its interest costs. PROVISION FOR LOAN AND LEASE LOSSES The allowance for loan and lease losses is established through a provision charged to expense. The $616 thousand provision for loan losses made during the second quarter of 2002, a decrease of $507 thousand or 45% when compared to the same quarter in 2001, was less than the previous year primarily in response to a decline in nonperforming loans. On a six-month comparative basis, the $1.6 million provision for loan losses during the first half of 2002 was a decrease of $243 thousand or 13% when compared to the same period in 2001. This decrease was also reflective of a decrease in nonperforming loans. The adequacy of the allowance for loan and lease losses is determined by management using factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, past loss experience, loan delinquencies, and potential substandard and doubtful credits. For additional details on the specific factors considered during this quarter, refer to the loans and allowance for loan and lease losses section of this report. NONINTEREST INCOME Total noninterest income decreased $256 thousand or 3% during the quarter ended on June 30, 2002, compared to the same period in 2001. Exclusive of securities gains and losses, including trading account securities gains and losses, and a valuation adjustment on mortgage servicing rights, noninterest income experienced a $607 thousand or 8% increase. The noninterest category reflecting significant improvement during the quarter was service charges and fees. On a year-to-date comparison, total noninterest income grew $790 thousand or 5%. Exclusive of securities gains and losses, including trading account securities gains and losses, and a valuation adjustment on mortgage servicing rights, noninterest income experienced a $1.9 million or 14% increase. In addition to gains on sale of loans, the other noninterest income category to reflect significant improvement during the first half of the year was service charges and fees. Service charges and fees increased $663 thousand or 43% during the quarters under comparison and $1.1 million or 38% during the six-month period under comparison. The addition of an overdraft privilege feature to our checking account product line, along with growth in these account balances, has resulted in the generation of additional service charge revenue related to activity fees charged to these accounts. Additionally, service fees collected on the mortgage loans Heartland has sold into the secondary market while retaining servicing has increased. Heartland's servicing portfolio was $183.9 million at year-end 2000, $268.6 million at year-end 2001 and $327.7 million at June 30, 2002. Also contributing to the increase in service charges and fees was the growth in fees collected for the processing of merchant credit card activity. Gains on sale of loans remained constant at $522 thousand for the quarters under comparison. For the six-month periods under comparison, gains on sale of loans increased by $613 thousand or 67%. The volume of mortgage loans sold into the secondary market during the first quarter of 2002 was greater than those sold during the same period in 2001, primarily as a result of the low rate environment during the first quarter of 2002 compared to the same quarter in 2001. During low rate environments, customers frequently elect to take fifteen- and thirty-year, fixed-rate mortgage loans, which Heartland usually elects to sell into the secondary market. During the second quarter of 2002, securities gains were $277 thousand or 79% below the amount recorded during the same period in 2001. The gains during the second quarter of 2001 resulted primarily from sales within the equity securities portfolio. For the six-month period ended on June 30, 2002, securities gains were $768 thousand or 83% below the amount recorded during the same period in 2001. During the first quarter of 2001, Heartland's interest rate forecast changed to a rising rate bias on the long end of the yield curve, and therefore, longer-term agency securities were sold at a gain to shorten the portfolio. The proceeds were invested in well-seasoned mortgage-backed securities that were projected to outperform the agency securities in a rising rate environment. Heartland elected to begin classifying some of its new equity securities purchases as trading during the first quarter of 2001. Losses on this portfolio totaled $214 thousand during the second quarter of 2002 compared to gains of $46 thousand during the same quarter in 2001. On a six-month comparison, losses totaled $242 thousand during 2002 and $179 thousand during 2001. The increased losses primarily resulted from the decline in the stock market. During the second quarter of 2002, an impairment loss on mortgage servicing rights was recorded in the amount of $326 thousand. The valuation of Heartland's mortgage servicing rights declined since year-end as a result of the further drop in mortgage loan interest rates. NONINTEREST EXPENSE Total noninterest expense was held to an increase of $910 thousand or 6% during the second quarter of 2002 when compared to the same quarter in 2001. For the six-month period ended on June 30, 2002, noninterest expense increased $2.0 million or 7%. Growth in some of these expenses tapered off as Heartland began to realize the full utilization of the resources it expended during the early stages of its growth initiatives. Salaries and employee benefits, the largest component of noninterest expense, increased $595 thousand or 9% for the quarters under comparison. On a year-to-date basis, salaries and employee benefits grew $1.4 million or 11%. This category made up more than 65% of the total increase in noninterest expense for both time periods. In addition to normal merit increases, these increases were also attributable to expansion efforts, primarily in New Mexico Bank & Trust's Albuquerque market. The number of full-time equivalent employees employed by Heartland increased from 571 at June 30, 2001, to 584 at June 30, 2002. Fees for outside services increased by $245 thousand or 28% for the quarters under comparison and $373 thousand or 23% for the six-month periods under comparison. Contributing to these increases were the following: - A consultant was engaged last fall to assist in the implementation of an overdraft privilege feature on Heartland's checking account products. The fee associated with these services is payable monthly throughout all of 2002 based upon the additional fees generated. - Beginning this year, Heartland elected to engage Darling Consulting Group to provide balance sheet management advisory services. Included in these services are quarterly asset/liability management position assessments and strategy formulation. - As on-line banking has grown in popularity, Heartland has incurred additional costs to provide this service to its customers. - Legal fees related to actions brought by Heartland to recover losses realized in an investment fund partnership, in which Heartland was a limited partner, and to resolve a dispute on the enforceability of a guarantee on a nonperforming commercial loan. Other noninterest expense increased $201 thousand or 10% for the quarters under comparison and $396 thousand or 10% for the six- month periods under comparison. These increases were the result of additional processing fees related to the increased activity in the merchant credit card processing area, additional minority interest related to the improved earnings at New Mexico Bank & Trust and a fraud loss related to a kiting scheme at Wisconsin Community Bank. Heartland's adoption of the provisions of Statement of Financial Accounting Standards ("FAS") No. 142, Goodwill and Other Intangible Assets, on January 1, 2002, discontinued the amortization of $9.5 million in unamortized goodwill. The amount of amortization expense recorded during the second quarter of 2001 on this goodwill was $135 thousand. For the six-month period ended on June 30, 2001, amortization expense on this goodwill was $269 thousand. INCOME TAX EXPENSE Income tax expense for the second quarter of 2002 increased $396 thousand or 32% when compared to the same period in 2001. On a six-month comparative basis, income tax expense increased $1.0 million or 42%. These increases reflected the continued growth in pre-tax earnings. Heartland's effective tax rate decreased to 29.53% during the second quarter of 2002 compared to 30.64% for the second quarter of 2001. For the six-month periods ended June 30, 2002 and 2001, the effective tax rate was 31.33% and 32.01%, respectively. In April of 2002, Dubuque Bank and Trust acquired a 99.9% ownership in a limited liability company that owns a certified historic structure for which historic rehabilitation tax credits apply to the 2002 tax year. The reduction in Heartland's effective tax rate was minimized as a result of a decrease in the amount of tax- exempt interest income recorded during 2002. Tax-exempt interest income was 12% of pre-tax income during the first six months of 2002 compared to 14% for the same period in 2001. FINANCIAL CONDITION LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES Total loans and leases increased $9.1 million, an increase of 1% since year-end 2001. Loan growth was slowed due to paydowns experienced in the mortgage loan portfolio. The residential mortgage loan portfolio experienced a decline of $30.7 million or 18% as customers continued to refinance their mortgage loans into fifteen- and thirty-year fixed rate loans, which Heartland usually sells into the secondary market. Servicing is retained on a majority of these loans so that the Heartland bank subsidiaries have an opportunity to continue providing their customers the excellent service they expect. Heartland's servicing portfolio was $268.6 million at year-end 2001 and $327.7 million at June 30, 2002. The decline in the mortgage loan portfolio was partially offset by an increase in the commercial and commercial real estate loan portfolio, which grew $41.6 million or 6% during the first half of 2002. Most of this growth occurred at New Mexico Bank & Trust, Wisconsin Community Bank, Riverside Community Bank and Dubuque Bank and Trust, principally as a result of continued calling efforts. The table below presents the composition of the loan portfolio as of June 30, 2002, and December 31, 2001. LOAN PORTFOLIO (Dollars in thousands) June 30, December 31, 2002 2001 Amount Percent Amount Percent ------ ------- ------ ------- Commercial and commercial real estate $ 693,091 61.97% $ 651,479 58.73% Residential mortgage 138,198 12.36 168,912 15.23 Agricultural and agricultural real estate 150,136 13.42 145,460 13.11 Consumer 123,098 11.00 127,874 11.53 Lease financing, net 13,958 1.25 15,570 1.40 ---------- ------- ---------- ------- Gross loans and leases $1,118,481 100.00% $1,109,295 100.00% ======= ======= Unearned discount (2,702) (3,457) Deferred loan fees (740) (633) ---------- ---------- Total loans and leases 1,115,039 1,105,205 Allowance for loan and lease losses (15,409) (14,660) ---------- ---------- Loans and leases, net $1,099,630 $1,090,545 ========== ========== The process utilized by Heartland to estimate the adequacy of the allowance for loan and lease losses is considered a critical accounting practice for Heartland. The allowance for loan and lease losses represents management's estimate of identified and unidentified losses in the existing loan portfolio. Thus, the accuracy of this estimate could have a material impact on Heartland's earnings. The adequacy of the allowance for loan and lease losses is determined using factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, past loss experience, loan delinquencies, and potential substandard and doubtful credits. The adequacy of the allowance for loan and lease losses is monitored on an ongoing basis by the loan review staff, senior management and the board of directors. Factors considered by the loan review committee included the following: - Heartland has continued to experience growth in more- complex commercial loans as compared to relatively lower- risk residential real estate loans. - The nation has continued in a period of economic slowdown. - During the last several years, Heartland has entered new markets in which it had little or no previous lending experience. There can be no assurances that the allowance for loan and lease losses will be adequate to cover all losses, but management believes that the allowance for loan and lease losses was adequate at June 30, 2002. While management uses available information to provide for loan and lease losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions. Along with other financial institutions, management shares a concern for the outlook of the economy during the remainder of 2002. Even though there are various signs of emerging strength, it is not certain that this strength will be sustainable. Additionally, the recent decline in equity prices may negatively impact consumer confidence. Should the economic climate continue to deteriorate, borrowers may experience difficulty, and the level of nonperforming loans, charge-offs, and delinquencies could rise and require further increases in the provision for loan and lease losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan and lease losses carried by the Heartland subsidiaries. Such agencies may require Heartland to make additional provisions to the allowance based upon their judgment about information available to them at the time of their examinations. The allowance for loan and lease losses increased by $749 thousand or 5% during the first six months of 2002. The allowance for loan and lease losses at June 30, 2002, was 1.38% of loans and 202% of nonperforming loans, compared to 1.33% of loans and 180% of nonperforming loans, at year-end 2001. Nonperforming loans decreased to .69% of total loans and leases at June 30, 2002, compared to .73% of total loans and leases at December 31, 2001. This decrease was primarily the result of one large credit that was partially paid-off, which brought the remaining balance to a serviceable level. During the first half of 2002, Heartland recorded net charge offs of $852 thousand compared to $761 thousand for the same period in 2001. Citizens Finance Co., Heartland's consumer finance subsidiary, was responsible for $493 thousand or 58% of the net charge-offs during the first six months of 2002 and $373 thousand or 49% during the same period in 2001. Increased losses at Citizens relate directly to the rapid growth it experienced during the previous two years with expansion into the Rockford, Illinois, market. Identification of problem loans in a portfolio begin to occur as the portfolio matures. Additionally, the weakened economy has affected the ability of borrowers to repay their consumer loans. Net losses as a percentage of average gross loans at Citizens were 4.23% for the first half of 2002 compared to 3.19% for the first half of 2001. Loans with payments past due for more than thirty days decreased from 5.30% of gross loans at December 31, 2001, to 5.28% at June 30, 2002. SECURITIES The composition of Heartland's securities portfolio is managed to maximize the return on the portfolio while considering the impact it has on Heartland's asset/liability position and liquidity needs. Securities represented 21% of total assets at June 30, 2002, as compared to 20% at December 31, 2001. The amount of securities held in Heartland's portfolio was increased during the first half of 2002 as deposit growth outpaced growth in the loan portfolio. During the first half of 2002, management changed the composition of the securities portfolio. Additional paydowns received on mortgage-backed securities were replaced with short-term U.S. treasury and government agency securities and municipal securities. During the first half of 2002, management purchased some longer-term municipal securities to take advantage of the unusually steep slope in the yield curve and the spread of the tax-equivalent yield on municipal securities over the yield on agency securities with the same maturities. Additionally, to improve net interest margin, management elected to reduce its fed funds and money market instruments position and invest in short- term U.S. treasury and government agency securities. The table below presents the composition of the securities portfolio by major category as of June 30, 2002, and December 31, 2001. SECURITIES PORTFOLIO (Dollars in thousands) June 30, December 31, 2002 2001 Amount Percent Amount Percent ------ ------- ------ ------- U.S. Treasury securities $ 498 .14% $ 498 .15% U.S. government agencies 116,975 33.89 78,736 24.33 Mortgage-backed securities 139,687 40.47 183,661 56.74 States and political subdivisions 58,721 17.01 30,948 9.56 Other securities 29,296 8.49 29,846 9.22 -------- ------- -------- ------- Total securities $345,177 100.00% $323,689 100.00% ======== ======= ======== ======= DEPOSITS AND BORROWED FUNDS Total deposits experienced an increase of $22.9 million or 2% during the first half of 2002. Increases in total deposits occurred at Galena State Bank, Riverside Community Bank and Wisconsin Community Bank. The demand deposit category experienced a decrease during the six months while savings and certificate of deposit account balances increased. Demand deposit accounts balances declined $7.0 million or 4% as all the Heartland bank subsidiaries experienced a decrease in these balances since year- end except for Galena State Bank and Riverside Community Bank. With the volatility in the stock market, customers have elected to keep a larger portion of their funds invested in savings and certificate of deposit products at banks. Savings deposit account balances grew by $3.5 million or 1% while certificate of deposit account balances grew by $26.4 million or 5% during the first six months of 2002. Short-term borrowings generally include federal funds purchased, treasury tax and loan note options, securities sold under agreement to repurchase and short-term Federal Home Loan Bank ("FHLB") advances. These funding alternatives are utilized in varying degrees depending on their pricing and availability. Over the six month period ended June 30, 2002, the amount of short-term borrowings had decreased $16.8 million or 10%. Repurchase agreement balances made up $6.5 million or 39% of this change and treasury tax and loan note options made up $4.0 million or 24% of this change. All of the bank subsidiaries provide repurchase agreements to their customers as a cash management tool, sweeping excess funds from demand deposit accounts into these agreements. This source of funding does not increase the bank's reserve requirements, nor does it create an expense relating to FDIC premiums on deposits. Although the aggregate balance of repurchase agreements is subject to variation, the account relationships represented by these balances are principally local. With the continued decline in interest rates during the last half of 2001, some of these repurchase agreement customers elected to invest a portion of their excess funds in higher-yielding products. Also included in short-term borrowings are the credit lines Heartland entered into with two unaffiliated banks. Under the unsecured credit lines, Heartland may borrow up to $50.0 million. At June 30, 2002, $25.0 million was outstanding as compared to $29.2 million at December 31, 2001. Other borrowings include all debt arrangements Heartland and its subsidiaries have entered into with original maturities that extend beyond one year. These borrowings were $136.3 million on June 30, 2002, compared to $143.8 million on December 31, 2001. The change in these account balances primarily resulted from activity in the bank subsidiaries' borrowings from the FHLB. All of the Heartland banks own stock in the FHLB of Des Moines, Chicago or Dallas, enabling them to borrow funds from their respective FHLB for short- or long-term purposes under a variety of programs. Total FHLB borrowings at June 30, 2002, and December 31, 2001, were $77.0 million and $86.5 million, respectively. Substantially all of these borrowings are fixed-rate advances for original terms between three and five years. Additionally, balances outstanding on capital securities issued by Heartland are included in total other borrowings. The issuance in October of 1999 for $25.0 million bears an annual rate of 9.60% and matures on September 30, 2029. A private placement offering for $8.0 million was completed in December of 2001. This variable rate issuance matures on December 18, 2031. An additional private placement offering for $5.0 million was completed in June of 2002. This additional variable rate issuance matures on June 30, 2032. CAPITAL RESOURCES Bank regulatory agencies have adopted capital standards by which all bank holding companies will be evaluated. Under the risk- based method of measurement, the resulting ratio is dependent upon not only the level of capital and assets, but also the composition of assets and capital and the amount of off-balance sheet commitments. Heartland and its bank subsidiaries have been, and will continue to be, managed so they meet the well- capitalized requirements under the regulatory framework for prompt corrective action. To be categorized as well capitalized under the regulatory framework, bank holding companies and banks must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios of 10%, 6% and 4%, respectively. As of March 31, 2002, the most recent notification from the FDIC categorized Heartland and each of its bank subsidiaries as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed each institution's category. Heartland's capital ratios were as follows for the dates indicated: CAPITAL RATIOS (Dollars in thousands) June 30, December 31, 2002 2001 Amount Ratio Amount Ratio ------ ----- ------ ----- Risk-Based Capital Ratios:(1) Tier 1 capital $ 133,075 10.50% $ 121,112 9.71% Tier 1 capital minimum requirement 50,694 4.00% 49,891 4.00% ---------- ------ ---------- ------ Excess $ 82,381 6.50% $ 71,221 5.71% ========== ====== ========== ====== Total capital $ 148,483 11.72% $ 135,770 10.89% Total capital minimum requirement 101,388 8.00% 99,782 8.00% ---------- ------ ---------- ------ Excess $ 47,095 3.72% $ 35,988 2.89% ========== ====== ========== ====== Total risk-adjusted assets $1,267,352 $1,247,274 ========== ========== Leverage Capital Ratios:(2) Tier 1 capital $ 133,075 8.24% $ 121,112 7.53% Tier 1 capital minimum requirement(3) 64,601 4.00% 64,336 4.00% ---------- ------ ---------- ------ Excess $ 68,474 4.24% $ 56,776 3.53% ========== ====== ========== ====== Average adjusted assets (less goodwill) $1,615,032 $1,608,402 ========== ========== (1) Based on the risk-based capital guidelines of the Federal Reserve, a bank holding company is required to maintain a Tier 1 capital to risk-adjusted assets ratio of 4.00% and total capital to risk-adjusted assets ratio of 8.00%. (2) The leverage ratio is defined as the ratio of Tier 1 capital to average adjusted assets. (3) Management of Heartland has established a minimum target leverage ratio of 4.00%. Based on Federal Reserve guidelines, a bank holding company generally is required to maintain a leverage ratio of 3.00% plus additional capital of at least 100 basis points. Commitments for capital expenditures are an important factor in evaluating capital adequacy. As a result of the acquisition of National Bancshares, Inc., the one-bank holding company of First National Bank of Clovis, remaining requisite cash payments under the notes payable total $637 thousand in 2003 and 2004, plus interest at 7.00%. Immediately following the closing of the acquisition, the bank was merged into New Mexico Bank & Trust. As a result of this affiliate bank merger, Heartland's ownership in New Mexico Bank & Trust increased to approximately 88%. In June of 2000, Heartland offered a portion of its shares of New Mexico Bank & Trust's common stock to interested investors. In no case would Heartland's interest be allowed to fall below 80%. All minority stockholders, including the initial investors, entered into a stock transfer agreement before shares were issued to them. This stock transfer agreement imposes certain restrictions on the investor's sale, transfer or other disposition of their shares and requires Heartland to repurchase the shares from the investor on April 9, 2003. As of June 30, 2002, Heartland's ownership in New Mexico Bank & Trust was 86%. Heartland has an incentive compensation agreement with certain employees of one of the bank subsidiaries, none of whom is an executive officer of Heartland, that requires a total payment of $3.8 million to be made no later than February 29, 2004, to those who remain employed with the subsidiary on December 31, 2003. Additionally, each employee is bound by a confidentiality and non- competition agreement. One-third of the payment will be made in cash and the remaining two-thirds in shares of Heartland's common stock. The obligation is being accrued over the performance period. On June 27, 2002, Heartland completed a private placement offering of $5.0 million of variable rate cumulative capital securities representing undivided beneficial interests in Heartland Financial Capital Trust II, a special purpose trust subsidiary formed for the sole purpose of this offering. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. The proceeds were used by Heartland for general corporate purposes. Interest is payable quarterly on March 30, June 30, September 30 and December 30 of each year. The debentures will mature and the capital securities must be redeemed on June 30, 2032. Heartland has the option to shorten the maturity date to a date not earlier than June 30, 2007. Heartland will not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. All of these securities qualified as Tier 1 capital for regulatory purposes as of June 30, 2002. On December 18, 2001, Heartland completed a private placement offering of $8.0 million of variable rate cumulative capital securities representing undivided beneficial interests in Heartland Financial Statutory Trust II, a special purpose trust subsidiary formed for the sole purpose of this offering. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. The proceeds were used by Heartland for general corporate purposes. Interest is payable quarterly on March 18, June 18, September 18 and December 18 of each year. The debentures will mature and the capital securities must be redeemed on December 18, 2031. Heartland has the option to shorten the maturity date to a date not earlier than December 18, 2006. Heartland will not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. All of these securities qualified as Tier 1 capital for regulatory purposes as of June 30, 2002. In October of 1999, Heartland completed an offering of $25.0 million of 9.60% cumulative capital securities representing undivided beneficial interests in Heartland Financial Capital Trust I, a special purpose trust subsidiary formed for the sole purpose of this offering. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. The proceeds were used by Heartland for general corporate purposes. All of these securities continued to qualify as Tier 1 capital for regulatory purposes as of June 30, 2002. Expansion efforts are underway at Wisconsin Community Bank, as it committed to the construction of a 3-story, 20,000 square foot building in Fitchburg, a suburb southwest of Madison. The bank will occupy the first floor and financially related companies or law offices will occupy the top two floors. Wisconsin Community Bank's share of the construction costs on this project is estimated at $2.5 million. This project is underway with completion targeted for January of 2003. Plans for the renovation and construction of a 50,000 square foot facility to accommodate the operations and support functions of Heartland are underway. Property in downtown Dubuque, Iowa, across the street from Dubuque Bank and Trust's main facility, has been purchased. The $4.5 million project has begun with completion anticipated next fall. A reduction in overall costs on this project will result from tax credits and other incentives made available on the project as it includes the rehabilitation of two historical structures and the creation of new jobs. Heartland continues to explore other opportunities to expand its umbrella of independent community banks through mergers and acquisitions as well as de novo and branching opportunities. As evidenced by the expansion into New Mexico, Heartland is seeking to operate in high growth areas, even if they are outside of its traditional Midwest market areas. Future expenditures relating to these efforts are not estimable at this time. LIQUIDITY Liquidity measures the ability of Heartland to meet maturing obligations and its existing commitments, to withstand fluctuations in deposit levels, to fund its operations and to provide for customers' credit needs. The liquidity of Heartland principally depends on cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings and its ability to borrow funds in the money or capital markets. Net cash outflows from investing activities decreased $16.8 million during the first six months of 2002 compared to the same period in 2001. The cash used by a net increase in loans and leases was $21.6 million during the first six months of 2002 compared to $14.4 million during the same period in 2001, a $7.1 million change, driven primarily by the growth in the commercial loans portfolio. During the first six months of 2002, proceeds from the sale of securities decreased $8.2 million compared to the same period in 2001. During the first half of 2001, management elected to shift a portion of its securities portfolio into mortgage-backed securities from U.S. government agencies. Proceeds from the maturity of and principal paydowns on securities increased $58.3 million during the first half of 2002 when compared to the same period in 2001, primarily as a result of increased paydowns on mortgage-backed securities. The increased paydowns within the securities portfolio resulted in additional purchases of securities. Purchases of securities increased $27.0 million for the periods under comparison. Financing activities used net cash of $2.6 million during the first six months of 2002. Conversely, during the first six months of 2001, financing activities provided net cash of $94.5 million. A net increase in deposit accounts provided cash of $22.9 million during the first six months of 2002 compared to $67.3 million during the same period in 2001. Short-term borrowings used cash of $16.8 million in 2002 and provided cash of $12.8 million in 2001. As deposit balances increased and loan growth slowed, Heartland did not find it necessary to increase its other borrowings as much during the first half of 2002 as it had during the same period in 2001. The proceeds from other borrowings had declined $23.2 million. Total cash inflows from operating activities increased $44.6 million for the first six months of 2002 compared to the same period in 2001. A large portion of this change resulted from real estate mortgage loan activity as customers continued to refinance their mortgage loans into fifteen- and thirty-year fixed rate loans, which Heartland usually sells into the secondary market. Loan sales activity provided cash of $11.5 million during 2002 compared to using cash of $26.6 million during the same period in 2001. Management of investing and financing activities, and market conditions, determine the level and the stability of net interest cash flows. Management attempts to mitigate the impact of changes in market interest rates to the extent possible, so that balance sheet growth is the principal determinant of growth in net interest cash flows. In the event of short-term liquidity needs, the bank subsidiaries may purchase federal funds from each other or from correspondent banks and may also borrow from the Federal Reserve Bank. Additionally, the subsidiary banks' FHLB memberships give them the ability to borrow funds for short- and long-term purposes under a variety of programs. Heartland's revolving credit agreements, as of June 30, 2002, provided an additional borrowing capacity of $25.0 million. These agreements contain specific covenants which, among other things, limit dividend payments and restrict the sale of assets by Heartland under certain circumstances. Also contained within the agreements are certain financial covenants, including the maintenance by Heartland of a maximum nonperforming assets to total loans ratio, minimum return on average assets ratio and maximum funded debt to total equity capital ratio. In addition, Heartland and each of its bank subsidiaries must remain well capitalized, as defined from time to time by the federal banking regulators. At June 30, 2002, Heartland was in compliance with the covenants contained in these credit agreements. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (Dollars in thousands) Market risk is the risk of loss arising from adverse changes in market prices and rates. Heartland's market risk is comprised primarily of interest rate risk resulting from its core banking activities of lending and deposit gathering. Interest rate risk measures the impact on earnings from changes in interest rates and the effect on current fair market values of Heartland's assets, liabilities and off-balance sheet contracts. The objective is to measure this risk and manage the balance sheet to avoid unacceptable potential for economic loss. Management continually develops and applies strategies to mitigate market risk. Exposure to market risk is reviewed on a regular basis by the asset/liability committees at the banks and, on a consolidated basis, by the Heartland board of directors. Management does not believe that Heartland's primary market risk exposures and how those exposures have been managed to-date in 2002 changed significantly when compared to 2001. Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. Heartland's use of derivative financial instruments relates to the management of the risk that changes in interest rates will affect its future interest payments. Heartland utilizes an interest rate swap contract to effectively convert a portion of its variable rate interest rate debt to fixed interest rate debt. Under the interest rate swap contract, Heartland agrees to pay an amount equal to a fixed rate of interest times a notional principal amount, and to receive in return an amount equal to a specified variable rate of interest times the same notional principal amount. The notional amounts are not exchanged and payments under the interest rate swap contract are made monthly. Heartland is exposed to credit-related losses in the event of nonperformance by the counterparty to the swap contract, which has been minimized by entering into the contract with a large, stable financial institution. As of June 30, 2002, Heartland had an interest rate swap contract to pay a fixed rate of interest and receive a variable rate of interest on $25.0 million of indebtedness. This contract expires on November 1, 2006. The fair market value of the interest rate swap contract was recorded as a liability in the amount of $321 thousand on of June 30, 2002. PART II ITEM 1. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Company or its subsidiaries is a party other than ordinary routine litigation incidental to their respective businesses. ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company's annual meeting of stockholders was held on May 22, 2002. At the meeting, James F. Conlan and Thomas L. Flynn were elected to serve as Class III directors (term expires in 2005). Continuing as Class I director (term expires in 2003) is Lynn B. Fuller. Continuing as Class II directors (term expires in 2002) are Mark C. Falb, John K. Schmidt and Robert Woodward. The stockholders approved the appointment of KPMG LLP as the Company's independent public accountants for the year ending December 31, 2002. There were 9,828,333 issued and outstanding shares of common stock entitled to vote at the annual meeting. The voting results on the above described items were as follows: For Withheld --- -------- Election of Directors James F. Conlan 8,418,819 165,641 Thomas L. Flynn 8,418,719 165,741 Broker For Against Abstain Non-Votes --- ------- ------- --------- Appointment of KPMG LLP 8,523,924 50,793 9,743 0 ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K Exhibits 10.1 Indenture by and between Heartland Financial USA, Inc. and Wells Fargo Bank, National Association, dated as of June 27, 2002. 10.2 Fourth Amendment to Second Amended and Restated Credit Agreement between Heartland Financial USA, Inc. and The Northern Trust Company dated as of June 29, 2002. 10.3 See Exhibit 10.2 for substantially the same form of a Fourth Amendment to Credit Agreement between Heartland Financial USA, Inc. and Harris Trust and Savings Bank dated as of June 29, 2002. 99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by the Company's Chief Executive Officer. 99.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by the Company's Chief Financial Officer. Reports on Form 8-K On June 11, 2002, the Company filed a report on Form 8-K stating under Item 5 that the Company declared a dividend of one preferred share purchase right for each outstanding share of common stock of the Company payable on June 26, 2002, to the stockholders of record on June 24, 2002. On July 19, 2002, the Company filed a report on Form 8-K stating under Item 5 that the Company issued a press release announcing its earnings for the quarter ended on June 30, 2002. On July 30, 2002, the Company filed a report on Form 8-K stating under Item 5 that the Company authorized management to acquire and hold in treasury up to $4,000,000 of the Company's common stock, par value $1.00 per share. 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 there unto duly authorized. HEARTLAND FINANCIAL USA, INC. (Registrant) Principal Executive Officer /s/ Lynn B. Fuller ----------------------- By: Lynn B. Fuller President Principal Financial and Accounting Officer /s/ John K. Schmidt ----------------------- By: John K. Schmidt Executive Vice President and Chief Financial Officer Dated: August 14, 2002