UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTS OF 1934 For the quarterly period ended June 30, 2004 OR [ ] 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 0-24648 FSF FINANCIAL CORP. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Minnesota 41-1783064 - ------------------------------- --------------------------------- (State or other jurisdiction of (IRS employer identification no.) incorporation or organization) 201 Main Street South, Hutchinson, Minnesota 55350-2573 - -------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (320) 234-4500 Former name, former address and former fiscal year, if changed since last report. Indicate by check 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X --- --- APPLICABLE ONLY TO CORPORATE ISSUERS: Indicated the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: July 29, 2004. ------------- Class Outstanding ----- ----------- $.10 par value common stock 2,386,398 shares FSF FINANCIAL CORP. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004 INDEX Page Number ------ PART I - CONSOLIDATED FINANCIAL INFORMATION Item 1. Financial Statements 1 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures about Market Risk 17 Item 4. Controls and Procedures 18 PART II - OTHER INFORMATION Item 1. Legal Proceedings 19 Item 2. Changes in Securities and Use of Proceeds 19 Item 3. Defaults Upon Senior Securities 19 Item 4. Submission of Matters to a Vote of Security Holders 19 Item 5. Other Information 19 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 FSF FINANCIAL CORP. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION At At June 30, September 30, 2004 2003 ------------------------- (in thousands, except share data) ASSETS ------ Cash and cash equivalents: Cash $ 3,986 $ 3,556 Interest-bearing deposits 21,751 77,045 ---------------------- Total cash and cash equivalents 25,737 80,601 Securities available for sale, at fair value: Equity securities - 12,009 Mortgage-backed and related securities 58,817 29,923 Debt securities 11,704 12,178 Restricted stock 3,912 4,797 Loans held-for-sale 17,036 17,122 Loans receivable, net 365,179 358,708 Foreclosed real estate 1,151 1,152 Accrued interest receivable 3,659 3,960 Premises and equipment 6,186 6,331 Goodwill 3,883 3,883 Identifiable intangibles 911 1,014 Investment in life insurance 8,649 8,388 Other assets 3,985 1,086 ---------------------- Total assets $ 510,809 $ 541,152 ====================== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Liabilities: Demand deposits $ 85,999 $ 69,684 Savings accounts 78,836 86,666 Certificates of deposit 216,060 234,665 ---------------------- Total deposits 380,895 391,015 Federal Home Loan Bank borrowings 72,000 93,000 Advances from borrowers for taxes and insurance 149 233 Other liabilities 6,135 5,717 ---------------------- Total liabilities 459,179 489,965 Stockholders' equity: Serial preferred stock, no par value 5,000,000 shares authorized, no shares issued - - Common stock, $.10 par value 10,000,000 shares authorized, 4,501,277 and 4,501,277 shares issued 450 450 Additional paid in capital 44,170 43,925 Retained earnings, substantially restricted 39,479 38,643 Treasury stock at cost (2,114,879 and 2,156,540 shares) (30,907) (31,444) Unearned ESOP shares at cost (-0- and 7,643 shares) - (76) Unearned MSP stock grants at cost (475) (484) Accumulated other comprehensive income (1,087) 173 ---------------------- Total stockholders' equity 51,630 51,187 ---------------------- Total liabilities and stockholders' equity $ 510,809 $ 541,152 ====================== See Notes to Unaudited Consolidated Financial Statements 1 FSF FINANCIAL CORP. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME Three Months Nine Months Ended June 30, Ended June 30, -------------------------- --------------------------- 2004 2003 2004 2003 -------------------------- --------------------------- (in thousands, except per share data) Interest income: Loans receivable $ 6,712 $ 7,399 $ 20,137 $ 23,304 Mortgage-backed and related securities 585 385 1,306 1,347 Investment securities 169 394 874 1,019 -------------------------- --------------------------- Total interest income 7,466 8,178 22,317 25,670 Interest expense: Deposits 1,611 2,293 5,166 7,485 Borrowed funds 972 1,256 3,201 3,818 -------------------------- --------------------------- Total interest expense 2,583 3,549 8,367 11,303 -------------------------- --------------------------- Net interest income 4,883 4,629 13,950 14,367 Provision for loan losses 755 305 1,483 786 -------------------------- --------------------------- Net interest income after provision for loan losses 4,128 4,324 12,467 13,581 -------------------------- --------------------------- Noninterest income: Gain on sale of loans- net 772 1,269 2,169 3,701 Gain on sale of available for sale securities - - 284 - Other service charges and fees 437 461 1,122 1,275 Service charges on deposit accounts 664 663 1,849 1,873 Commission income 341 303 966 895 Other 88 102 294 265 -------------------------- --------------------------- Total noninterest income 2,302 2,798 6,684 8,009 -------------------------- --------------------------- Noninterest expense: Compensation and benefits 2,772 2,793 8,329 8,500 Occupancy and equipment 502 449 1,473 1,256 Data processing 262 254 760 744 Professional fees 332 186 623 466 Other 994 920 2,756 2,660 -------------------------- --------------------------- Total noninterest expense 4,862 4,602 13,941 13,626 -------------------------- --------------------------- Income before provision for income taxes 1,568 2,520 5,210 7,964 Income tax expense 567 894 2,016 3,022 -------------------------- --------------------------- Net income $ 1,001 $ 1,626 $ 3,194 $ 4,942 ========================== =========================== Basic earnings per share $ 0.43 $ 0.72 $ 1.37 $ 2.21 Diluted earnings per share $ 0.41 $ 0.68 $ 1.30 $ 2.09 Cash dividend declared per common share $ 0.35 $ 0.30 $ 1.05 $ 0.90 Comprehensive income $ (349) $ 1,644 $ 1,934 $ 5,560 ========================== =========================== See Notes to Unaudited Consolidated Financial Statements 2 FSF FINANCIAL CORP. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS Three Months Nine Months Ended June 30, Ended June 30, ---------------------- ---------------------- 2004 2003 2004 2003 ---------------------- ---------------------- (in thousands) Cash flows from operating activities: Net income $ 1,001 $ 1,626 $ 3,194 $ 4,942 Adjustments to reconcile net income to net cash provided by (used in) operating activities Depreciation 267 230 762 646 Net amortization of discounts and premiums (8) (8) (70) (98) Provision for loan losses 755 305 1,483 786 ESOP and MSP stock compensation expense 3 225 227 661 Amortization of intangibles 35 43 103 128 Net loan fees deferred and amortized 17 (98) (32) (355) Loans originated for sale (60,443) (91,528) (157,548) (255,383) Loans sold 56,869 91,258 159,803 255,065 Gain on available-for-sale securities - - (284) - Gain on sale of loans (772) (1,269) (2,169) (3,701) (Increase) decrease in: Accrued interest receivable (187) (264) 301 543 Life insurance (85) - (261) - Other assets (106) 188 137 321 Deferred taxes 901 20 1,084 (314) Other liabilities 131 315 (512) 125 ---------------------- ---------------------- Net cash provided by (used in) operating activities (1,622) 1,043 6,218 3,366 ---------------------- ---------------------- Cash flows from investing activities: Loan originations and principal repayments on loans, net 3,278 7,527 (1,731) 18,031 Purchase of loans (5,000) - (7,500) - Principal repayments on mortgage-related securities held-to-maturity - - - 2,178 Purchase of available-for-sale securities (26,132) (2,968) (52,181) (7,030) Proceeds from FHLB stock redeemed - - 885 - Proceeds from the sale of available-for-sale securities - - 20,187 - Principal repayments and proceeds from maturities of securities available-for-sale 3,220 8,594 13,435 18,364 Investment in foreclosed real estate (200) (131) (353) (143) Security deposit (1,700) - (1,700) - Proceeds from sale of foreclosed real estate 598 321 1,665 571 Purchase of equipment and property improvements (155) (175) (618) (989) ---------------------- ---------------------- Net cash (used in) provided by investing activities $ (26,091) $ 13,168 $ (27,911) $ 30,982 ---------------------- ---------------------- See Notes to Unaudited Consolidated Financial Statements 3 FSF FINANCIAL CORP. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Three Months Nine Months Ended June 30, Ended June 30, -------------------- -------------------- 2004 2003 2004 2003 -------------------- -------------------- (in thousands) Cash flows from financing activities: Net (decrease) increase in deposits $ (4,706) $ (8,826) $(10,087) $ 12,216 Payments on FHLB advances - - (21,000) (5,000) Allocated dividends used to retire debt on ESOP - - 25 - Net decrease in mortgage escrow funds (77) (108) (84) (150) Treasury stock purchased - (26) (137) (872) Dividends on common stock (822) 102 (2,359) 627 Proceeds from exercise of stock options 43 (669) 471 (1,985) -------------------- -------------------- Net cash (used in) provided by financing activities (5,562) (9,527) (33,171) 4,836 -------------------- -------------------- Net decrease in cash and cash equivalents (33,275) 4,685 (54,864) 39,184 Cash and cash equivalents Beginning of period 59,012 49,114 80,601 14,615 -------------------- -------------------- End of period $ 25,737 $ 53,799 $ 25,737 $ 53,799 ==================== ==================== Supplemental disclosures of cash flow information: Cash payments for: Interest on advances and other borrowed money $ 972 $ 1,255 $ 3,200 $ 3,817 Interest on deposits $ 1,606 $ 2,316 $ 5,479 $ 7,963 Income taxes $ 732 $ 770 $ 1,774 $ 3,144 Supplemental schedule of non-cash investing and financing activities: Foreclosed real estate $ 532 $ 859 $ 1,310 $ 1,410 Transfer of securities from held-to-maturity to available -for-sale $ - $ - $ - $ 30,462 Unrealized gain on available-for-sale securities transferred, net of tax $ - $ - $ - $ 561 See Notes to Unaudited Consolidated Financial Statements 4 FSF FINANCIAL CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2004 NOTE 1- PRINCIPLES OF CONSOLIDATION The unaudited consolidated financial statements as of and for the three and nine months ended June 30, 2004 include the accounts of FSF Financial Corp. ("the Corporation") and its wholly owned subsidiaries, Insurance Planners of Hutchinson, Inc. ("the Agency") and First Federal fsb ("the Bank"). Firstate Services and Homeowners Mortgage Corporation ("HMC") are wholly owned subsidiaries of the Bank. All significant inter-company accounts and transactions have been eliminated in the consolidated financial statements. NOTE 2- BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include information or footnotes necessary for a complete presentation of consolidated financial condition, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America . However, all adjustments consisting of normal recurring accruals, which in the opinion of management are necessary for fair presentation of the consolidated financial statements, have been included. The results of operations for the three and nine month periods ended June 30, 2004 are not necessarily indicative of the results which may be expected for the entire fiscal year or any other future period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation's Annual Report on Form 10-K for the year ended September 30, 2003. NOTE 3- EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share: For the Three Months ended For the Nine Months ended June 30, June 30, ------------------------------ ------------------------------ 2004 2003 2004 2003 ------------------------------ ------------------------------ Numerator: Net income - Numerator for basic earnings per share and diluted earnings per share-- income available to common stockholders $ 1,001,000 $ 1,626,000 $ 3,194,000 $ 4,942,000 ============================== ============================== Denominator: Denominator for basic earnings per share-- weighted-average shares 2,343,301 2,264,577 2,331,141 2,241,262 Effect of dilutive securities: Stock - based compensation plans 127,163 135,674 131,793 128,783 ------------------------------ ------------------------------ Denominator for diluted earnings per share-- adjusted weighted-average shares and assumed conversions 2,470,464 2,400,251 2,462,934 2,370,045 ============================== ============================== Basic earnings per share $ 0.43 $ 0.72 $ 1.37 $ 2.21 Diluted earnings per share $ 0.41 $ 0.68 $ 1.30 $ 2.09 5 NOTE 4- STOCK OPTION ACCOUNTING The Corporation accounts for stock options under the intrinsic value method of recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation- Transition and Disclosure, is effective for the interim period beginning after December 15, 2002 and requires pro-forma net income and earnings per share disclosures on a quarterly basis. The following table illustrates the effect on net income and earnings per share as if the Corporation had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. Three Months Nine Months Ended June 30, Ended June 30, ------------------------- ------------------------- 2004 2003 2004 2003 ------------------------- ------------------------- (in thousands) (in thousands) Net income, as reported $ 1,001 $ 1,626 $ 3,194 $ 4,942 Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects - - 4 77 ------------------------- ------------------------- Pro-forma net income $ 1,001 $ 1,626 $ 3,190 $ 4,865 ========================= ========================= Earnings per share: Basic, as reported $ 0.43 $ 0.72 $ 1.37 $ 2.21 Basic, pro-forma $ 0.43 $ 0.72 $ 1.37 $ 2.17 Diluted, as reported $ 0.41 $ 0.68 $ 1.30 $ 2.09 Diluted, pro-forma $ 0.41 $ 0.68 $ 1.30 $ 2.05 On November 19, 2002, the Corporation awarded 1,250 stock options from the 1994 stock option plan and 20,687 stock options from the 1998 stock option plan. The awards may be exercised over a ten-year period at an exercise price of $23.00, the fair value of the Corporation's stock on the date of the option grant. In addition, 46,212 options were exercised at various prices in the current fiscal year. NOTE 5- EFFECT OF NEW FINANCIAL ACCOUNTING STANDARDS In March 2004 the Sec issued Staff Accounting Bulletin (SAB) No. 105 "Application of Accounting Principles to Loan Commitments". This SAB related to FASB Statement No. 133 " Accounting for Derivative Instruments and Hedging Activities" for valuating loans commitments, considered to be derivatives, on mortgage loans that will be sold. This SAB is effective for commitments entered into after April 1, 2004. This additional guidance did not have a material effect on the Corporation's operating results or financial condition. In January 2003, the EITF began a project to provide additional guidance on when a market value decline on debt and marketable equity securities should be considered other-than-temporary. Currently, declines in market value that are considered to be other-than-temporary require that a loss be recognized through the income statement. The EITF issued additional guidance in March 2004 establishing criteria for recognition and measurement under this pronouncement to be effective for reporting periods beginning after June 15, 2004. This additional guidance did not have a material effect on the Corporation's operating results or financial condition. Management continuously monitors emerging issues and accounting bulletins, some of which could potentially impact the Corporation's financial statements. 6 NOTE 6- COMPREHENSIVE INCOME Comprehensive income consists of net income and other gains and losses affecting shareholder's equity that, under generally accepted accounting principles in the United States of America, is excluded from net income. For the Corporation, the difference between net income and comprehensive income consists of the change, for the periods reported, in unrealized gains and losses on securities available for sale, net of tax. At September 30, 2002, the Bank had a total of $33.1 million of securities that were classified as held-to-maturity. During the quarter ended December 31, 2002, the Bank transferred all of the securities to available-for-sale in accordance with SFAS 115 and SFAS 130. In order to remain within the held-to-maturity classification, the Bank must have the ability and intent to hold the securities to maturity. Although the Bank still has the ability to hold the securities to maturity, the intent to hold the securities to maturity no longer exists. Based upon a review of interest rates, potential liquidity needs, interest rate risk characteristics of the securities and other factors, management has determined that it would be in the best interest of the Bank to transfer the securities. This will provide greater flexibility in dealing with changing economic circumstances. The following table provides information regarding the impact of the transfer on comprehensive income. Three Months Nine Months Ended June 30, Ended June 30, ------------------------- ------------------------- 2004 2003 2004 2003 ------------------------- ------------------------- (in thousands) (in thousands) Net income $ 1,001 $ 1,626 $ 3,194 $ 4,942 Other comprehensive income Unrealized holding gains on securities transferred from held to maturity, net of tax expense - - - 561 Unrealized holding gains (losses) during the period (2,616) 23 (2,182) 89 Less: Reclassification adjustment for net gains included in net income - - (284) - Tax (expense) benefit 1,266 (5) 1,206 (32) ------------------------- ------------------------- Comprehensive income $ (349) $ 1,644 $ 1,934 $ 5,560 ========================= ========================= 7 FSF FINANCIAL CORP. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. When used in this discussion, the words "believes", "anticipates", "contemplates", "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Those risks and uncertainties include changes in interest rates, risks associated with the effect of integrating newly acquired businesses, the ability to control costs and expenses and general economic conditions. General The Corporation's total assets at June 30, 2004 and September 30, 2003 totaled $510.8 million and $541.2 million, respectively. The decrease of $30.4 million was primarily the result of the repayment of Federal Home Loan Bank ("FHLB") advances and the reduction of deposits, in particular, certificates of deposit. Cash and cash equivalents decreased $54.9 million from $80.6 million at September 30, 2003 to $25.7 million at June 30, 2004, mainly due to payments on FHLB advances, a reduction in deposits coupled with an increase in loans. The Corporation utilized this excess liquidity to fund loan originations. During the quarter ended December 31, 2002, the Corporation transferred all of its held-to-maturity debt securities and mortgage-backed and related securities to the available-for-sale category. The net carrying amount of these securities at the time of transfer was $31.0 million and the unrealized gain, net of income taxes, was $561,000. During the nine months ended June 30, 2004, $52.2 million of available-for-sale securities were purchased and $20.2 million were sold, including $12.0 million of equity securities. Loans held for sale decreased $86,000 to $17.0 million at June 30, 2004 from $17.1 million at September 30, 2003. As of June 30, 2004, the Bank and HMC had forward commitments to sell these loans held for sale in the secondary market. Payment for these loans usually occurs within fourteen days of funding. Loans receivable increased $6.5 million to $365.2 million at June 30, 2004 from $358.7 million at September 30, 2003. The balance of consumer loans decreased by $6.3 million and the one-to-four family loans decreased by $7.0 million. These decreases were generally the result of prepayments and refinancing activity due to the lower interest rate environment. Construction loans increased from $263.2 million at September 30, 2003 to $275.8 million at June 30, 2004. During that period, the Bank also sold $2.9 million of agricultural loans to Farmer Mac, an agency of the federal government. These loans were sold, with servicing retained, in order to allow the Bank to expand the agricultural lending base without increasing the overall percentage of agricultural loans. 8 The following table sets forth information on loans originated and purchased for the periods indicated: Three Months Nine Months Ended June 30, Ended June 30, -------------------------- -------------------------- 2004 2003 2004 2003 -------------------------- -------------------------- (in thousands) (in thousands) Loans originated: One-to-four family residential mortgages $ 22,165 $ 65,051 $ 55,922 $ 183,125 Residential construction 88,732 66,698 196,015 157,965 Land 6,325 - 11,084 - Agricultural 9,891 10,819 43,463 42,133 Commercial business & real estate 6,141 4,271 22,727 18,141 Consumer 8,088 4,985 13,858 27,015 -------------------------- -------------------------- Total loans originated 141,342 151,824 343,069 428,379 -------------------------- -------------------------- Loans purchased: Commercial business 5,000 - 7,500 - -------------------------- -------------------------- Total new loans $ 146,342 $ 151,824 $ 350,569 $ 428,379 ========================== ========================== The following table sets forth the composition of the Bank's loans in dollars and in percentages of total loans at the dates indicated: June 30, 2004 September 30, 2003 --------------------------------------------------------------------- Amount % Amount % --------------------------------------------------------------------- (dollars in thousands) Residential real estate: One-to-four family (1) $ 34,369 6.9% $ 41,415 8.5% Residential construction 275,819 55.3% 263,227 53.8% Multi-family 7,327 1.5% 7,703 1.6% --------------------------------------------------------------------- 317,515 63.7% 312,345 63.9% Agricultural loans 61,210 12.3% 57,259 11.7% Land and commercial real estate 42,772 8.6% 40,831 8.4% Commercial business 28,078 5.6% 22,961 4.7% --------------------------------------------------------------------- 132,060 26.5% 121,051 24.8% Consumer loans: Home equity and second mortgages 22,324 4.5% 22,482 4.6% Automobile loans 10,880 2.1% 11,550 2.3% Other 15,850 3.2% 21,272 4.4% --------------------------------------------------------------------- Total consumer loans 49,054 9.8% 55,304 11.3% --------------------------------------------------------------------- Total loans 498,629 100.0% 488,700 100.0% ============= ============ Less: Loans in process (114,282) (110,657) Deferred fees (480) (512) Allowance for loan losses (1,652) (1,701) -------------------- ------------------------ Total loans, net $ 382,215 $ 375,830 ==================== ======================== - ------------------------------------------------- 1. Includes loans held for sale in the amount of $17.0 million and $17.1 million as of June 30, 2004 and September 30, 2003. 9 In originating loans, the Bank recognizes that credit losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the quality of the collateral for the loan. The Bank's management evaluates the need to establish loss allowances against losses on loans and other assets each quarter based on estimated losses on specific loans and on any real estate held for sale or investment when a finding is made that a loss is estimable and probable. Such an evaluation includes a review of all loans for which full collectibility may not be reasonably assured and considers, among other matters, the estimated market value of the underlying collateral of problem loans, prior loss experience, economic conditions and overall portfolio quality. While management recognizes and charges against the allowance for loan losses accounts that are determined to be uncollectible, experience indicates that at any point in time, probable losses may exist in the loan portfolio which are not specifically identifiable. Therefore, based upon management's best estimate, an amount may be charged to earnings to maintain the allowance for loan losses at a level sufficient to recognize probable losses. Loans are evaluated for impairment in accordance with SFAS 114, including all loans that are in a troubled debt restructuring involving a modification of terms, are measured at the present value of expected future cash flows discounted at the loan's initial effective interest rate. The fair value of the collateral of an impaired collateral dependent loan or an observable market price, if one exists, may be used as an alternative to discounting. If the measure of the impaired loan is less than the recorded investment in the loan, impairment is recognized through a charge to earnings and a reduction to the loan balance or an increase in the allowance for loan losses. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Bank believes it has established its existing allowance for loan losses in accordance with GAAP. The allowance for loan losses is evaluated based on a detailed review of the loan portfolio, historic loan losses, current economic conditions and other factors. From period to period, the outstanding balance in various loan categories will increase and decrease thereby increasing or decreasing the amount of the allowance attributable to particular categories. Management believes that the resulting level of the allowance for loan losses reflects probable incurred losses in the loan portfolio. However, there can be no assurance that banking regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase its allowance for loan losses or that a deteriorating real estate market or other unforeseen economic changes may cause an increase in allowance for loan losses. This is likely to negatively affect the Bank's financial condition and earnings. The following table sets forth information with respect to the Bank's non-performing assets at the dates indicated: June 31, September 30, 2004 2003 ----------------------------- (dollars in thousands) Loans accounted for on a non-accrual basis: Mortgage loans: Residential construction loans $ 3,746 $ 3,819 Permanent loans secured by one-to-four family units 121 483 Non-residential loans 734 884 Non-mortgage loans: Commercial and agricultural 1,316 411 Consumer 216 442 ----------------------------- Total non-accrual loans 6,133 6,039 Foreclosed real estate and real estate held for investment 1,151 1,152 ----------------------------- Total non-performing assets $ 7,284 $ 7,191 ============================= Total non-performing loans to net loans 1.60% 1.61% ============================= Total non-performing loans to total assets 1.20% 1.12% ============================= Total non-performing assets to total assets 1.43% 1.33% ============================= 10 The nonaccrual residential construction loans are comprised of 25 loans. The outstanding balance of the loans ranges from $1,000 to $470,000. There is one permanent loan secured by one-to-four family residential units for $121,000. The non-residential loan is a participation in a commercial real estate loan with another financial institution. A purchase agreement on the property is being negotiated. The nonaccrual commercial and agricultural loans are comprised of 26 loans. The outstanding values of these loans range from $4,500 to $566,000. The consumer loan total is made up of 13 loans that range from $1,000 to $96,000. The foreclosed real estate consists of 9 construction loans with balances between $5,000 and $198,000, a commercial real estate loan with a balance of $222,000 and one single family home for $142,000. Other assets include a $1.7 million security deposit related to the previously announced proposed merger with MidCountry Financial Corp. Deposits, after interest credited, decreased $10.1 million from $391.0 million at September 30, 2003 to $380.9 million at June 30, 2004. Overall cost of funds on deposits during the period decreased 73 basis points (100 basis points equals 1%) compared with the same nine month period in 2003, as a result of the Bank's attempt to maintain deposit rates consistent with competitors in the market place. Demand deposits increased $16.3 million or 23.4% from September 30, 2003 to June 30, 2004. Savings account balances decreased 9.0% during the same period, while certificates of deposit decreased $18.6 million. The Bank utilized the deposits for liquidity and to reduce Federal Home Loan Bank ("FHLB") borrowings. Treasury stock decreased to 2,114,879 shares at June 30, 2004 due to the exercise of stock options. Treasury shares are used for general corporate purposes, including the issuance of shares in connection with the exercise of stock options. Total stockholders' equity increased $443,000 since September 30, 2003 mainly due to net income offset by a decrease in other comprehensive income coupled with the release of treasury shares. Total stockholder's equity was also reduced by the amount of dividends paid during the first nine months of the fiscal year. Accumulated other comprehensive income decreased as a result of changes in the net unrealized gains and losses on the available-for-sale securities due to fluctuations in interest rates. Because of interest rate volatility, the Corporation's accumulated other comprehensive income could materially fluctuate. Book value per share decreased from $22.30 at September 30, 2003 to $22.02 at June 30, 2004. 11 RESULTS OF OPERATIONS Comparison of the Three Months Ended June 30, 2004 and 2003 The following table sets forth information with respect to the Corporation's average balance sheet, interest and dividends earned and paid and related yields and rates (dollars in thousands): Three Months Ended June 30, --------------------------------------------------------------------------- 2004 2003 --------------------------------------------------------------------------- Interest Interest Average Yields & Average Yields & Balance Interest Rates (1) Balance Interest Rates (1) --------------------------------------------------------------------------- (dollars in thousands) Assets: Loans receivable (2) $ 381,039 $ 6,712 7.05 % $ 398,372 $ 7,399 7.43 % Mortgage-backed securities 56,583 585 4.14 39,795 385 3.87 Investment securities (3) 46,686 169 1.45 76,927 394 2.05 ----------------------- ----------------------- Total interest-earning assets 484,308 7,466 6.17 515,094 8,178 6.35 --------------------- ---------------------- Other assets 29,925 29,232 ------------- ------------- Total assets $ 514,233 $ 544,326 ============= ============= Liabilities: Interest-bearing deposits $ 383,618 $ 1,611 1.68 % $ 394,890 $ 2,293 2.32 % Borrowings 72,000 972 5.40 93,000 1,256 5.40 ----------------------- ----------------------- Total interest-bearing liabilities 455,618 2,583 2.27 487,890 3,549 2.91 --------------------- ---------------------- Other liabilities 6,422 6,742 ------------- ------------- Total liabilities 462,040 494,632 Stockholders' equity 52,193 49,694 ------------- ------------- Total liabilities and stockholders' equity $ 514,233 $ 544,326 ============= ============= Net interest income $ 4,883 $ 4,629 ========== ========== Net spread (4) 3.90 % 3.44 % Net margin (5) 4.03 % 3.59 % Ratio of average interest-earning assets to average interest-bearing liabilities 1.06X 1.06X 1. Annualized. 2. Average balances include non-accrual loans and loans held for sale. 3. Includes interest-bearing deposits in other financial institutions. 4. Net spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. 5. Net margin represents net interest income as a percentage of interest-earning assets. Net Income The Corporation recorded net income of $1.0 million for the three months ended June 30, 2004, as compared to net income of $1.6 million for the three months ended June 30, 2003. This decrease in net income was $625,000 or 38.4%. The decrease in net income for third quarter 2004 was primarily the result of a decrease in noninterest income and an increased provision for loan losses. Net interest income increased $254,000 in the third quarter of fiscal 2004, an increase of 5.5% over third quarter 2003. The increase in net interest income was primarily due to a 64 basis point reduction in cost of funds, offset by an 18 basis point decline in yields on interest earning assets. The mix of the Bank's deposits helped to stabilize its cost of funds in this lower interest rate environment. Noninterest income was 47.3% and 60.8% of noninterest expense for the quarters ended June 30, 2004 and 2003, respectively. 12 Total Interest Income Total interest income decreased by $712,000 to $7.5 million for the quarter ended June 30, 2004 from the comparable 2003 period. The average yield on loans decreased to 7.05% for the quarter ended June 30, 2004 from 7.43% for the quarter ended June 30, 2003. During the same period, the average yield on mortgage-backed securities increased 27 basis points to 4.14%. The average yield on investment securities decreased to 1.45% for the three months ended June 30, 2004 from 2.05% for the same period in 2003. Total Interest Expense Total interest expense decreased to $2.6 million for the three months ended June 30, 2004 from $3.5 million for the same period in 2003. The average cost of deposits decreased 64 basis points to 1.68% for the quarter ended June 30, 2004 from 2.32% for the same period in 2003, as the rates offered by the Bank on deposits decreased. No assurance can be made that deposits can be maintained in the future without further increasing the cost of funds if interest rates continue to increase. The average balance of borrowings decreased $21.0 million to $72.0 million for the three months ended June 30, 2004 from $93.0 million for the three months ended June 30, 2003. The cost of borrowings remained the same at 5.40% for the quarter ended June 30, 2004. Borrowings decreased as the Bank utilized repayments of loans and investments to meet liquidity needs. Net Interest Income Net interest income increased by $254,000 to $4.9 million for the quarter ended June 30, 2004, from $4.6 million for the same period in 2003. Average interest-earning assets decreased $30.8 million from $515.1 million for the quarter ended June 30, 2003 to $484.3 million for the quarter ended June 30, 2004, while the average yield on interest-earning assets decreased from 6.35% for 2003 to 6.17% for 2004. Average interest-bearing liabilities decreased by $32.3 million to $455.6 million for the quarter ended June 30, 2004 from $487.9 million for the quarter ended June 30, 2003, while the cost of interest-bearing liabilities decreased from 2.91% in 2003 to 2.27% in 2004. Provision for Loan Losses The Corporation's provision for loan losses was $755,000 for the quarter ended June 30, 2004, compared to $305,000 for the same period in 2003. The allowance for loan losses is established through a provision for loan losses charged to expense. While the Corporation maintains its allowance for losses at a level which it considers necessary to reflect probable incurred losses, there can be no assurance that further additions will not be made to the loss allowances or that such losses will not exceed the estimated amounts. The increase was primarily due to a $300,000 valuation allowance for an agricultural credit and a $200,000 valuation allowance on a commercial building that were required due to impairment analysis. (See Allowance for Loan Losses Table on page 16.) Noninterest Income Total noninterest income decreased from $2.8 million for the quarter ended June 30, 2003 to $2.3 million for the quarter ended June 30, 2004. Gain on sale of loans decreased $497,000 over the same period in 2003 primarily due to a decrease in the refinancing market and loans that are sold in the secondary market. Other service charges and fees decreased from $461,000 for the three months ended June 30, 2003 to $437,000 for the same period ended June 30, 2004, which was mainly attributable to a decrease in servicing and late fees as the outstanding loan portfolio balance has decreased in the periods compared and also a reduction in the application fees related to a reduction in loan originations. Service charges on deposit accounts remained the same for the periods compared. Noninterest Expense Total noninterest expense increased $260,000 from June 30, 2003 as compared to the same period in 2004. Compensation and benefits remained at $2.8 million for the periods compared. Occupancy and equipment expense increased $53,000 over the periods compared. This increase was mainly attributable to an increase in amortization and depreciation expense on software and computer updates as the Bank continues to enhance its data systems. Professional expense increased $146,000 over the periods compared due primarily to the increased costs in the previously announced proposed merger of the Corporation with MidCountry Financial Corp. Income Tax Expense Income taxes decreased to $567,000 for the quarter ended June 30, 2004 from $894,000 for the same period in 2003 due to a decrease of $952,000 in pretax income. 13 Comparison of the Nine Months Ended June 30, 2004 and 2003 The following table sets forth information with respect to the Corporation's average balance sheet, interest and dividends earned and paid and related yields and rates (dollars in thousands): Nine Months Ended June 30, ------------------------------------------------------------------------------- 2004 2003 ------------------------------------------------------------------------------- Interest Interest Average Yields & Average Yields & Balance Interest Rates (1) Balance Interest Rates (1) ------------------------------------------------------------------------------- (dollars in thousands) Assets: Loans receivable (2) $ 373,581 $ 20,137 7.19 % $ 409,417 $23,304 7.59 % Mortgage-backed securities 41,907 1,306 4.16 43,653 1,347 4.11 Investment securities (3) 75,909 874 1.54 61,912 1,019 2.19 ------------------------ ------------------------ Total interest-earning assets 491,397 22,317 6.06 514,982 25,670 6.65 ----------------------- ------------------------ Other assets 30,111 29,426 ------------- ------------ Total assets $ 521,508 $ 544,408 ============= ============ Liabilities: Interest-bearing deposits $ 384,748 $ 5,166 1.79 % $ 395,368 $ 7,485 2.52 % Borrowings 78,843 3,201 5.41 93,934 3,818 5.42 ------------------------ ------------------------ Total interest-bearing liabilities 463,591 8,367 2.41 489,302 11,303 3.08 ----------------------- ------------------------ Other liabilities 5,936 6,988 ------------- ------------ Total liabilities 469,527 496,290 Stockholders' equity 51,981 48,118 ------------- ------------ Total liabilities and stockholders' equity $ 521,508 $ 544,408 ============= ============ Net interest income $ 13,950 $14,367 =========== ============ Net spread (4) 3.65 % 3.57 % Net margin (5) 3.79 % 3.72 % Ratio of average interest-earning assets to average interest-bearing liabilities 1.06X 1.05X 1. Annualized. 2. Average balances include non-accrual loans and loans held for sale. 3. Includes interest-bearing deposits in other financial institutions. 4. Net spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. 5. Net margin represents net interest income as a percentage of interest-earning assets. Net Income The Corporation recorded net income of $3.2 million for the nine months ended June 30, 2004, as compared to net income of $4.9 million for the nine months ended June 30, 2003. This decrease in net income was $1.7 million or 35.4%. The decrease in net income for the nine-month period was primarily the result of a decrease in net interest income and noninterest income. Net interest income decreased $417,000 for the nine months ended June 30, 2004, a decrease of 2.9% over the same period in 2003. The decrease in net interest income was primarily due to a 59 basis point decline in yields on interest earning assets offset by a 67 basis point reduction on cost of funds. The mix of the Bank's deposits helped to stabilize its cost of funds in this lower interest rate environment. Noninterest income was 47.9% and 58.8% of noninterest expense for the nine months ended June 30, 2004 and 2003, respectively. 14 Total Interest Income Total interest income decreased by $3.4 million to $22.3 million for the nine months ended June 30, 2004 from the comparable 2003 period. The average yield on loans decreased to 7.19% for the nine months ended June 30, 2004 from 7.59% for the nine months ended June 30, 2003. During the same period, the average yield on mortgage-backed securities increased 5 basis points to 4.16%. The average yield on investment securities decreased to 1.54% for the nine months ended June 30, 2004 from 2.19% for the same period in 2003. Total Interest Expense Total interest expense decreased to $8.4 million for the nine months ended June 30, 2004 from $11.3 million for the same period in 2003. The average cost of deposits decreased 73 basis points to 1.79% for the nine months ended June 30, 2004 from 2.52% for the same period in 2003, as the rates offered by the Bank on deposits decreased. No assurance can be made that deposits can be maintained in the future without increasing the cost of funds if interest rates increase. The average balance of borrowings decreased $15.1 million to $78.8 million for the nine months ended June 30, 2004 from $93.9 million for the nine months ended June 30, 2003. The cost of borrowings decreased one basis point to 5.41% for the nine months ended June 30, 2004 from 5.42% for the same period in 2003. Borrowings decreased as the Bank utilized repayments of loans and investments to meet liquidity needs. Net Interest Income Net interest income decreased by $417,000 to $14.0 million for the nine months ended June 30, 2004, from $14.4 million for the same period in 2003. Average interest-earning assets decreased $23.6 million from $515.0 million for the nine months ended June 30, 2003 to $491.4 million for the nine months ended June 30, 2004, while the average yield on interest-earning assets decreased from 6.65% for 2003 to 6.06% for 2004. Average interest-bearing liabilities decreased by $25.7 million to $463.6 million for the nine months ended June 30, 2004 from $489.3 million for the nine months ended June 30, 2003, while the cost of interest-bearing liabilities decreased from 3.08% in 2003 to 2.41% in 2004. Provision for Loan Losses The Corporation's provision for loan losses was $1.5 million for the nine months ended June 30, 2004, compared to $786,000 for the same period in 2003. The allowance for loan losses is established through a provision for loan losses charged to expense. While the Corporation maintains its allowance for losses at a level which it considers necessary to reflect probable incurred losses, there can be no assurance that further additions will not be made to the loss allowances or that such losses will not exceed the estimated amounts. (See Provision for Loan Losses for the Three Months Ended June 30, 2004 discussion on page 13 and also the Allowance for Loan Losses Table on page 16). 15 The following table sets forth information with respect to the Bank's allowance for loan losses at the dates indicated: For the Nine Months Ended June 30, ---------------------------------------- 2004 2003 ---------------------------------------- (dollars in thousands) Average loans outstanding $ 373,581 $ 409,417 ---------------------------------------- Allowance balance (beginning of period) $ 1,701 $ 1,681 ---------------------------------------- Provision: Residential and construction 690 568 Land and commercial real estate 203 - Commercial and agricultural business 590 167 Consumer - 51 ---------------------------------------- Total provision 1,483 786 Charge-offs: Residential and construction 626 431 Land and commercial real estate 204 73 Commercial and agricultural business 590 160 Consumer 205 257 ---------------------------------------- Total charge-offs 1,625 921 Recoveries: Residential and construction 33 - Land and commercial real estate - - Consumer 60 70 ---------------------------------------- Total recoveries 93 70 ---------------------------------------- Net charge-offs 1,532 851 ---------------------------------------- Allowance balance (end of period) $ 1,652 $ 1,616 ======================================== Allowance as percent of net loans 0.43% 0.41% Net loans charged off as a percent of average 0.41% 0.21% loans Noninterest Income Total noninterest income decreased from $8.0 million for the nine months ended June 30, 2003 to $6.7 million for the nine months ended June 30, 2004. Gain on sale of loans decreased $1.5 million over the same period in 2003 primarily due to a decrease in the refinancing market and loans that are sold in the secondary market. Other service charges and fees decreased from $1.3 million for the nine months ended June 30, 2003 to $1.1 million for the same period ended June 30, 2004, which was mainly attributable to a decrease in servicing and late fees as the outstanding loan portfolio balance has decreased in the periods compared and a reduction in application fees related to a reduction in loan originations. Service charges on deposit accounts decreased $24,000. Net gains on sale of available-for-sale securities totaled $284,000 for the nine-month period as the Bank sold its equity securities and various debt securities. Noninterest Expense Total noninterest expense increased $315,000 from June 30, 2003 as compared to the same period in 2004. Compensation and benefits decreased $171,000 for the periods compared. Occupancy and equipment expense increased $217,000 over the periods compared. This increase was mainly attributable to an increase in amortization and depreciation expense on software and computer updates as the Bank continues to enhance its data systems. Professional expense increased $157,000 over the periods compared due primarily to the increased costs in the previously announced proposed merger of the Corporation with MidCountry Financial Corp. Income Tax Expense Income taxes decreased to $2.0 million for the nine months ended June 30, 2004 from $3.0 million for the same period in 2003 due to a decrease of $2.8 million in pretax income. 16 LIQUIDITY AND CAPITAL RESOURCES The Corporation's primary sources of funds are deposits, borrowings, principal and interest payments on loans, investments and mortgage-backed securities, sales of mortgage loans and funds provided by operations. While scheduled payments on loans, mortgage-backed securities and short-term investments are relatively predictable sources of funds, deposit flows and early loan repayments are greatly influenced by general interest rates, economic conditions and competition. The amount of certificate accounts that are scheduled to mature during the twelve months ending June 30, 2005 is approximately $172.4 million. To the extent that these deposits do not remain upon maturity, the Bank believes that it can replace these funds with new deposits, excess liquidity and FHLB advances or outside borrowings. It has been the Bank's experience that substantial portions of such maturing deposits remain at the Bank. The following table presents, as of June 30, 2004, the Corporation's significant fixed and determinable contractual obligations by payment date. The payment amount represents those amounts contractually due to the recipient and does not include any unamortized premiums or discounts or other similar carrying amount adjustments. (in thousands) -------------------------------------------------------- One One to Over Year or Three Three Less Years Years Total -------------------------------------------------------- Long-Term Debt FHLB borrowings $ - $ 10,000 $ 62,000 $ 72,000 ======================================================== Other Contractual Obligations Non-cancelable operating leases $ 362 $ 696 $ 104 $ 1,162 Unused lines of credit 40,971 - - 40,971 Standby letters of credit 302 - - 302 Development letters of credit 6,595 - - 6,595 Commitments to sell loans 19,128 - - 19,128 Commitments to extend credit 2,349 - - 2,349 OTS regulations require the Bank to maintain core capital of 4.0% of assets, of which 2.0% must be tangible equity capital, excluding goodwill. The Bank is also required to maintain risk-based capital equal to 8.0% of total risk-based assets. The Bank's regulatory capital exceeded its tangible equity, tier 1 (risk-based), tier 1 (core) and risk-based capital requirements by 7.7%, 9.2%, 5.2% and 5.8%, respectively. Management believes that under current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future. Events beyond the control of the Bank, such as increased interest rates or a downturn in the economy in areas in which the Bank operates, could adversely affect future earnings and, as a result, the ability of the Bank to meet its future minimum capital requirements. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes from the information regarding market risk disclosed under the heading "Asset and Liability Management" in the Corporation's Annual Report for the year ended September 30, 2003. 17 CONTROLS AND PROCEDURES The Corporation's management evaluated, with the participation of the Corporation's Chief Executive Officer and Chief Financial Officer, the effectiveness of the Corporation's disclosure controls and procedures, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Corporation in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no changes in the Corporation's internal control over financial reporting that occurred during the Corporation's last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting. 18 ITEM 1. LEGAL PROCEEDINGS Neither the Corporation nor any of its subsidiaries were engaged in any legal proceedings of a material nature at June 30, 2004. From time to time, the Corporation is a party to legal proceedings in the ordinary course of business wherein it enforces its security interest in loans. ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION (a) Not applicable. (b) Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed as part of this report. 3.1 Articles of Incorporation of FSF Financial Corp. * 3.2 Bylaws of FSF Financial Corp. * 4.0 Stock Certificate of FSF Financial Corp. * 10.1 Form of Employment Agreement with Donald A. Glas, George B. Loban and Richard H. Burgart * 10.2 First Federal fsb Management Stock Plan ** 10.3 FSF Financial Corp. 1996 Stock Option Plan ** 10.4 FSF Financial Corp. 1998 Stock Compensation Plan *** 31.0 Rule 13a-14(a) Certifications 32.0 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K (i) The Corporation furnished a current report on Form 8-K on April 21, 2004 pursuant to items 7 and 12 to report operating results for the quarter ended March 31, 2004. (ii) The Corporation furnished a current report on Form 8-K on May 18, 2004 pursuant to items 5 and 7 to report the execution of a merger agreement whereby MidCountry Financial Corp. will acquire the Company. - -------------------------------------------------------------------------------- * Incorporated herein by reference into this document from the Exhibits to Form S-1, Registration Statement initially filed with the Commission on June 1, 1994. Registration No. 33-79570. ** Incorporated herein by reference into this document from the Registrant's Proxy Statement for the Annual Meeting of Stockholders held on January 17, 1996 and filed with the Commission on December 13, 1995. *** Incorporated herein by reference into this document from the Registrant's Proxy Statement for the Annual Meeting of Stockholders held on January 20, 1998 and filed with the Commission on December 10, 1997. 19 FSF FINANCIAL CORP. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FSF FINANCIAL CORP. Date: July 30, 2004 By: /s/ Donald A. Glas - --------------------- ------------------------------- Donald A. Glas Chief Executive Officer Date: July 30, 2004 By: /s/ Richard H. Burgart - --------------------- ------------------------------- Richard H. Burgart Chief Financial Officer 20