================================================================================
UNITED STATES
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 the quarterly period ended March 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) FOR THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________
Commission File Number 0-24100
HMN FINANCIAL, INC.
(Exact name of Registrant as specified in its Charter)
Delaware 41-1777397
- --------------------------------------------------------------------- ------------------------------------------------
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)
1016 Civic Center Drive N.W., Rochester, MN 55901
- --------------------------------------------------------------------- ------------------------------------------------
(Address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (507) 535-1200
------------------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes (X) No ( )
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer |_| Accelerated filer [X] Non-accelerated filer |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes ( ) No (X)
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
Class Outstanding at April 19, 2006
- ----------------------------------- -----------------------------------
Common stock, $0.01 par value 4,412,964
================================================================================
HMN FINANCIAL, INC.
CONTENTS
<Table>
<Caption>
PART I -- FINANCIAL INFORMATION
Page
Item 1: Financial Statements (unaudited)
Consolidated Balance Sheets at March 31, 2006 and December 31, 2005 3
Consolidated Statements of Income for the Three Months Ended March 31,
2006 and 2005 4
Consolidated Statement of Stockholders' Equity and Comprehensive Income
for the Three Month Period Ended March 31, 2006 5
Consolidated Statements of Cash Flows for the Three Months Ended 6
March 31, 2006 and 2005
Notes to Consolidated Financial Statements 7
Item 2: Management's Discussion and Analysis of Financial Condition and Results of
Operations 14
Item 3: Quantitative and Qualitative Disclosures about Market Risk Discussion
included in Item 2 under Market Risk 19
Item 4: Controls and Procedures 21
PART II -- OTHER INFORMATION
Item 1: Legal Proceedings 22
Item 1A: Risk Factors 22
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 22
Item 3: Defaults Upon Senior Securities 22
Item 4: Submission of Matters to a Vote of Security Holders 22
Item 5: Other Information 22
Item 6: Exhibits 22
Signatures 23
</Table>
2
PART I -- FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------------------------
March 31, December 31,
2006 2005
- ---------------------------------------------------------------------------------------------------------------------
(unaudited)
ASSETS
Cash and cash equivalents.......................................... $ 55,132,473 47,268,795
Securities available for sale, at fair value:
Mortgage-backed and related securities
(amortized cost $7,254,122 and $7,428,504).................... 6,697,944 6,879,756
Other marketable securities
(amortized cost $118,117,448 and $113,749,841)............... 117,384,344 112,778,813
----------------- ------------------
124,082,288 119,658,569
----------------- ------------------
Loans held for sale................................................ 5,011,272 1,435,141
Loans receivable, net.............................................. 767,880,982 785,678,461
Accrued interest receivable........................................ 4,817,953 4,460,014
Real estate, net................................................... 1,174,315 1,214,621
Federal Home Loan Bank stock, at cost.............................. 8,364,600 8,364,600
Mortgage servicing rights, net..................................... 2,484,849 2,653,635
Premises and equipment, net........................................ 12,304,743 11,941,863
Investment in limited partnerships................................. 134,548 141,048
Goodwill........................................................... 3,800,938 3,800,938
Core deposit intangible, net....................................... 191,296 219,760
Prepaid expenses and other assets.................................. 2,150,332 1,854,948
Deferred tax asset................................................. 2,453,100 2,544,400
----------------- ------------------
Total assets................................................... $ 989,983,689 991,236,793
================= ==================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits........................................................... $ 727,466,404 731,536,560
Federal Home Loan Bank advances.................................... 160,900,000 160,900,000
Accrued interest payable........................................... 1,859,576 2,085,573
Advance payments by borrowers for taxes and insurance.............. 1,070,637 1,038,575
Accrued expenses and other liabilities............................. 6,040,754 4,947,816
----------------- ------------------
Total liabilities.............................................. 897,337,371 900,508,524
----------------- ------------------
Commitments and contingencies
Stockholders' equity:
Serial preferred stock ($.01 par value):
Authorized 500,000 shares; issued and outstanding none....... 0 0
Common stock ($.01 par value):
Authorized 11,000,000; issued shares 9,128,662............... 91,287 91,287
Additional paid-in capital......................................... 57,564,482 58,011,099
Retained earnings, subject to certain restrictions................. 100,763,377 98,951,777
Accumulated other comprehensive loss............................... (778,382) (917,577)
Unearned employee stock ownership plan shares...................... (4,302,642) (4,350,999)
Unearned compensation restricted stock awards...................... 0 (182,521)
Treasury stock, at cost 4,715,698 and 4,721,402 shares............. (60,691,804) (60,874,797)
----------------- ------------------
Total stockholders' equity..................................... 92,646,318 90,728,269
----------------- ------------------
Total liabilities and stockholders' equity......................... $ 989,983,689 991,236,793
================= ==================
- ---------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
3
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
- -----------------------------------------------------------------------------------------------------------------------
Three Months Ended
March 31,
2006 2005
- -----------------------------------------------------------------------------------------------------------------------
Interest income:
Loans receivable................................................ $ 14,702,780 13,333,019
Securities available for sale:
Mortgage-backed and related................................. 70,562 89,768
Other marketable............................................ 889,631 641,756
Cash equivalents................................................ 256,426 52,269
Other........................................................... 62,821 79,528
--------------- ------------
Total interest income....................................... 15,982,220 14,196,340
--------------- ------------
Interest expense:
Deposits........................................................ 4,867,681 3,702,631
Federal Home Loan Bank advances ................................ 1,725,856 1,822,691
--------------- ------------
Total interest expense....................................... 6,593,537 5,525,322
--------------- ------------
Net interest income.......................................... 9,388,683 8,671,018
Provision for loan losses............................................ 515,000 636,000
--------------- ------------
Net interest income after provision for loan losses.......... 8,873,683 8,035,018
--------------- ------------
Non-interest income:
Fees and service charges........................................ 714,778 602,597
Mortgage servicing fees......................................... 303,675 292,980
Gain on sales of loans.......................................... 245,977 293,316
Losses in limited partnerships.................................. (6,500) (7,710)
Other........................................................... 228,404 245,548
--------------- ------------
Total non-interest income.................................... 1,486,334 1,426,731
--------------- ------------
Non-interest expense:
Compensation and benefits...................................... 3,258,871 2,774,104
Occupancy....................................................... 1,100,292 995,254
Deposit insurance premiums...................................... 31,197 27,906
Advertising..................................................... 130,658 83,908
Data processing................................................. 288,715 237,488
Amortization of mortgage servicing rights, net.................. 216,540 239,033
Other........................................................... 913,138 932,692
--------------- ------------
Total non-interest expense................................... 5,939,411 5,290,385
--------------- ------------
Income before income tax expense............................. 4,420,606 4,171,364
Income tax expense.................................................... 1,680,200 1,356,300
--------------- ------------
Net income................................................... 2,740,406 2,815,064
=============== ============
Basic earnings per share............................................. $ 0.71 0.74
=============== ============
Diluted earnings per share........................................... $ 0.68 0.70
=============== ============
- -----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
4
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2006
(unaudited)
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------------------------------------------
Unearned
Employee Unearned
Accumulated Stock Compensation Total
Additional Other Ownership Restricted Stock-
Common Paid-in Retained Comprehensive Plan Stock Treasury Holders'
Stock Capital Earnings Income Shares Awards Stock Equity
(Loss)
-------------------------------------------------------------------------------------------
Balance, December 31, 2005 $91,287 58,011,099 98,951,777 (917,577) (4,350,999) (182,521) (60,874,797) 90,728,269
Net income 2,740,406 2,740,406
Other comprehensive income, net of
tax:
Net unrealized losses on securities
available for sale 139,195 139,195
-----------
Total comprehensive income 2,879,601
Purchase of treasury stock (323,000) (323,000)
Employee stock options exercised (119,812) 168,800 48,988
Tax benefits of exercised stock 47,648 47,648
options
Unearned compensation restricted (337,193) 337,193 0
stock awards
Stock option compensation 16,106 16,106
Reclassification of restricted stock (182,521) 182,521
equity
Amortization of restricted stock 40,653 40,653
awards
Dividends paid (928,806) (928,806)
Earned employee stock ownership plan 88,502 48,357 136,859
shares
-------------------------------------------------------------------------------------------
Balance, March 31, 2006 $91,287 57,564,482 100,763,377 (778,382) (4,302,642) 0 (60,691,804) 92,646,318
===========================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
5
HMN FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
<Table>
<Caption>
- -----------------------------------------------------------------------------------------------------------------
Three Months Ended
March 31,
-------------------------------
2006 2005
---------------- -------------
Cash flows from operating activities:
Net income................................................................. $ 2,740,406 2,815,064
Adjustments to reconcile net income to cash provided by operating
activities:
Provision for loan losses................................................ 515,000 636,000
Depreciation............................................................. 468,791 431,856
Amortization of discounts, net........................................... (391,650) (143,378)
Amortization of deferred loan fees....................................... (367,847) (208,343)
Amortization of core deposit intangible.................................. 28,464 28,464
Amortization of mortgage servicing rights and servicing costs............ 216,540 239,033
Capitalized mortgage servicing rights.................................... (47,754) (144,872)
Gain on sales of real estate............................................. (1,430) (5,640)
Gain on sales of loans................................................... (245,977) (293,316)
Proceeds from sales of real estate....................................... 41,430 39,141
Proceeds from sale of loans held for sale................................ 14,785,405 14,093,471
Disbursements on loans held for sale..................................... (17,268,774) (12,599,099)
Amortization of restricted stock awards.................................. 40,653 18,140
Amortization of unearned ESOP shares..................................... 48,357 48,357
Earned employee stock ownership shares priced above original cost........ 88,502 94,237
Increase in accrued interest receivable.................................. (357,939) (787,954)
Increase (decrease) in accrued interest payable.......................... (225,997) 629,045
Equity losses of limited partnerships.................................... 6,500 7,710
Decrease (increase) in other assets...................................... (213,215) 309,168
Increase in other liabilities............................................ 1,055,936 156,495
Other, net............................................................... 317 486
---------------- -------------
Net cash provided by operating activities.............................. 915,718 5,364,065
---------------- -------------
Cash flows from investing activities:
Principal collected on securities available for sale....................... 172,868 475,599
Proceeds collected on maturities of securities available for sale.......... 30,500,000 8,000,000
Purchases of securities available for sale................................. (34,604,906) (4,991,400)
Purchases of Federal Home Loan Bank Stock.................................. 0 (973,500)
Redemption of Federal Home Loan Bank Stock................................. 0 1,568,700
Net decrease (increase) in loans receivable................................ 16,805,805 (31,416,483)
Purchases of premises and equipment........................................ (831,671) (454,456)
---------------- -------------
Net cash provided (used) in investing activities........................ 12,042,096 (27,791,540)
----------------- ------------
Cash flows from financing activities:
Increase (decrease) in deposits............................................ (3,939,486) 29,040,952
Purchase of treasury stock................................................. (323,000) (972,000)
Stock options exercised.................................................... 48,988 24,887
Stock option compensation ................................................. 16,106 0
Dividends to stockholders.................................................. (928,806) (842,426)
Proceeds from Federal Home Loan Bank advances.............................. 0 39,000,000
Repayment of Federal Home Loan Bank advances............................... 0 (39,000,000)
Proceeds from Federal Reserve Bank advances................................ 1,000,000 0
Repayment of Federal Reserve Bank advances................................. (1,000,000) 0
Increase in advance payments by borrowers for taxes and insurance.......... 32,062 218,019
---------------- -------------
Net cash provided (used) by financing activities........................ (5,094,136) 27,469,432
---------------- -------------
Increase in cash and cash equivalents................................... 7,863,678 5,041,957
Cash and cash equivalents, beginning of period................................ 47,268,795 34,298,394
---------------- -------------
Cash and cash equivalents, end of period...................................... $ 55,132,473 39,340,351
================ =============
Supplemental cash flow disclosures:
Cash paid for interest..................................................... $ 6,819,534 4,896,277
Cash paid for income taxes................................................. 1,676,278 237,000
Supplemental noncash flow disclosures:
Transfer of loans to real estate........................................... 0 952,252
Loans transferred to loans held for sale................................... 844,304 0
- -----------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
6
HMN FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
MARCH 31, 2006 AND 2005
(1) HMN FINANCIAL, INC.
HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company
that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a
community banking philosophy and operates retail banking and loan production
offices in Minnesota and Iowa. The Bank has one wholly owned subsidiary, Osterud
Insurance Agency, Inc. (OIA) which offers financial planning products and
services. HMN has another wholly owned subsidiary, Security Finance Corporation
(SFC) which acts as an intermediary for the Bank in transacting like-kind
property exchanges for Bank customers. During the 2005 period for which
financial information is presented in this Form 10-Q, the Bank had one other
subsidiary that is no longer operating. Home Federal Holding, Inc. (HFH), a
wholly owned subsidiary, was the holding company for Home Federal REIT, Inc.
(HFREIT) which invested in real estate loans acquired from the Bank. HFH and
HFREIT were both dissolved in 2005.
The consolidated financial statements included herein are for HMN, SFC, the Bank
and the Bank's consolidated entities as described above. All significant
intercompany accounts and transactions have been eliminated in consolidation.
(2) BASIS OF PREPARATION
The accompanying unaudited consolidated financial statements were prepared in
accordance with instructions for Form 10-Q and therefore, do not include all
disclosures necessary for a complete presentation of the consolidated balance
sheets, consolidated statements of income, consolidated statement of
stockholders' equity and consolidated statements of cash flows in conformity
with generally accepted accounting principles. However, all normal recurring
adjustments which are, in the opinion of management, necessary for the fair
presentation of the interim financial statements have been included. The
statement of income for the three-month period ended March 31, 2006 is not
necessarily indicative of the results which may be expected for the entire year.
Certain amounts in the consolidated financial statements for prior periods have
been reclassified to conform with the current period presentation.
(3) NEW ACCOUNTING STANDARDS
As of January 1, 2006, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) which
requires companies to recognize in compensation expense the grant-date fair
value of stock awards issued. The Company adopted FAS 123R using the modified
prospective transition method. In accordance with the modified prospective
transition method, the Company's Consolidated Financial Statements for prior
periods have not been restated to reflect the impact of FAS 123R. As a result of
applying FAS 123R, the Company recognized share-based compensation expense of
$16,100 for the three months ended March 31, 2006 (for additional information
see Note 12).
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 156, Accounting for Servicing of
Financial Assets -- an amendment of FASB Statement No. 140. Effective as of the
beginning of an entity's first fiscal year that begins after September 15, 2006,
an entity is required to recognize a servicing asset or liability each time it
undertakes an obligation to service a financial asset. SFAS No. 156 requires
that all separately recognized servicing assets and liabilities be initially
measured at fair value and permits, but does not require, the subsequent
measurement of servicing assets and liabilities at fair value. It also permits a
one-time reclassification, at the time of initial adoption, of
available-for-sale securities to trading securities by entities with recognized
servicing rights, without calling into question the treatment of other
available-for-sale securities under Statement 115, provided that the
available-for-sale securities are identified in some manner as offsetting the
entity's exposure to changes in the fair value of servicing assets or
liabilities that a servicer elects to subsequently measure at
7
fair value. Separate presentation of servicing assets and liabilities
subsequently measured at fair value are required to be disclosed in the
statement of financial position. The impact of adopting SFAS No. 156 in the
first quarter of 2007 is not anticipated to have a material impact on the
Company's financial condition or results of operations.
(4) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company has commitments outstanding to extend credit to future borrowers
that had not closed prior to the end of the quarter. The Company intends to sell
these commitments which are referred to as its mortgage pipeline. As commitments
to originate or purchase loans enter the mortgage pipeline, the Company
generally enters into commitments to sell the mortgage pipeline into the
secondary market on a firm commitment or best efforts basis. The commitments to
originate, purchase or sell loans on a firm commitment basis are derivatives. As
a result of marking to market the mortgage pipeline and the related firm
commitments to sell for the period ended March 31, 2006, the Company recorded an
increase in other assets of $9,403 and an increase in other liabilities of
$84,650 and a loss included in the gain on sales of loans of $75,247.
The current commitments to sell loans held for sale are derivatives that do not
qualify for hedge accounting. As a result, these derivatives are marked to
market and the related loans held for sale are recorded at the lower of cost or
market. The Company recorded a decrease in loans held for sale of $72,766 and an
increase in other assets of $72,766 due to the mark to market adjustment on the
commitments to sell loans held for sale.
(5) COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity during a period from
transactions and other events from nonowner sources. Comprehensive income is the
total of net income and other comprehensive income, which for the Company is
comprised of unrealized gains and losses on securities available for sale. The
components of other comprehensive income and the related tax effects were as
follows:
<Table>
<Caption>
For the period ended March 31,
--------------------------------------------------------------------------------------
(Dollars in thousands) 2006 2005
----------------------------------------- ----------------------------------------
Securities available for sale: Before tax Tax effect Net of tax Before tax Tax effect Net of tax
------------ ---------- ----------- ---------- ----------- ----------
Net unrealized gains
(losses) arising during
the period $ 230 91 139 (759) (268) (491)
------------ ---------- ----------- ---------- ----------- ----------
Other comprehensive income $ 230 91 139 (759) (268) (491)
============ ========== =========== ========== =========== ==========
</Table>
(6) SECURITIES AVAILABLE FOR SALE
The following table shows the securities available for sale portfolio's gross
unrealized losses and fair value, aggregated by investment category and length
of time that individual securities have been in a continuous loss position, at
March 31, 2006. The Company has reviewed these securities and has concluded that
the unrealized losses are temporary and no other-than-temporary impairment has
occurred at March 31, 2006.
<Table>
<Caption>
Less than twelve months Twelve months or more Total
---------------------------------- --------------------------------- ----------------------
# of Fair Unrealized # of Fair Unrealized Fair Unrealized
(Dollars in thousands) Investments Value Losses Investments Value Losses Value Losses
---------------------------------- --------------------------------- -----------------------
Mortgage backed
securities:
FHLMC 0 $ 0 0 2 $ 2,821 (292) 2,821 (292)
FNMA 1 364 (18) 2 3,148 (251) 3,512 (269)
Other marketable debt
securities:
FNMA 4 19,832 (31) 3 14,897 (95) 34,729 (126)
FHLMC 1 4,878 (12) 4 19,795 (195) 24,673 (207)
FHLB 1 4,992 (6) 7 34,556 (443) 39,548 (449)
---------- ------------ ---------- ---------- ---------- ---------- ---------- ----------
Total temporarily
impaired securities 7 $ 30,066 (67) 18 $75,217 (1,276) 105,283 (1,343)
========== ============ ========== ========== ========== ========== ========== ==========
These fixed rate investments are temporarily impaired due to changes in interest
rates and the Company has the ability and intent to hold to maturity or until
the temporary loss is recovered. Mortgage backed securities in the table above
had an average life of less than four years and the other marketable securities
had an average life of less than one year at March 31, 2006.
8
(7) INVESTMENT IN MORTGAGE SERVICING RIGHTS
A summary of mortgage servicing activity is as follows:
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------
Three months Twelve months Three months
ended ended ended
March 31, 2006 December 31, 2005 March 31, 2005
- ------------------------------------------------------------------------------------------------
Mortgage servicing rights:
Balance, beginning of period........ $ 2,653,635 3,231,242 3,231,242
Originations........................ 47,754 442,159 144,872
Amortization........................ (216,540) (1,019,766) (239,033)
------------- ------------- ------------
Balance, end of period.............. 2,484,849 2,653,635 3,137,081
------------- ------------- ------------
Mortgage servicing rights, net...... $ 2,484,849 2,653,635 3,137,081
============= ============= ============
Fair value of mortgage servicing
rights................................ $ 4,419,868 4,598,931 4,644,284
============= ============= ============
- ------------------------------------------------------------------------------------------------
</Table>
All of the loans being serviced were single family loans serviced for the
Federal National Mortgage Association (FNMA) under the mortgage-backed security
program or the individual loan sale program. The following is a summary of the
risk characteristics of the loans being serviced at March 31, 2006.
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------------
Weighted
Loan Weighted Average
Principal Average Remaining Number
Balance Interest Rate Term of Loans
--------------- --------------- ------------- ----------
Original term 30 year fixed rate $ 209,943,413 5.90 % 328 1,845
Original term 15 year fixed rate 200,244,090 5.28 % 137 2,580
Adjustable rate 5,185,170 5.37 % 318 51
- ---------------------------------------------------------------------------------------------------------
</Table>
(8) INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated
amortization at March 31, 2006 is presented in the table below. Amortization
expense for intangible assets was $245,004 for the period ended March 31, 2006.
<Table>
<Caption>
- --------------------------------------------------------------------------------------------------------------------
Gross Unamortized
Carrying Accumulated Valuation Intangible
Amount Amortization Adjustment Assets
- --------------------------------------------------------------------------------------------------------------------
Amortized intangible assets:
Mortgage servicing rights $ 4,361,030 (1,876,181) 0 2,484,849
Core deposit intangible 1,567,000 (1,375,704) 0 191,296
--------------- --------------- --------------- ---------------
Total $ 5,928,030 (3,251,885) 0 2,676,145
=============== =============== =============== ===============
The following table indicates the estimated future amortization expense for
amortized intangible assets:
<Table>
<Caption>
------------------------------------------------------------------------------------------------------
Mortgage Core
Servicing Deposit
Rights Intangible Total
------------------------------------------------------------------------------------------------------
Year ended December 31,
2006 325,438 85,393 410,831
2007 375,907 105,903 481,810
2008 318,387 0 318,387
2009 269,182 0 269,182
2010 227,124 0 227,124
------------------------------------------------------------------------------------------------------
9
Projections of amortization are based on existing asset balances and the
existing interest rate environment as of March 31, 2006. The Company's actual
experience may be significantly different depending upon changes in mortgage
interest rates and other market conditions.
(9) EARNINGS PER SHARE
The following table reconciles the weighted average shares outstanding and the
income available to common shareholders used for basic and diluted EPS:
<Table>
<Caption>
- ------------------------------------------------------------------------------------------
Three months ended March 31,
2006 2005
------------- ---------------
Weighted average number of common shares outstanding
used in basic earnings per common share calculation 3,839,874 3,824,857
Net dilutive effect of:
Options 168,074 173,788
Restricted stock awards 12,877 7,014
------------- ---------------
Weighted average number of shares outstanding
adjusted for effect of dilutive securities 4,020,825 4,005,659
============= ===============
Income available to common shareholders $ 2,740,406 2,815,064
Basic earnings per common share $ 0.71 0.74
Diluted earnings per common share $ 0.68 0.70
- ------------------------------------------------------------------------------------------
(10) REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory and possibly additional discretionary actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings, and other factors. Quantitative measures established by regulations
to ensure capital adequacy require the Bank to maintain minimum amounts and
ratios (set forth in the following table) of Tier I or Core capital, and
Risk-based capital (as defined in the regulations) to total assets (as defined).
Management believes, as of March 31, 2006, that the Bank meets all capital
adequacy requirements to which it is subject.
Management believes that based upon the Bank's capital calculations at March 31,
2006 and other conditions consistent with the Prompt Corrective Actions
Provisions of the OTS regulations, the Bank would be categorized as well
capitalized.
On March 31, 2006 the Bank's tangible assets and adjusted total assets were
$982.9 million and its risk-weighted assets were $797.9 million. The following
table presents the Bank's capital amounts and ratios at March 31, 2006 for
actual capital, required capital and excess capital including ratios in order to
qualify as being well capitalized under the Prompt Corrective Actions
regulations.
10
- -------------------------------------------------------------------------------------------------------------------------
To Be Well
Capitalized
Required to be Under Prompt
Adequately Corrective Actions
Actual Capitalized Excess Capital Provisions
--------------------- ------------------ ----------------- ------------------
Percent Percent Percent Percent
of of of of
(dollars in thousands) Amount Assets(1) Amount Assets(1) Amount Assets(1) Amount Assets(1)
---------- --------- ------ --------- ------ --------- ------ ---------
Bank stockholder's equity........... $ 88,200
Less:
Net unrealized losses on certain
securities available for sale.... 778
Goodwill and core deposit
intangible....................... (3,992)
Excess mortgage servicing rights.. (1,747)
---------
Tier I or core capital 83,239
---------
Tier I capital to adjusted total
assets............................ 8.47% 39,318 4.00% 43,921 4.47% 49,147 5.00%
Tier I capital to risk-weighted
assets............................ 10.43% 31,915 4.00% 51,324 6.43% 47,872 6.00%
Plus:
Allowable allowance for loan
losses........................... 9,117
---------
Risk-based capital.................. $ 92,356 63,830 28,526 79,787
=========
Risk-based capital to risk-weighted
assets.............................. 11.58% 8.00% 3.58% 10.00%
(1) Based upon the Bank's adjusted total assets for the tangible and core capital ratios and risk-weighted assets
for the risk-based capital ratio.
- -------------------------------------------------------------------------------------------------------------------------
</Table>
The tangible capital of the Bank was in excess of the minimum 2% required at
March 31, 2006 but is not reflected in the table above.
(11) COMMITMENTS AND CONTINGENCIES
The Bank issued standby letters of credit which guarantee the performance of
customers to third parties. The standby letters of credit issued and available
at March 31, 2006 were approximately $16.3 million, expire over the next two
years, and are collateralized primarily with commercial real estate mortgages.
Since the conditions under which the Bank is required to fund the standby
letters of credit may not materialize, the cash requirements are expected to be
less than the total outstanding commitments.
(12) STOCK-BASED COMPENSATION
The company adopted Statement of Financial Accounting Standards No. 123 (revised
2004), Share-Based Payment (FAS 123R) on January 1, 2006 using the modified
prospective transition method. Under the modified prospective transition method,
awards that are granted, modified or settled beginning at the date of adoption
will be measured and accounted for in accordance with FAS 123R. In addition,
expense is recognized in the statement of income for unvested awards that were
granted prior to the date of adoption based on the fair value of the award as
determined at the grant date. The consolidated financial statements as of and
for the three months ended March 31, 2006 reflect $16,100 of additional
compensation expense as a result of implementing FAS 123R. In accordance with
the modified prospective transition method, the Consolidated Financial
Statements for prior periods have not been restated. Therefore, the results for
the first quarter of 2006 are not directly comparable to the same period in
2005.
Prior to the adoption of FAS 123R, the Company applied the existing accounting
rules under APB Opinion No. 25, which provided that no compensation expense was
charged for options granted at an exercise price equal to the market value of
the underlying common stock on the date of the grant. If the fair value
recognition provisions of FAS 123R had been applied to stock-based compensation
for the three months ended March 31, 2005, the Company's pro forma net income
and earnings per share would have been as follows:
11
<Table>
<Caption>
- ------------------------------------------------------------------------------
Quarter Ended
March 31, 2005
--------------
Net income:
As reported........................................... $ 2,815,064
Deduct: Total stock-based employee compensation
expense determined under fair value method for all
awards, net of related tax effects.................. 41,910
--------------
Pro forma............................................ $ 2,773,154
==============
Earnings per Common share:
As reported:
Basic................................................ $ 0.74
Diluted.............................................. 0.70
Pro forma:
Basic ............................................... 0.73
Diluted.............................................. 0.70
- ------------------------------------------------------------------------------
</Table>
The Company utilizes a valuation model to determine the fair value of stock
options on the date of grant. The model derives the fair value of stock options
based on certain assumptions related to expected stock price volatility,
expected option life, risk-free interest rate and dividend yield. No stock
options were granted during the quarter ended March 31, 2006.
(13) BUSINESS SEGMENTS
The Bank has been identified as a reportable operating segment in accordance
with the provisions of SFAS No. 131. SFC and HMN, the holding company, did not
meet the quantitative thresholds for determining reportable segments and
therefore are included in the "Other" category.
The Company evaluates performance and allocates resources based on the segments
net income and return on average assets and equity. Each corporation is managed
separately with its own officers and board of directors some of whom may overlap
between the corporations.
12
The following table sets forth certain information about the reconciliations of
reported profit or loss and assets for each of the Company's reportable
segments.
<Table>
<Caption>
Home
(Dollars in thousands) Federal
Savings Other Eliminations Consolidated
Bank Total
- ----------------------------------------------------------------------------------------------------------
AT OR FOR THE QUARTER ENDED MARCH 31, 2006:
Interest income - external customers.... $ 15,939 43 0 15,982
Non-interest income - external customers 1,493 0 0 1,493
Losses on limited partnerships.......... (7) 0 0 (7)
Intersegment non-interest income........ 34 2,808 (2,842) 0
Interest expense........................ 6,594 0 0 6,594
Amortization of mortgage servicing
rights, net ........................... 217 0 0 217
Other non-interest expense.............. 5,598 157 (33) 5,722
Income tax expense (benefit)............ 1,725 (45) 0 1,680
Net income.............................. 2,810 2,739 (2,809) 2,740
Goodwill .............................. 3,801 0 0 3,801
Total assets............................ 985,107 93,269 (88,392) 989,984
Net interest margin..................... 4.10 % NM NM 4.10%
Return on average assets................ 1.14 % NM NM 1.14%
Return on average realized common equity 12.96 % NM NM 11.82%
AT OR FOR THE QUARTER ENDED MARCH 31, 2005:
Interest income - external customers.... $ 14,186 10 0 14,196
Non-interest income - external customers 1,434 0 0 1,434
Losses on limited partnerships.......... (8) 0 0 (8)
Intersegment interest income............ 0 16 (16) 0
Intersegment non-interest income........ 34 2,847 (2,881) 0
Interest expense........................ 5,541 0 (16) 5,525
Amortization of mortgage servicing
rights, net ........................... 239 0 0 239
Other non-interest expense.............. 4,923 162 (34) 5,051
Income tax expense (benefit)............ 1,459 (103) 0 1,356
Net income.............................. 2,848 2,814 (2,847) 2,815
Goodwill .............................. 3,801 0 0 3,801
Total assets............................ 987,117 85,056 (80,847) 991,326
Net interest margin..................... 3.78 % NM NM 3.79%
Return on average assets................ 1.17 % NM NM 1.18%
Return on average realized common equity 14.36 % NM NM 13.22%
NM - Not meaningful
13
HMN FINANCIAL, INC.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING INFORMATION
This quarterly report and other reports filed with the Securities and Exchange
Commission may contain "forward-looking" statements that deal with future
results, plans or performance. When used in this Form 10-Q, the words
"anticipates", "believes", "estimates", "expects", "intends" and similar
expressions, as they relate to the Company and its management, are intended to
identify such forward-looking statements. In addition, the Company's management
may make such statements orally to the media, or to securities analysts,
investors or others. Forward looking statements deal with matters that do not
relate strictly to historical facts. The Company's future results may differ
materially from historical performance and forward-looking statements about the
Company's expected financial results or other plans are subject to a number of
risks and uncertainties. These include but are not limited to possible
legislative changes and adverse economic, business and competitive developments
such as shrinking interest margins; deposit outflows; reduced demand for
financial services and loan products; changes in accounting policies and
guidelines or monetary and fiscal policies of the federal government or tax
laws; changes in credit and other risks posed by the Company's loan and
investment portfolios; technological, computer-related or operational
difficulties; adverse changes in securities markets; results of litigation or
other significant uncertainties. For additional discussion of the risks and
uncertainties applicable to the Company, see the "Risk Factors" section of the
Company's Annual Report on Form 10-K for the year ended December 31, 2005.
GENERAL
The earnings of the Company are primarily dependant on the Bank's net interest
income, which is the difference between interest earned on its loans and
investments, and the interest paid on interest-bearing liabilities such as
deposits and Federal Home Loan Bank (FHLB) advances. The difference between the
average rate of interest earned on assets and the average rate paid on
liabilities is the "interest rate spread". Net interest income is produced when
interest-earning assets equal or exceed interest-bearing liabilities and there
is a positive interest rate spread. The Company's interest rate spread has been
enhanced by the increased level of commercial loans placed in portfolio and the
increased amount of lower rate deposits. Net interest income and net interest
rate spread are affected by changes in interest rates, the volume and the mix of
interest-earning assets and interest-bearing liabilities, and the level of
non-performing assets. The Company's net income is also affected by the
generation of non-interest income, which consists primarily of gains or losses
from the sale of securities, gains from the sale of loans, and the generation of
fees and service charges on deposit accounts. The Bank incurs expenses in
addition to interest expense in the form of salaries and benefits, occupancy
expenses, provisions for loan losses and amortization expense on mortgage
servicing assets.
The earnings of financial institutions, such as the Bank, are significantly
affected by prevailing economic and competitive conditions, particularly changes
in interest rates, government monetary and fiscal policies, and regulations of
various regulatory authorities. Lending activities are influenced by the demand
for and supply of single family and commercial properties, competition among
lenders, the level of interest rates and the availability of funds. Commercial
real estate loan activity was down in the first quarter of 2006 when compared to
the same period of 2005 due to increased rate competition on long term fixed
rate loans, and we expect this trend to continue. Deposit flows and costs of
deposits are influenced by prevailing market rates of interest on competing
investments, account maturities and the levels of personal income and savings.
The interest rates charged by the FHLB on advances to the Bank also have a
significant impact on the Bank's overall cost of funds.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those policies that the Company's management
believes are the most important to understanding the Company's financial
condition and operating results. The Company has identified the following
policies as being critical because they require difficult, subjective, and/or
complex judgments that are inherently uncertain. Therefore, actual financial
results could differ significantly depending upon the estimates used.
14
Allowance for Loan Losses and Related Provision
The allowance for loan losses is based on periodic analysis of the loan
portfolio. In this analysis, management considers factors including, but not
limited to, specific occurrences of loan impairment, changes in the size of the
portfolios, national and regional economic conditions such as unemployment data,
loan portfolio composition, loan delinquencies, local construction permits,
development plans, local economic growth rates, historical experience and
observations made by the Company's ongoing internal audit and regulatory exam
processes. Loans are charged off to the extent they are deemed to be
uncollectible. The Company has established separate processes to determine the
adequacy of the loan loss allowance for its homogeneous single-family and
consumer loan portfolios and its non-homogeneous loan portfolios. The
determination of the allowance for the non-homogeneous commercial, commercial
real estate, and multi-family loan portfolios involves assigning standardized
risk ratings and loss factors that are periodically reviewed. The loss factors
are estimated using a combination of the Company's own loss experience and
external industry data and are assigned to all loans without identified credit
weaknesses. The Company also performs an individual analysis of impairment on
each non-performing loan that is based on the expected cash flows or the value
of the assets collateralizing the loans. The determination of the allowance on
the homogeneous single-family and consumer loan portfolios is calculated on a
pooled basis with individual determination of the allowance of all
non-performing loans.
The adequacy of the allowance for loan losses is dependent upon management's
estimates of variables affecting valuation, appraisals of collateral,
evaluations of performance and status, and the amounts and timing of future cash
flows expected to be received on impaired loans. Such estimates, appraisals,
evaluations and cash flows may be subject to frequent adjustments due to
changing economic prospects of borrowers or properties. The estimates are
reviewed periodically and adjustments, if any, are recorded in the provision for
loan losses in the periods in which the adjustments become known. The allowance
is allocated to individual loan categories based upon the relative risk
characteristics of the loan portfolios and the actual loss experience. The
Company increases its allowance for loan losses by charging the provision for
loan losses against income. The methodology for establishing the allowance for
loan losses takes into consideration probable losses that have been identified
in connection with specific loans as well as losses in the loan portfolio for
which specific reserves are not required. Although management believes that
based on current conditions the allowance for loan losses is maintained at an
adequate amount to provide for probable loan losses inherent in the portfolio as
of the balance sheet dates, future conditions may differ substantially from
those anticipated in determining the allowance for loan losses and adjustments
may be required in the future.
Mortgage Servicing Rights
The Company recognizes as an asset the rights to service mortgage loans for
others, which are referred to as mortgage servicing rights (MSRs). MSRs are
capitalized at the relative fair value of the servicing rights on the date the
mortgage loan is sold and are carried at the lower of the capitalized amount,
net of accumulated amortization, or fair value. MSRs are capitalized and
amortized in proportion to, and over the period of, estimated net servicing
income. Each quarter the Company evaluates its MSRs for impairment in accordance
with Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and
interest rate are the predominant risk characteristics of the underlying loans
used to stratify the MSRs for purposes of measuring impairment. If temporary
impairment exists, a valuation allowance is established for any excess of
amortized cost over the current fair value through a charge to income. If the
Company later determines that all or a portion of the temporary impairment no
longer exists, a reduction of the valuation allowance is recorded as an increase
to income. The valuation is based on various assumptions, including the
estimated prepayment speeds and default rates of the stratified portfolio.
Changes in the mix of loans, interest rates, prepayment speeds, or default rates
from the estimates used in the valuation of the mortgage servicing rights may
have a material effect on the amortization and valuation of MSRs. Management
believes that the assumptions used and the values determined are reasonable
based on current conditions. However, future economic conditions may differ
substantially from those anticipated in determining the value of the MSRs and
adjustments may be required in the future. The Company does not formally hedge
its MSRs because they are hedged naturally by the Company's origination volume.
Generally, as interest rates rise the origination volume declines and the value
of MSRs increases and as interest rates decline the origination volume increases
and the value of MSRs decreases.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax basis.
15
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. These calculations are based on many
complex factors including estimates of the timing of reversals of temporary
differences, the interpretation of federal and state income tax laws, and a
determination of the differences between the tax and the financial reporting
basis of assets and liabilities. Actual results could differ significantly from
the estimates and interpretations used in determining the current and deferred
income tax liabilities.
NET INCOME
The Company's net income for the first quarter of 2006 was $2.7 million, down
$75,000, or 2.7%, from net income of $2.8 million for the first quarter of 2005.
Diluted earnings per common share for the first quarter of 2006 were $0.68, down
$0.02, or 2.9%, from $0.70 for the first quarter of 2005. Pretax income for the
first quarter of 2006 was $4.4 million, up $249,000, or 6.0%, from pretax income
of $4.2 million for the first quarter of 2005. The increase in pretax income in
2006 was offset by an increase in income taxes due to an increase in the
Company's effective tax rate from 32.5% in the first quarter of 2005 to 38.0% in
the first quarter of 2006. The increase in the effective tax rate was primarily
due to changes in state tax laws that were enacted in the third quarter of 2005.
.........
NET INTEREST INCOME
Net interest income was $9.4 million for the first quarter of 2006, an increase
of $718,000, or 8.3%, compared to $8.7 million for the first quarter of 2005.
Interest income was $16.0 million for the first quarter of 2006, an increase of
$1.8 million, or 12.6%, from $14.2 million for the first quarter of 2005.
Interest income increased because of an increase in the average interest rate
earned on loans and investments. Interest rates increased primarily because of
the 200 basis point increase in the prime interest rate between the periods.
Increases in the prime rate, which is the rate that banks charge their prime
business customers, generally increase the rates on adjustable rate consumer and
commercial loans in the portfolio and on new loans originated. The increase in
interest income due to increased rates was partially offset by a $28 million
decrease in the average outstanding single-family mortgage and consumer loan
portfolio balances between the periods. The average yield earned on
interest-earning assets was 6.98% for the first quarter of 2006, an increase of
77 basis points from the 6.21% average yield for the first quarter of 2005.
Interest expense was $6.6 million for the first quarter of 2006, an increase of
$1.1 million, or 19.3%, compared to $5.5 million for the first quarter of 2005.
Interest expense increased because of the higher interest rates paid on deposits
which were caused by the 200 basis point increase in the federal funds rate
between the periods. Increases in the federal funds rate, which is the rate that
banks charge other banks for short term loans, generally increase the rates
banks pay for deposits. The average interest rate paid on interest-bearing
liabilities was 3.07% for the first quarter of 2006, an increase of 51 basis
points from the 2.56% average interest rate paid in the first quarter of 2005.
Net interest margin (net interest income divided by average interest earning
assets) for the first quarter of 2006 was 4.10%, an increase of 31 basis points,
compared to 3.79% for the first quarter of 2005.
PROVISION FOR LOAN LOSSES
The provision for loan losses was $515,000 for the first quarter of 2006, a
decrease of $121,000, compared to $636,000 for the first quarter of 2005. The
provision for loan losses decreased primarily because of the $12 million
reduction in the commercial loan portfolio in the first quarter of 2006 compared
to the $40 million in growth that was experienced in the first quarter of 2005.
The reduction in loan growth was the result of management's decision not to
pursue long-term, low fixed-rate commercial loan business in an environment of
rising short-term interest rates. The decrease in the provision related to the
reduced loan growth was partially offset by an increase in the provision due to
increased commercial loan risk rating downgrades in the first quarter of 2006
when compared to the same period of 2005.
16
A reconciliation of the Company's allowance for loan losses is summarized as
follows:
<Table>
<Caption>
2006 2005
------------- ---------------
Balance at January 1, $ 8,777,655 8,995,892
Provision 515,000 636,000
Charge offs (91,208) (271,737)
Recoveries 47,203 33,420
------------- ---------------
Balance at March 31, $ 9,248,650 9,393,575
============= ===============
NON-INTEREST INCOME
Non-interest income was $1.5 million for the first quarter of 2006, an increase
of $60,000, or 4.2%, from $1.4 million for the first quarter of 2005. Fees and
service charges increased $112,000 between the periods primarily because of
increased retail deposit account activity and late fees. Loan servicing fees
increased $11,000 primarily because of an increase in the number of commercial
loans that are being serviced for others. Gain on sale of loans decreased
$47,000 between the periods due to a decrease in the number of single-family
mortgage loans sold and a decrease in the profit margins realized on the loans
that were sold. Competition in the single-family loan origination market has
increased as the overall market has slowed and profit margins have been lowered
in order to remain competitive and maintain origination volumes. Other
non-interest income decreased $17,000 primarily because of lower revenues from
the sale of uninsured investment products.
NON-INTEREST EXPENSE
Non-interest expense was $5.9 million for the first quarter of 2006, an increase
of $649,000, or 12.3%, from $5.3 million for the first quarter of 2005.
Compensation expense increased $485,000 primarily because of annual payroll cost
increases, an increase in the number of employees and increased pension costs.
Occupancy expense increased $105,000 due primarily to additional costs
associated with new branch and loan origination offices opened in Rochester in
the first quarter of 2006. Data processing costs increased $51,000 due to
increases in the services provided by the Bank's third party processor between
the periods. Advertising expense increased $47,000 between the periods primarily
because of the costs associated with promoting the new branch and the
introduction of new checking account offerings in the first quarter of 2006.
INCOME TAX EXPENSE
Income tax expense increased $324,000 between the periods due to an increase in
taxable income and an effective tax rate that increased from 32.5% for the first
quarter of 2005 to 38.0% for the first quarter of 2006. The increase in the
effective tax rate was primarily the result of state tax law changes enacted in
the third quarter of 2005. In the first quarter of 2005, the Company had a Real
Estate Investment Trust (REIT) and related company that acquired and held
mortgage assets and other authorized investments to generate income. The tax
laws relating to these entities were changed, retroactively to January 1, 2005,
in the third quarter of 2005. A tax adjustment was recorded in the third quarter
of 2005 to account for the increase in tax for the first two quarters of 2005.
Because of this adjustment, quarterly tax expense for the first three quarters
of 2006 will not be comparable to the tax expense for same periods in 2005.
17
NON-PERFORMING ASSETS
The following table summarizes the amounts and categories of non-performing
assets in the Bank's portfolio at March 31, 2006 and December 31, 2005.
<Table>
<Caption>
---------------------------------------------------------------------------------------------------
March 31, December 31,
(Dollars in Thousands) 2006 2005
---------------------------------------------------------------------------------------------------
Non-Accruing Loans:
One-to-four family real estate $ 529 $ 626
Commercial real estate 948 948
Consumer 274 496
Commercial business 284 259
------------ ----------------
Total 2,035 2,329
------------ ----------------
Other assets 177 178
Foreclosed and Repossessed Assets:
One-to-four family real estate 1,274 1,315
Consumer 4 61
------------ ----------------
Total non-performing assets $ 3,491 $ 3,883
============ ================
Total as a percentage of total assets 0.35 % 0.39 %
============ ================
Total non-performing loans $ 2,035 $ 2,329
============ ================
Total as a percentage of total loans receivable,
net 0.26 % 0.30 %
============ ================
Allowance for loan loss to non-performing loans 454.37 % 376.88 %
============ ================
---------------------------------------------------------------------------------------------------
Total non-performing assets were $3.5 million at March 31, 2006, a decrease of
$392,000, from $3.9 million at December 31, 2005. During the first quarter of
2006, the following activity occurred related to non-performing assets: $390,000
of previously performing loans were classified as non-performing, $7,000 in
non-performing loans were foreclosed or repossessed, $82,000 in loans were
charged off as a loss, $110,000 in foreclosed assets were sold, and $597,000 in
assets were reclassified as performing.
DIVIDENDS
On April 25, 2006 the Company declared a cash dividend of $0.24 per share,
payable on June 7, 2006 to shareholders of record on May 19, 2006.
During the first quarter of 2006, the Company declared and paid dividends as
follows:
Record date Payable date Dividend per share Dividend Payout Ratio
- ----------- ------------ ------------------ ---------------------
February 17, 2006 March 7, 2006 $0.24 27.59%
The annualized dividend payout ratio for the past four quarters, ending with the
June 7, 2006 payment will be 35.04%.
The declaration of dividends are subject to, among other things, the Company's
financial condition and results of operations, the Bank's compliance with its
regulatory capital requirements including the fully phased-in capital
requirements, tax considerations, industry standards, economic conditions,
regulatory restrictions, general business practices and other factors.
LIQUIDITY
For the quarter ended March 31, 2006, the net cash provided by operating
activities was $916,000. The Company collected $30.7 million in principal
repayments and maturities on securities during the quarter. It purchased $34.6
million in securities and $832,000 in premises and equipment and received $16.8
million relating to a decrease in net loans receivable. The Company had a net
decrease in deposit balances of $3.9 million during the quarter, received
$49,000 related to the exercise of HMN stock options, paid $929,000 in dividends
to its shareholders and paid $323,000 to purchase treasury stock.
The Company has certificates of deposits with outstanding balances of $227.0
million that come due over the next
18
12 months. Based upon past experience management anticipates that the majority
of the deposits will renew for another term. The Company believes that deposits
which do not renew will be replaced with deposits from other customers or
brokers. FHLB advances or proceeds form the sale of securities could also be
used to replace unanticipated outflows of deposits.
The Company has $10.0 million of FHLB advances that will mature during the next
twelve months. The Company also has $110.9 million of FHLB advances that mature
beyond March 31, 2007 but have call features that can be exercised by the FHLB
during the next twelve months. If the call features are exercised, the Company
has the option of requesting any advance otherwise available to it pursuant to
the credit policy of the FHLB.
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates.
The Company's market risk arises primarily from interest rate risk inherent in
its investing, lending and deposit taking activities. Management actively
monitors and manages its interest rate risk exposure.
The Company's profitability is affected by fluctuations in interest rates. A
sudden and substantial increase in interest rates may adversely impact the
Company's earnings to the extent that the interest rates borne by assets and
liabilities do not change at the same speed, to the same extent, or on the same
basis. The Company monitors the projected changes in net interest income that
occur if interest rates were to suddenly change up or down. The Rate Shock Table
located in the Asset/Liability Management section of this report, which follows,
discloses the Company's projected changes in net interest income based upon
immediate interest rate changes called rate shocks.
The Company utilizes a model that uses the discounted cash flows from its
interest-earning assets and its interest-bearing liabilities to calculate the
current market value of those assets and liabilities. The model also calculates
the changes in market value of the interest-earning assets and interest-bearing
liabilities due to different interest rate changes. The Company believes that
over the next twelve months interest rates could fluctuate in a range of 200
basis points up or down from where the rates were at March 31, 2006. The
following table discloses the projected changes in market value to the Company's
interest-earning assets and interest-bearing liabilities based upon incremental
100 basis point changes in interest rates from interest rates in effect on March
31, 2006.
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------------------
Market Value
---------------------------------------------------------------
(Dollars in thousands)
Basis point change in interest rates -200 -100 0 +100 +200
- ------------------------------------------------------------------------------------------------------------
Total market risk sensitive assets......... $ 996,293 990,164 981,791 970,995 958,597
Total market risk sensitive liabilities.... 870,946 856,444 844,655 834,505 825,797
Off-balance sheet financial instruments.... 246 110 0 (310) (588)
Net market risk............................ $ 125,593 133,830 137,136 136,180 132,212
Percentage change from current market value (8.42) % (2.41) % 0.00 % (0.70) % (3.59) %
- ------------------------------------------------------------------------------------------------------------
The preceding table was prepared utilizing the following assumptions (the Model
Assumptions) regarding prepayment and decay ratios which were determined by
management based upon their review of historical prepayment speeds and future
prepayment projections. Fixed rate loans were assumed to prepay at annual rates
of between 10% to 76%, depending on the note rate and the period to maturity.
Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of
between 11% and 31%, depending on the note rate and the period to maturity.
Growing Equity Mortgage (GEM) loans were assumed to prepay at annual rates of
between 5% and 49% depending on the note rate and the period to maturity.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) were
projected to have prepayments based upon the underlying collateral securing the
instrument and the related cash flow priority of the CMO tranche owned.
Certificate accounts were assumed not to be withdrawn until maturity. Passbook
accounts were assumed to decay at an annual rate of 20% and money market
accounts were assumed to decay at an annual rate of 31%. Non-interest checking
accounts were assumed to decay at an annual rate of 33% and NOW accounts were
assumed to decay at an annual rate of 17%. FHLB advances were projected to be
called at the first call date where the projected interest rate on similar
remaining term
19
advances exceeded the interest rate on the callable advance.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. The interest rates on certain types of assets and liabilities
may fluctuate in advance of changes in market interest rates, while interest
rates on other types of assets and liabilities may lag behind changes in market
interest rates. The model assumes that the difference between the current
interest rate being earned or paid compared to a treasury instrument or other
interest index with a similar term to maturity (the Interest Spread) will remain
constant over the interest changes disclosed in the table. Changes in Interest
Spread could impact projected market value changes. Certain assets, such as
ARMs, have features which restrict changes in interest rates on a short-term
basis and over the life of the assets. The market value of the interest-bearing
assets which are approaching their lifetime interest rate caps could be
different from the values disclosed in the table. In the event of a change in
interest rates, prepayment and early withdrawal levels may deviate significantly
from those assumed in calculating the foregoing table. The ability of many
borrowers to service their debt may decrease in the event of a substantial
sustained interest rate increase.
ASSET/LIABILITY MANAGEMENT
The Company's management reviews the impact that changing interest rates will
have on its net interest income projected for the twelve months following March
31, 2005 to determine if its current level of interest rate risk is acceptable.
The following table projects the estimated annual impact on net interest income
of immediate interest rate changes called rate shocks.
<Table>
<Caption>
Projected
Rate Shock Change in Net
in Basis Interest Percentage
(Dollars in thousands) Points Income Change
------------- --------------- ------------
+200 $1,487 12.67 %
+100 782 6.66 %
0 0 0.00 %
-100 (1,366) (11.64)%
-200 (2,919) (24.88)%
</Table>
The preceding table was prepared utilizing the Model Assumptions regarding
prepayment and decay ratios which were determined by management based upon their
review of historical prepayment speeds and future prepayment projections
prepared by third parties.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. In the event of a change in interest rates, prepayment and
early withdrawal levels would likely deviate significantly from those assumed in
calculating the foregoing table. The ability of many borrowers to service their
debt may decrease in the event of a substantial increase in interest rates and
could impact net interest income.
In an attempt to manage its exposure to changes in interest rates, management
closely monitors interest rate risk. The Bank has an Asset/Liability Committee
which meets frequently to discuss changes in the interest rate risk position and
projected profitability. The Committee makes adjustments to the asset liability
position of the Bank which are reviewed by the Board of Directors of the Bank.
This Committee also reviews the Bank's portfolio, formulates investment
strategies and oversees the timing and implementation of transactions to assure
attainment of the Board's objectives in the most effective manner. In addition,
each quarter the Board reviews the Bank's asset/liability position, including
simulations of the effect on the Bank's capital of various interest rate
scenarios.
In managing its asset/liability mix, the Bank, at times, depending on the
relationship between long- and short-term interest rates, market conditions and
consumer preference, may place more emphasis on managing net interest margin
than on better matching the interest rate sensitivity of its assets and
liabilities in an effort to enhance net interest income. Management believes
that the increased net interest income resulting from a mismatch in the maturity
of its asset and liability portfolios can, in certain situations, provide high
enough returns to justify the increased exposure to sudden and unexpected
changes in interest rates.
20
To the extent consistent with its interest rate spread objectives, the Bank
attempts to manage its interest rate risk and has taken a number of steps to
restructure its balance sheet in order to better match the maturities of its
assets and liabilities. The Bank has primarily focused its fixed rate
one-to-four family residential lending program on loans that are saleable to
third parties and only places fixed rate loans that meet certain risk
characteristics into its loan portfolio. The Bank does place into portfolio
adjustable rate single-family loans that reprice over a one, three or five-year
period. The Bank's commercial loan production has primarily been in adjustable
rate loans and the fixed rate commercial loans placed in portfolio have been
shorter-term loans, usually with maturities of five years or less, in order to
manage the Company's interest rate risk exposure.
ITEM 4: CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. As of the end of the period
covered by this report, the Company conducted an evaluation, under the
supervision and with the participation of the principal executive officer and
principal financial officer, of the Company's disclosure controls and procedures
(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934 (Exchange Act). Based on this evaluation, the principal executive
officer and principal financial officer concluded that the Company's disclosure
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms.
Changes in internal controls. There was no change in the Company's internal
controls over financial reporting during the Company's most recently completed
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, the Company's internal controls over financial reporting.
21
HMN FINANCIAL, INC.
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings.
None.
ITEM 1A. Risk Factors.
No changes from risk factors previously disclosed in December 31, 2005
Form 10-K.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a) and (b) Not applicable
(c) Information Regarding Share Repurchases
<Table>
<Caption>
(c) Total Number
of Shares
(a) Total Purchased as Part (d) Maximum Number
Number of (b) Average of Publicly of Shares that May Yet
Shares Price Paid Announced Plans Be Purchased Under the
Period Purchased per Share or Programs Plans or Programs
- -------------------------------------- ------------ ---------------- -------------------- -----------------------
January 1 through January 31, 2006 0 $ N/A N/A 197,000
February 1 through February 28, 2006 10,000 32.30 10,000 187,000
March 1 through March 31, 2006 0 N/A N/A 187,000
--------- -------------
Total 10,000 $32.30 10,000
========= =============
(1) On July 26, 2005, the Board of Directors extended the stock repurchase
program for 197,000 shares of the Company's common stock. This program expires
on February 25, 2007.
ITEM 3. Defaults Upon Senior Securities.
Not applicable.
ITEM 4. Submission of Matters to a Vote of Security Holders.
None.
ITEM 5. Other Information.
None.
ITEM 6. Exhibits.
See Index to Exhibits on page 24 of this report.
22
SIGNATURES
Pursuant to the requirement 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.
HMN FINANCIAL, INC.
Registrant
Date: May 4, 2006 /s/ Michael McNeil
------------------------------ Michael McNeil,
President and Chief Executive Officer
(Principal Executive Officer)
(Duly Authorized Representative)
Date: May 4, 2006 /s/ Jon Eberle
------------------------------ Jon Eberle,
Chief Financial Officer
(Principal Financial Officer)
23
HMN FINANCIAL, INC.
INDEX TO EXHIBITS
FOR FORM 10-Q
<Table>
<Caption>
Sequential
Reference Page Numbering
Regulation to Prior Where Attached
S-K Filing or Exhibits Are
Exhibit Exhibit Located in This
Number Document Attached Hereto Number Form 10-Q Report
- --------------------------------------------------------------------------------------------------------------------------------
3.1 Amended and Restated Articles of Incorporation *1 N/A
3.2 Amended and Restated By-laws *2 N/A
4 Form of Common Stock Certificates *3 N/A
31.1 Rule 13a-14(a)/15d-14(a) Certification of CEO 31.1 Filed Electronically
31.2 Rule 13a-14(a)/15d14(a) Certification of CFO 31.2 Filed Electronically
32 Section 1350 Certification of CEO and CFO 32 Filed Electronically
- -------------------------------------------------------------------------------------------------------------------------------
*1 Incorporated by reference to the same numbered exhibit to the Company's Quarterly Report on Form 10-Q for the
period ended March 31, 1998 (File No. 0-24100).
*2 Incorporated by reference Exhibit 3 to the Company's Current Report on Form 8-K dated February 22, 2005, filed
on February 23, 2005 (File 0-24100).
*3 Incorporated by reference to the same numbered exhibit to the Company's Registration Statement on Form S-1
dated April 1, 1994 (File No. 33-77212).
- -------------------------------------------------------------------------------------------------------------------------------
24