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13
HILLS BANCORPORATION
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Assets and
Liabilities Review (continued)
Interest rates, which
help drive both new loan growth and secondary market loans, including
refinances, continue to be at record low levels compared to the last fifty
years. Effective June 25, 2003, the Federal Reserve Open Market Committee
lowered the federal funds target rate to 1.00%. The 1.00% is the lowest level
since July of 1958. The decrease was the first in 2003 with the last 25 basis
point decrease occurring on November 6, 2002. The decrease in the federal funds
rate marked the thirteenth decrease since May 16, 2000, when the rate was 6.50%.
Overall, the local economy remains in good condition but weaknesses have been
seen with some layoffs in employment. Budget restraints continue to affect the
University of Iowa and state government spending. In addition, the national
economy has not directly affected the Company, but obviously the continued war
in Iraq and the aftermath process of peace and other national economic news will
continue to affect the financial markets. The new tax relief act signed into law
in May, 2003, contains major tax cuts for individuals and business taxpayers.
One of the most talked about provisions is lower tax on corporate dividends and
this has aided recent stock market gains. As of June 30, 2003, the major stock
indices all show a positive growth for the first six months of 2003.
The growth of deposits in
the first half of the year has been $38.01 million and a total of $49.2 million
when repurchase agreements are included. Borrowings from the FHLB remained
static at $167.6 million for the two periods presented.
Dividends
and Equity
In January 2003, Hills
Bancorporation paid a dividend of $2,853,000 or $1.90 per share, an 8.57%
increase from the $1.75 paid in January 2002. After payment of the dividend and
the adjustment for accumulated other comprehensive income, stockholders’
equity as of June 30, 2003 totaled $92,546,000. The total stockholders’
equity of Hills Bancorporation as of June 30, 2003, before the reduction for the
ESOP shares, totaled 9.26% of total assets. The total equity under this
measurement was $101.7 million. Under risk-based capital rules, the total risk
based capital is 12.83% of risk-adjusted assets, and substantially in excess of
required minimums.
14
HILLS BANCORPORATION
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
RESULTS OF
OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002.
Net
income, net interest income and other income
Net income for the six
months ended June 30, 2003 is $7,508,000, which represents a $2,212,000 increase
over the reported income for the same period in 2002. As discussed at the end of
the first quarter for 2003, the increase in net income is related to three
significant factors, one the increased earning assets, two the improved net
interest margin and third, the increase in the gain of sale of loans. Net
interest income, not including fees increased $2.4 million for the six months
ended June 30, 2003 compared to 2002. The improvement is due to an increase in
average earning assets of $123.3 million and a rise in the net interest margin
by approximately eight basis points. The mortgage refinancing growth continued
in the second quarter of the year as the number of loans sold on the secondary
market and the resulting gain on sale was $2,452,000 which is $461,000 more than
for all of 2002 and $1,833,000 higher than gains on sale of loans for the period
ended June 30, 2002.
The net income for the
quarter ended June 30, 2003 was $1,454,000 ahead of the same quarter in 2002.
This change is due in large part to the gain on sale of loans, which are loans
sold to the secondary market, which were $1,345,000 higher in 2003 than 2002 for
the three months. The other large difference is that net interest income is $1.2
million higher due to average earning assets increasing $124.8 million.
Trust fees increased to
$1,178,000 for the six months ended June 30, 2003 from $1,159,000 one year ago.
The number of trust accounts continues to increase, but the decline in stocks
values in 2001 and 2002 had the effect of reducing otherwise expected increases
in fees since the fees are based on asset value of the account. Deposit account
charges and fees increased $274,000 in the two periods shown. The change is
primarily due to increase service charges on selected deposit accounts and the
volume of accounts having increased. Other fees and charges increased $286,000
from the first six months of 2003 compared to the same period in 2002. The
increase included $252,000 in credit card processing fees, but this income was
offset by additional processing fees of $285,000, included in the other expense
category.
In comparing the three
months ended June 30, 2003 and 2002, other income increased $1,640,000 to
$3,845,000. The increase was the result of the gain on sale of loans increasing
$1,345,000 and this was primarily due to the continued low rate environment.
Deposit account charges increased $131,000 from $791,000 to $922,000. As for the
six months results discussed, the change is due to increased service charges and
the volume of accounts. The $145,000 increase for the three months ended June
30, 2003 in other fees is primarily an increase in credit card processing fees,
and offset by similar increases in processing fees included in the expenses.
15
HILLS
BANCORPORATION
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF THE
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Provision
for loan losses and allowance for loan losses
The provision for loan
losses for the six months ended June 30, 2003 is $449,000 compared to $487,000
for the six months ended June 30, 2002. The first quarter provision for this
line item was $484,000 compared to a credit of $35,000 for the second quarter of
2003. The net provision is the result of management’s determination on a
quarterly basis of the allowance for loan losses required based on its review of
the loan portfolio. In its review, management considers loan concentrations,
loans with higher credit risks (primarily agricultural loans) and overall
increases in net loans outstanding. The allowance for loan losses balance is
also affected by the net charge-offs for each quarter. For the first quarter of
2003, the charged-off loans exceeded loan recoveries by $79,000 while in the
second quarter recoveries exceeded loans charged-off by $244,000, resulting in a
higher reserve balance before the provision.
The allowance for loan
losses totaled $12,740,000 at June 30, 2003 compared to $10,350,000 at June 30,
2002. The percentage of the allowance to outstanding loans was 1.49% and 1.38%
at June 30, 2003 and 2002, respectively. The increase in the balance of the
allowance is due primarily to the deterioration of several loans that are in the
swine production segment of agricultural loans. The methodology used in 2003 is
consistent with the prior years. Beginning in 2001, the Bank refined the
methodology used to compute the allowance for loan losses, primarily by applying
estimated loss rates to several risk categories of loans instead of more general
categories of loans.
The University of Iowa
continues to have a dominant effect on the economy of the Bank’s primary
trade area, Johnson County, Iowa, and has helped the local economy remain strong
even when the national economy has experienced weaknesses. However, in the last
eighteen months the economy of the state of Iowa has weakened and the University
continues to suffer from budget cuts. For its fiscal year beginning July 1, 2003
the University expects continued budget constraints. The possible effects on the
local economy cannot be predicted, but are likely to weaken the economy in
future years.
Other
expenses and income taxes expense
Total other expenses were
$13,492,000 and $12,060,000 for the six months ended June 30, 2002 and 2002,
respectively. The increase includes $795,000 in salaries and benefits which is
the direct result of increased full-time equivalents of thirty-five since June
30, 2002. The new employees added included nine in the secondary market
department and eleven in the Marion office, which opened in February 2003. All
other expenses other than salaries and benefits increased a total of $637,000 or
11.92%. Credit card processing fees, which composed part of the other expenses,
increased $285,000 and was offset by $252,000 of increased fee income of credit
card processing included in the other income section.
The three months ended
June 30, 2003 compared to the same period ending June 30, 2002, saw an increase
in other expenses of $748,000. Salaries and employee benefits accounted for
$392,000 of the increase and reflects salary increases over the prior year and
the increase discussed above in the full-time equivalents added in 2003. The
only other large increase in expenses was the credit card processing expense of
approximately $145,000 discussed in the other income review.
Income tax expense was
$3,695,000 and $2,339,000 for the six months ended June 30, 2003 and 2002,
respectively. The corresponding percentage of income taxes compared to income
before income taxes is 32.98% in 2003 and 30.63% in 2002. For the three months,
the percentage of income taxes increased form 30.10% in 2002 to 33.05% in 2003.
The percentage is up slightly due to substantially more income from the gain on
sale of loans and not a corresponding increase in non-taxable interest income.
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HILLS
BANCORPORATION
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF THE
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Earnings per
share
Earnings per share, both
basic and diluted increased for the quarter ended June 30, 2003 compared to
2002. For the quarter ended June 30, 2003 basic and diluted earnings per share
were $2.73 and $2.72 in comparison to $1.78 and $1.76 for the quarter ended June
30, 2002. The earnings per share for the six months ended June 30, 2003 and June
30, 2002, were $4.98 and $3.53 for basic earnings per share and $4.97 and $3.50
for diluted earnings per share.
Liquidity
The Company actively
monitors and manages its liquidity position with the objective of maintaining
sufficient cash flows to fund operations, meet client commitments, take
advantage of market opportunities and provide a margin against unforeseeable
liquidity needs. Federal funds sold and investment securities available for sale
are readily marketable assets. Maturities of all investment securities are
managed to meet the Company’s normal liquidity needs, to respond to market
changes or to adjust the Company’s interest rate risk position. Federal
funds sold and investment securities available for sale comprised 19.9% of the
Company’s total assets at
June 30, 2003.
Net cash provided from
operations is another primary source of liquidity. For the six months ended June
30, 2003 and 2002, net cash provided by operating activities was $2,498,000 and
$6,748,000 respectively.
The Company has
historically maintained a stable deposit base and a relatively low level of
large deposits, which has mitigated the volatility in liquidity. As of June 30,
2003, the Company had advances of $167,606,000 from the FHLB of Des Moines.
These advances were used as a means of providing both long and short-term,
fixed-rated funding for certain assets and managing interest rate risk. The
Company had additional borrowing capacity available from the FHLB of
approximately $135 million at June 30, 2003.
As additional liquidity,
the Company has the ability to borrow up to $10 million from the Federal Reserve
Bank of Chicago, and two lines of credit with two banks totaling $96 million,
that does require the pledging of investment securities when drawn upon.
The combination of high
levels of potentially liquid assets, low dependence on volatile liabilities and
additional borrowing capacity provided sufficient liquidity for the Company
through June 30, 2003.
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HILLS
BANCORPORATION
ITEM 3.
QUANTITATIVE
AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Market
Risk Management
Market risk is the risk
of loss arising from adverse changes in market prices and rates. The
Company’s market risk is comprised primarily of interest rate risk
resulting from its core banking activities of lending and deposit gathering.
Interest rate risk measures the impact on earnings from changes in interest
rates and the effect on current fair market values of the Company’s assets,
liabilities and off-balance sheet contracts. The objective is to measure this
risk and manage the balance sheet to avoid unacceptable potential for economic
loss. Management continually develops and applies strategies to mitigate market
risk. Exposure to market risk is reviewed on a regular basis by the
asset/liability committee at the bank. Management does not believe that the
Company’s primary market risk exposures and how those exposures have been
managed to date in 2003 changed significantly when compared to 2002.
Asset/Liability
Management
The Company has a fully
integrated asset/liability management system to assist in managing the balance
sheet. The process, which is used to project the results of alternative
investment decisions, includes the development of simulations that reflect the
effects of various interest rate scenarios on net interest income. Management
analyzes the simulations to manage interest risk, the net interest margin and
levels of net interest income.
The goal is to structure
the balance sheet so that net interest margin fluctuates in a narrow range
during periods of changing interest rates. The Company currently believes that
net interest income would fall by less than 5 percent if interest rates
increased or decreased by 300 basis points over a one-year time horizon. This is
within the Company’s policy limits.
To improve net interest
income and lessen interest rate risk, management continues its strategy of
de-emphasizing fixed-rate portfolio residential real estate loans with long
re-pricing periods. The Company continues to focus on reducing interest rate
risk by emphasizing growth in variable-rate consumer and commercial loans. Other
actions include the use of fixed-rate Federal Home Loan Bank (FHLB) advances as
alternatives to certificates of deposit, and active management of the available
for sale investment securities portfolio to provide for cash flows that will
facilitate rate risk management.
The highly competitive
banking environment in Iowa also greatly impacts the Company’s net interest
margin. The effect of competition on net interest income is difficult to
predict.
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HILLS
BANCORPORATION
ITEM 4.
EVALUATION OF DISCLOSURE CONTROLS
Based on their evaluation
of the effectiveness of the registrant’s disclosure controls and procedures
as of a date within 90 days prior to the filing date of this quarterly report,
the undersigned officers of the registrant have concluded that such disclosure
controls and procedures are adequate. There were no significant changes in
internal controls or in other factors that could significantly affect internal
controls, including any corrective actions with regard to significant
deficiencies and material weaknesses, subsequent to the date of the most recent
evaluation by the undersigned officers of the registrant of the design and
operation of internal controls which could adversely affect the
registrant’s ability to record, process, summarize and report financial
data.
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HILLS BANCORPORATION
PART II – OTHER INFORMATION
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