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HILLS BANCORPORATION - Quarter Report: 2007 June (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2007

 

Commission file number: 0-12668

 

Hills Bancorporation

 

 

Incorporated in Iowa

I.R.S. Employer Identification

 

No. 42-1208067

 

 

131 MAIN STREET, HILLS, IOWA 52235

 

 

Telephone number: (319) 679-2291

 

 

Indicate by checkmark 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.

x Yes   o No

 

Indicate by checkmark 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 o               Accelerated Filer x

Non-accelerated filer o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

 

 

SHARES OUTSTANDING

 

CLASS

At July 31, 2007  

 

Common Stock, no par value

4,497,121

 

 

 

Page 1 of 35

 


 

HILLS BANCORPORATION

Index to Form 10-Q

 

Part I
FINANCIAL INFORMATION

 

      Page
Number
Item 1.   Financial Statements    
         
    Consolidated balance sheets, June 30, 2007 (unaudited)
       and December 31, 2006
3  
    Consolidated statements of income (unaudited) for three and six
       months ended June 30, 2007 and 2006
4  
    Consolidated statements of comprehensive income (unaudited) for
       three and six months ended June 30, 2007 and 2006
5  
    Consolidated statements of stockholders’ equity (unaudited)
       for six months ended June 30, 2007 and 2006
6  
    Consolidated statements of cash flows (unaudited) for six
       months ended June 30, 2007 and 2006
7  - 8
    Notes to consolidated financial statements 9  -12
     
 Item 2.   Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
13  - 25
         
Item 3.   Quantitative and Qualitative Disclosures About Market Risk 26  
         
Item 4.   Controls and Procedures 27  
         
    Part II
OTHER INFORMATION
   
         
Item 1.   Legal proceedings 28  
         
Item 1A.   Risk factors 28  
         
Item 2.   Unregistered sales of equity securities and use of proceeds 28  
         
Item 3.   Defaults upon senior securities 28  
         
Item 4.   Submission of matters to a vote of security holders 28  
         
Item 5.   Other information 29  
         
Item 6.   Exhibits 29  
         
Signatures     30  
         
Exhibits Index     31  

 

 

Page 2 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
(Amounts In Thousands, Except Shares)

ASSETS
June 30, 2007
(Unaudited)
 
December 31, 2006

 
             
Cash and due from banks $ 26,560   $ 23,397  
Federal funds sold   8,052      

   Total cash and cash equivalents $ 34,612   $ 23,397  
Investment securities:
   Available for sale at fair value (amortized cost June 30, 2007 $190,065;
      December 31, 2006 $180,106)
  186,857     178,057  
   Held to maturity at amortized cost (fair value June 30, 2007 $130;
      December 31, 2006 $177)
  125     170  
Stock of Federal Home Loan Bank   13,280     12,757  
Loans held for sale   5,388     3,808  
Loans, net   1,293,005     1,279,227  
Property and equipment, net   21,601     22,061  
Tax credit real estate   6,940     7,111  
Accrued interest receivable   11,541     10,292  
Deferred income taxes   8,490     7,613  
Goodwill   2,500     2,500  
Other assets   4,582     4,240  

  $ 1,588,921   $ 1,551,233  

 
LIABILITIES AND STOCKHOLDERS’ EQUITY            

 
             
Liabilities            
   Noninterest-bearing deposits $ 139,704   $ 143,274  
   Interest-bearing deposits   989,056     964,135  

         Total deposits $ 1,128,760   $ 1,107,409  
   Short-term borrowings   53,015     59,063  
   Federal Home Loan Bank borrowings   245,379     235,379  
   Federal Reserve Bank borrowings   8,000      
   Accrued interest payable   3,533     3,500  
   Other liabilities   7,644     6,303  

  $ 1,446,331   $ 1,411,654  

 
Redeemable Common Stock Held by Employee Stock            
   Ownership Plan (ESOP) $ 21,766   $ 20,940  

STOCKHOLDERS’ EQUITY
   Capital stock, no par value; authorized 10,000,000 shares; issued
       June 30, 2007 4,579,670 shares; December 31, 2006 4,571,659 shares
$   $  
   Paid in capital   12,643     12,364  
   Retained earnings   136,051     131,852  
   Accumulated other comprehensive loss   (1,981 )   (1,265 )
   Treasury stock at cost (June 30, 2007 82,549 shares;
      December 31, 2006 67,921 shares)
  (4,123 )   (3,372 )

  $ 142,590   $ 139,579  
   Less maximum cash obligation related to ESOP shares   21,766     20,940  

  $ 120,824   $ 118,639  

  $ 1,588,921   $ 1,551,233  


See Notes to Consolidated Financial Statements.

 

 

Page 3 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)


Three Months Ended
June 30,
Six Months Ended
June 30,

 
2007 2006 2007 2006

Interest income:                          
  Loans, including fees     $ 21,888   $ 19,709   $ 43,262   $ 38,080
  Investment securities:                          
    Taxable       1,202     1,150     2,241     2,290
    Nontaxable       776     715     1,539     1,422
  Federal funds sold       142     20     250     31

                 Total interest income     $ 24,008   $ 21,594   $ 47,292   $ 41,823

Interest expense:                          
  Deposits     $ 8,925   $ 6,580   $ 17,443   $ 12,538
  Short-term borrowings       484     783     989     1,200
  FHLB borrowings       2,987     2,814     5,930     5,603

                 Total interest expense     $ 12,396   $ 10,177   $ 24,362   $ 19,341

                 Net interest income     $ 11,612   $ 11,417   $ 22,930   $ 22,482
Provision for loan losses       954     1,054     1,486     1,709

                 Net interest income after provision for loan losses     $ 10,658   $ 10,363   $ 21,444   $ 20,773

Other income:    
  Net gain on sale of loans     $ 326   $ 227   $ 527   $ 381
  Trust fees       960     870     1,888     1,713
  Service charges and fees       2,020     1,761     3,731     3,333
  Rental revenue on tax credit real estate       190     190     306     402
  Other noninterest income       640     724     1,313     1,398

      $ 4,136   $ 3,772   $ 7,765   $ 7,227

     
Other expenses:                          
  Salaries and employee benefits     $ 4,832   $ 4,625   $ 9,648   $ 9,102
  Occupancy       585     543     1,163     1,096
  Furniture and equipment       891     824     1,723     1,613
  Office supplies and postage       321     359     639     648
  Advertising and business development       454     520     815     859
  Outside services       1,272     1,249     2,428     2,412
  Rental expenses on tax credit real estate       240     224     491     465
  Other noninterest expense       326     330     626     601

      $ 8,921   $ 8,674   $ 17,533   $ 16,796

                 Income before income taxes     $ 5,873   $ 5,461   $ 11,676   $ 11,204
Income taxes       1,806     1,671     3,604     3,465

                 Net income     $ 4,067   $ 3,790   $ 8,072   $ 7,739

     
Earnings per share:    
  Basic     $ 0.90   $ 0.83   $ 1.79   $ 1.70
  Diluted       0.90     0.83     1.78     1.69

 

See Notes to Consolidated Financial Statements.

 

 

Page 4 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Amounts In Thousands)


Three Months Ended
June 30,
Six Months Ended
June 30,




 
2007 2006 2007 2006

 
                             
Net income     $ 4,067   $ 3,790   $ 8,072   $ 7,739  




 
Other comprehensive loss:    
      Unrealized holding losses arising during the period,     $ (1,491 ) $ (1,347 ) $ (1,159 ) $ (2,037 )
      Income tax effect of unrealized losses       570     515     443     779  




 
Other comprehensive loss     $ (921 ) $ (832 ) $ (716 ) $ (1,258 )




 
Comprehensive income     $ 3,146   $ 2,958   $ 7,356   $ 6,481  




 

See Notes to Consolidated Financial Statements.

 

 

Page 5 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)
(Amounts In Thousands, Except Share Amounts)

Paid In
Capital
Retained
Earnings
Accumulated
Other
Comprehensive
Loss
Maximum
Cash
Obligation
Related
To ESOP
Shares
Treasury
Stock

Total

                                         
Balance, December 31, 2006     $ 12,364   $ 131,852   $ (1,265 ) $ (20,940 ) $ (3,372 ) $ 118,639  
   Issuance of 8,487 shares of
     common stock
      188                     188  
   Forfeiture of 476 shares of
     common stock
      (20 )                   (20 )
   Share-based compensation       18                     18  
   Income tax benefit related to
     share-based compensation
      93                     93  
   Change related to ESOP shares                   (826 )       (826 )
   Net income           8,072                 8,072  
   Cash dividends ($.86 per share)           (3,873 )               (3,873 )
   Purchase of 14,628 shares of
     common stock
                      (751 )   (751 )
   Other comprehensive loss               (716 )           (716 )

Balance, June 30, 2007     $ 12,643   $ 136,051   $ (1,981 ) $ (21,766 ) $ (4,123 ) $ 120,824  

                                         
Balance, December 31, 2005     $ 11,970   $ 119,989   $ (1,783 ) $ (20,634 ) $ (63 ) $ 109,479  
   Issuance of 2,803 shares of
     common stock
      134                     134  
   Forfeiture of 1,180 shares of
     common stock
      (42 )                   (42 )
   Share-based compensation       28                     28  
   Change related to ESOP shares                   576         576  
   Net income           7,739                 7,739  
   Cash dividends ($.81 per share)           (3,695 )               (3,695 )
   Purchase of 3,977 shares of
     common stock
                      (188 )   (188 )
   Other comprehensive loss               (1,258 )           (1,258 )

Balance, June 30, 2006     $ 12,090   $ 124,033   $ (3,041 ) $ (20,058 ) $ (251 ) $ 112,773  

See Notes to Consolidated Financial Statements.

 

 

Page 6 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Amounts In Thousands)

Six Months Ended
June 30,

 
2007 2006

 
Cash Flows from Operating Activities                
   Net income     $ 8,072   $ 7,739  
   Adjustments to reconcile net income to net cash and
        cash equivalents provided by operating activities:
               
      Depreciation       1,146     1,170  
      Provision for loan losses       1,486     1,709  
      Share-based compensation       18     28  
      Forfeiture of common stock       (20 )   (42 )
      Compensation expensed through issuance of common stock       92     134  
      Excess tax benefits from share-based compensation       (93 )    
      Provision for deferred income taxes       (434 )   (839 )
      Increase in accrued interest receivable       (1,249 )   (803 )
      Amortization of discount on investment securities, net       176     287  
      (Increase) decrease in other assets       (249 )   747  
      Increase in accrued interest and other liabilities       1,374     400  
      Loans originated for sale       (61,286 )   (49,706 )
      Proceeds on sales of loans       60,233     42,696  
      Net gain on sales of loans       (527 )   (381 )

         Net cash and cash equivalents provided by operating activities     $ 8,739   $ 3,139  

                 
Cash Flows from Investing Activities                
   Proceeds from maturities of investment securities:                
      Available for sale     $ 18,462   $ 15,460  
      Held to maturity       45     45  
   Purchases of investment securities available for sale       (29,120 )   (10,074 )
   Loans made to customers, net of collections       (15,264 )   (81,417 )
   Purchases of property and equipment       (686 )   (1,058 )
   Investment in tax credit real estate, net       171     279  

         Net cash used in investing activities     $ (26,392 ) $ (76,765 )

     
Cash Flows from Financing Activities                
   Net increase in deposits     $ 21,351   $ 36,446  
   Net increase (decrease) in short-term borrowings       (6,048 )   33,250  
   Stock options exercised       96      
   Excess tax benefits from share-based compensation       93      
   Borrowings from FHLB       30,000     15,000  
   Payments on FHLB borrowings       (20,000 )   (10,000 )
   Borrowings from FRB       8,000      
   Purchase of treasury stock       (751 )   (188 )
   Dividends paid       (3,873 )   (3,695 )

         Net cash provided by financing activities     $ 28,868   $ 70,813  

 

 

 

Page 7 of 35

 


 

HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued)
(Amounts In Thousands)


Six Months Ended
June 30,

 
2007 2006

 
             
Increase (decrease) in cash and cash equivalents $ 11,215   $ (2,813 )
 
Cash and cash equivalents:
   Beginning of year   23,397     29,956  

 
   End of period $ 34,612   $ 27,143  

 
 
Supplemental Disclosures            
   Cash payments for:            
      Interest paid to depositors $ 17,410   $ 12,309  
      Interest paid on other obligations   6,919     6,803  
      Income taxes paid   3,980     4,336  
 
   Noncash financing activities:            
      Increase (decrease) in maximum cash obligation
         related to ESOP shares
$ 826   $ (576 )

See Notes to Consolidated Financial Statements.

 

 

Page 8 of 35

 


 

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1.

Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X. These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown. Certain prior year amounts may be reclassified to conform to the current year presentation.

 

Operating results for the six month period ended June 30, 2007 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2007. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2006 filed with the Securities Exchange Commission on March 9, 2007.

 

Note 2.

Earnings Per Share

 

Basic earnings per share amounts are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce the loss or increase the income per common share from continuing operations.

 

The computation of basic and diluted earnings per share for the periods presented is as follows:

 

Three months ended
June 30,
Six months ended
June 30,



 


 
2007 2006 2007 2006



 


 
                             
Common shares outstanding at the beginning of the period       4,497,275     4,559,350     4,503,738     4,562,237  
Weighted average number of net shares issued (redeemed)       1,994     73     270     (1,928 )

 
 
 
 
         Weighted average shares outstanding (basic)       4,499,269     4,559,423     4,504,008     4,560,309  
Weighted average of potential dilutive shares
   attributable to stock options granted, computed under
   the treasury stock method
      26,945     27,373     27,130     27,493  

 
 
 
 
         Weighted average number of shares (diluted)       4,526,214     4,586,796     4,531,138     4,587,802  

 
 
 
 
   
Net income (In Thousands)     $ 4,067   $ 3,790   $ 8,072   $ 7,739  

 
 
 
 
     
Earnings per share:                            
   Basic     $ 0.90   $ 0.83   $ 1.79   $ 1.70  

 
 
 
 
   Diluted     $ 0.90   $ 0.83   $ 1.78   $ 1.69  

 
 
 
 

Note 3.

Recent Accounting Pronouncements

 

In March 2006, the FASB issued FASB Statement No. 156 (“FAS 156”), Accounting for Servicing of Financial Assets and amendment of FASB Statement No. 140 (“FAS 140”), Accounting for Transfers and Extinguishment of Liabilities. FAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. The Company elected the fair value measurement method with changes in fair value reflected in earnings for subsequent measurements. FAS 156 was effective for the Company as of January 1, 2007. The adoption of this statement did not have a significant effect on the Company’s financial statements.

 

 

 

Page 9 of 35

 


 

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

 

Note 3.

Recent Accounting Pronouncements (continued)

 

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit based on the technical merits of the position. The provisions of FIN 48 were effective as of January 1, 2007. The adoption of the Interpretation did not have a significant effect on the Company’s financial statements. See Footnote 7.

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements. The Statement provides a single definition of fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Previously, different definitions of fair value were contained in various accounting pronouncements that prescribe fair value as the relevant measure of value, except FAS 123R and related interpretation and pronouncements that require or permit measurement similar to fair value but are not intended to measure fair value. The Statement is effective for financial statements issued for year beginning after November 15, 2007. The Company is currently evaluating the impact that the Statement will have on its consolidated financial statements.

 

In February 2007, the FASB issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilties – Including an Amendment of FASB Statement No. 115 (“FAS 159). FAS 159 permits companies to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of FAS 159 is to provide opportunities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply hedge accounting provisions. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The Statement is effective for financial statements issued for the year beginning after November 15, 2007. The Company is currently evaluating the impact that the Statement will have on its consolidated financial statements.

 

Note 4.

Employee Benefit Plans

 

The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 198,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Director options granted on or before December 31, 2006 may be exercised immediately. Director options granted on or after January 1, 2007 and officers’ rights under the plan vest over a five-year period from the date of the grant.

 

Information concerning the issuance of stock options is presented in the following table:


Options Weighted-Average
Exercise Price
Weighted-Average Remaining
Contractual Term (years)
Aggregate
Intrinsic Value
(In Thousands)

 
Outstanding at January 1, 2007      
57,195
   
$26.79
   
4.88
   
$1,532
 

 
Options outstanding at June 30, 2007      
55,110
   
  30.36
   
5.35
   
  1,673
 

 
Options exercisable at June 30, 2007      
31,930
   
  27.45
   
4.53
   
    876
 

 

Options for 4,580 shares of stock were granted during the second quarter of 2007. The weighted-average value of the options granted was $16.98 per share.

 

 

Page 10 of 35

 


 

 

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

 

Note 4.

Employee Benefit Plans (continued)

 

The fair value of each option is estimated as of the date of grant using a Black-Scholes option pricing model. The expected lives of options granted incorporate historical employee exercise behavior. The risk-free rate for periods that coincide with the expected life of the options is based on the annual 10 year interest rate swap rate as published by the Federal Reserve Bank. Expected volatility is based on volatility levels of the Company’s peer’s common stock as the Company’s stock has limited trading activity. Expected dividend yield was based a set dividend rate. Significant assumptions related to the options granted in 2007 include:

 
  Risk-free interest rate 5.21%   
  Expected option life 7.5 years    
  Expected volatility 25.33%   
  Expected dividends 1.69%   

 

At June 30, 2007, 115,635 shares were available for issuance under the plan. Stock options for 6,665 shares with a weighted-average exercise price of $14.57 were exercised during the six months ended June 30, 2007. The intrinsic value of the options exercised was $97,088.

 

As of June 30, 2007, there was $34,472 in unrecognized compensation cost for stock options granted under the plan compared to $52,600 as of June 30, 2006. This unrecognized cost is expected to be recognized over a weighted-average period of 1.49 years.

 

Note 5.

Stock Repurchase Program

 

In July of 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization will expire on December 31, 2009. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory and legal factors. The Company has purchased 82,549 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2007. Of these 82,549 shares, 6,683 shares were purchased during the quarter ended June 30, 2007, at an average price per share of $51.98.

 

 

Page 11 of 35

 


 

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

 

Note 6.

Commitments and Contingencies

 

The Company’s subsidiary, Hills Bank and Trust (the “Bank”) is a party to financial instruments with off-balance–sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, credit card participations and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at June 30, 2007 and December 31, 2006 is as follows:

 

 
June 30, 2007
December 31, 2006
     




 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:                
   Home equity loans     $ 20,149   $ 18,796  
   Credit card participations       29,879     28,091  
   Commercial, real estate and home construction       82,967     83,699  
   Commercial lines and real estate purchase loans       98,776     70,200  
Outstanding letters of credit       9,965     10,107  

 

Commitments for commercial and real estate loans increased $28.6 million since December 31, 2006. The majority of this increase is due to the volume of residential real estate loan commitments as of June 30, 2007. Real estate loan commitments were $34.9 million at June 30, 2007 and $3.6 million at December 31, 2006, an increase of $21.3 million.

 

Note 7.

Income Taxes

 

Federal income tax expense for the six months ended June 30, 2007 and 2006 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. On January 1, 2007, the Company adopted FIN 48, Accounting for Uncertainty in Income Taxes. The evaluation was performed for those tax years which remain open to audit. The Company files a consolidated tax return for federal purposes and separate tax returns for the State of Iowa purposes. The tax years ended December 31, 2006, 2005 and 2004, remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2006, 2005 and 2004, remain open for examination. As a result of the implementation of FIN 48, the Company did not recognize any increase or decrease for unrecognized tax benefits. There were no material unrecognized tax benefits on January 1, 2007 and June 30, 2007. No interest or penalties on these unrecognized tax benefits has been recorded. As of June 30, 2007, the Company does not anticipate any significant increase or decrease in unrecognized tax benefits during the remainder of 2007.

 

 

Page 12 of 35

 



HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations

 

The following is management’s discussion and analysis of the financial condition of Hills Bancorporation (“Hills Bancorporation” or “the Company”) and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.

 

Special Note Regarding Forward Looking Statements

 

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

 

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:

 

 

The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.

 

 

The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.

 

 

The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

 

 

The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

 

 

The ability of the Company to obtain new customers and to retain existing customers.

 

 

The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

 

 

Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.

 

 

The ability of the Company to develop and maintain secure and reliable electronic systems.

 

 

Page 13 of 35

 


 

HILLS BANCORPORATION

 

Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)


 

The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

 

 

Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.

 

 

The economic impact of terrorist attacks and military actions.

 

 

Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.

 

 

The costs, effects and outcomes of existing or future litigation.

 

 

Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

 

 

The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

 

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

 

Critical Accounting Policies

 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company’s allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company’s markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual loans in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the Management’s Discussion and Analysis of Financial Condition and Results of Operation that is included. Although management believes the levels of the allowance as of June 30, 2007 and December 31, 2006 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

 

 

Page 14 of 35

 


 

HILLS BANCORPORATION

 

Item 2.   Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Overview

 

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At June 30, 2007, the Bank has thirteen full-service locations.

 

Net income for the six-month period ended June 30, 2007 was $8.07 million compared to $7.74 million for the same six months of 2006, an increase of 4.30%. The $472,000 increase in net income before income taxes is due to the combined result of an increase in net interest income of $448,000, other income of $538,000, the decrease in the provision for loan losses of $223,000 and expenses increasing $737,000. Return on average equity was 13.49% for the six months ended June 30, 2007 compared to 14.07% for the same period in 2006. Return on average assets was 1.03% in 2007 compared to 1.06% in 2006. Dividends of $.86 per share were paid in January 2007 to 1,535 shareholders. The 2007 dividend was a 6.17% increase over the prior year’s dividend of $.81 per share.

 

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earnings assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.23% compared to 3.39% in 2006. Average earning assets were $1.491 billion in 2007 and $1.391 billion in 2006.

 

Highlights noted on the balance sheet as of June 30, 2007 for the Company included the following:

Total assets are over $1.5 billion, at $1.589 billion.

Net loans are $1.298 billion.

Loan growth of $15.4 million since December 31, 2006.

Deposit growth of $21.4 million since December 31, 2006.

 

A detailed discussion of the financial condition and results of operations follows this overview.

 

Financial Condition

 

The asset growth for the six months ended June 30, 2007 of $37.7 million included a net loan increase of $15.4 million, an increase in federal funds sold of $8.1 million and an increase in investment securities of $8.8 million. The upward movement of the federal funds target rate started on June 30, 2004 when the rate was increased from 1.00% to 1.25%; the rate increased 17 times to 5.25% at June 30, 2007. The Federal Reserve Open Market Committee has not changed the target rate at its eight meetings since June 29, 2006. Interest rates on loans are generally affected by these increases since interest rates for the U.S. Treasury market normally increase when the Federal Reserve Board raises the federal funds target rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. Increases in interest rates may at some point materially reduce the loan demand and slow the economy, but at the current interest rate levels, demand for loans remains good. The overall economy in the Company’s principal place of business, Johnson and Linn Counties, remains good with unemployment levels that remain low.

 

 

Page 15 of 35

 



HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

The tables below set forth the composition of the loan portfolio as of June 30, 2007 and December 31, 2006 (dollars in thousands), along with changes in the allowance for loan losses and non-performing loan information:  

 

  June 30, 2007 December 31, 2006






  Amount Percent Amount Percent




 
(Amounts In Thousands)
(Amounts In Thousands)
                               
  Agricultural     $ 48,334     3.68 % $ 49,223     3.80 %
  Commercial and financial       130,500     9.95     118,339     9.12  
  Real estate:                            
     Construction       109,163     8.32     114,199     8.80  
     Mortgage       995,181     75.86     983,489     75.83  
  Loans to individuals       28,677     2.19     31,827     2.45  




        $ 1,311,855     100.00 % $ 1,297,077     100.00 %

 
  Less allowance for loan losses       18,850           17,850        


 
        $ 1,293,005         $ 1,279,227        


 

Loan growth of $12.2 million in commercial and financial loans is due to extensions of credit to existing customers.

 

The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring that, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment.

 

Changes in the allowance for loan losses for the periods shown in the following table were as follows:

 

  Three Months Ended
June 30,
Six Months Ended
June 30,






  2007 2006 2007 2006






 
(Amounts In Thousands)
(Amounts In Thousands)
                               
  Balance, beginning     $ 18,410   $ 16,150   $ 17,850   $ 15,360  
      Provision charged to expense       954     1,054     1,486     1,709  
      Recoveries       259     281     723     781  
      Loans charged off       (773 )   (385 )   (1,209 )   (750 )






  Balance, ending     $ 18,850   $ 17,100   $ 18,850   $ 17,100  






 

Non-performing loan information at June 30, 2007 and December 31, 2006, was as follows:

 

  June 30, 2007 December 31, 2006
         
   
 
 
(Amounts in thousands)
                   
  Non-accrual loans     $ 651   879  
                   
  Accruing loans past due ninety days or more       5,735     4,983  
                   
  Restructured loans            
                   
  Non-performing loans (includes non-accrual loans)       34,921     14,681  

 

 

Page 16 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Non-performing loans increased by $20.2 million from December 31, 2006 to June 30, 2007. Non-performing loans include any loan that has been placed on nonaccrual status. Non-performing loans also include loans that based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. These loans are also considered impaired loans. This increase in non-performing loans is due to deterioration in the credit quality of four borrower relationships having an aggregate balance of approximately $19.2 million as of June 30, 2007. The Bank believes these loans are adequately collateralized by real estate.

 

Federal funds sold increased from zero at December 31, 2006 to $8.1 million at June 30, 2007. Deposit growth of $21.4 million exceeded the funds required for loan growth.

 

The estimated fair value of the investment securities held by the Company increased by $8.8 million from December 31, 2006 to June 30, 2007. This increase resulted from purchases of securities of approximately $10.0 million in excess of maturities during the six-month period ended June 30, 2007. The purchases were offset by a decline in the market value of securities available for sale of $1.2 million since December 31, 2006. The carrying values of investment securities for June 30, 2007 and December 31, 2006 are summarized in the following table (dollars in thousands):

 

  June 30, 2007 December 31, 2006





  Amount Percent Amount Percent





  Securities available for sale                            
                               
  U.S. Government agencies
   and corporations
    $ 102,061     54.62 % $ 94,068     52.83 %
                               
  State and political
   subdivisions
      84,796     45.38     83,989     47.17  





                               
  Total securities
   available for sale
    $ 186,857     100.00 % $ 178,057     100.00 %





       
  Securities held to maturity                            
     State and political
      subdivisions
    $ 125     100.00 % $ 170     100.00 %





 

Deposit growth was $21.4 million in the first six months of 2007. Repurchase agreements decreased $3.8 million in the same period. Short-term borrowings at December 31, 2006 included federal funds purchased that decreased $2.2 million to $8.5 million as of June 30, 2007. The borrowings from the Federal Home Loan Bank (FHLB) decreased by $20 million with the maturity in June 2007 of an advance with the interest rate of 4.48%. The Company borrowed an additional $30 million in June 2007. One $15 million advance is at a rate of 4.62% for ten years and is callable in one year. The second $15 million advance is at a rate of 4.89% for ten years that is callable in three years. The Company also borrowed $8 million from the Federal Reserve Bank on June 29, 2007. These funds were a short-term borrowing at 6.25% and were repaid on July 2, 2007. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

 

 

Page 17 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Dividends and Equity

 

In January 2007, Hills Bancorporation paid a dividend of $3,873,000 or $.86 per share, a 6.17% increase from the $.81 per share paid in January 2006. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2007 totaled $120.8 million. Under risk-based capital rules, the total amount of risk based capital of the Company as of June 30, 2007, was 12.75% of risk-adjusted assets, and is substantially in excess of the required minimum of 8.00%. Risk-based capital was 13.38% and 13.31% as of June 30 and December 31, 2006, respectively. As of June 30, 2007, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s category.

 

Discussion of operations for the six months ended June 30, 2007 and 2006  

 

Net Income Overview

 

Net income increased $333,000 for the six months ended June 30, 2007 compared to the first six months of 2006. Total net income was $8,072,000 in 2007 and $7,739,000 in the comparable period in 2006. The changes in net income in 2007 from the first six months of 2006 were the result of the following:

 

Net interest income increased by $448,000.

The provision for loan losses decreased by $223,000.

Other income increased by $538,000.

Other expenses increased by $737,000.

Income taxes increased by $139,000.

 

For the six-month periods ended June 30, 2007 and 2006, basic earnings per share were $1.79 and $1.70, respectively. Diluted earnings per share were $1.78 for the six months ended June 30, 2007 compared to $1.69 for the same period in 2006.

 

Quarterly fluctuations in the Company’s net income continue to be driven primarily by two important factors. The first important factor is the interaction between changes in net interest margin and changes in average earnings assets. Net interest income of $22.9 million for the first six months of 2007 was derived from the Company’s $1.491 billion of average earning assets during that period and its net interest margin of 3.23%. Average earning assets in the six months ending June 30, 2006 were $1.391 billion and the net interest margin was 3.39%. The margin compression was the result of the continued flattening of the yield curve and pricing pressure on loans and short-term deposits. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.13% would have resulted approximately in a $739,000 decrease in income before income taxes in the six month period ending June 30, 2007. Similarly, an increase in the net interest margin of 10 basis points to 3.33% would have resulted in approximately a $739,000 increase in net interest income before taxes. Despite the decline in the net interest margin, the net interest income for the Company increased due to the increase in average earning assets over the similar six-month period in 2006.

 

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.298 billion at June 30, 2007. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which includes non-accrual loans) and loans past due 90 days or more. The provision for loan losses was $1,486,000 in the first six months of 2007 compared to $1,709,000 the same period in 2006.

 

 

Page 18 of 35

 


 

HILLS BANCORPORATION

 

Item 2. Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the six months ended June 30, 2007 and 2006 (continued)

 

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the first six months of 2007 was 3.23% compared to 3.39% in 2006 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2007 compared to the comparable period in 2006 are shown in the following table:

 

Change in
Average Balance
Change in
Average Rate
Increase (Decrease) in Net Interest Income
             
 
Volume Changes Rate Changes Net Change

 



           
(Amounts in Thousands)
                                   
Interest income:                                  
  Loans, net     $ 105,350     0.28 % $ 3,410   $ 1,790   $ 5,200  
  Taxable securities       (19,177 )   0.52     (339 )   290     (49 )
  Nontaxable securities       5,936     0.04     161     19     180  
  Federal funds sold       8,512     0.92     174     45     219  

 


      100,621         $ 3,406   $ 2,144   $ 5,550  

 


     
Interest expense:                                  
  Interest-bearing demand deposits     $ 12,653     0.50   $ (56 ) $ (379 ) $ (435 )
  Savings deposits       (8,790 )   0.46     211     (735 )   (524 )
  Time deposits       82,823     0.82     (1,576 )   (2,370 )   (3,946 )
  Short-term borrowings       (10,865 )   0.05     332     (121 )   211  
  FHLB borrowings       12,996         (327 )       (327 )

 


      $ 88,817         $ (1,416 ) $ (3,605 ) $ (5,021 )

 


Change in net interest income                 $ 1,990   $ (1,461 ) $ 529  



 

A summary of the net interest spread and margin is as follows:

 

                                        (Tax Equivalent Basis) 2007 2006
 
   
 
 
                   
  Yield on average interest-earning assets       6.51 %   6.18 %
  Rate on average interest-bearing liabilities       3.83     3.27  


  Net interest spread       2.68 %   2.91 %
  Effect of noninterest-bearing funds       0.55     0.48  


  Net interest margin (tax equivalent interest income
   divided by average interest-earning assets)
      3.23 %   3.39 %


 

 

Page 19 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the six months ended June 30, 2007 and 2006 (continued)

 

Provision for Loan Losses

 

The provision for loan losses was $1,486,000 in 2007 compared to $1,709,000 in 2006, a decrease of $223,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the impact of borrowers’ ability to repay, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risks (primarily agricultural and spec real estate construction loans).

 

The provision for loan losses was larger in 2006 due to loan growth of $87.1 million in the first six months compared to $15.4 million in loan growth in the same period in 2007. The decrease in provision expense due to less loan growth was offset by a larger increase in problem and watch loans in 2007. Problem and watch loans increased $27.4 million in the six-month period ended June 30, 2007 compared to an increase of $3.6 million during the same period in 2006. The increase in non-performing loans is due to the deterioration in the credit quality of four borrower relationships having an aggregate balance of approximately $19.2 million as of June 30, 2007. The Bank believes these loans are adequately collateralized by real estate.

 

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the six months ended June 30, 2007 and 2006, recoveries were $723,000 and $781,000, respectively; and charge-offs were $1,209,000 in 2007 and $750,000 in 2006. The allowance for loan losses totaled $18,850,000 at June 30, 2007 compared to $17,850,000 at December 31, 2006. The allowance represented 1.43% and 1.37% of outstanding loans at June 30, 2007 and December 31, 2006, respectively. The methodology used in 2007 is consistent with 2006.

 

Net Gain on Sale of Loans

 

Net gain on sale of loans for the six months ended June 30, 2007 was $527,000 compared to $381,000 for the comparable period ended June 30, 2006. Loans sold in the first six months of 2007 totaled $61.3 million compared to $49.7 million in the same period in 2006, an increase of 24%.

 

Other Income

 

Other income, other than the net gain on sale of loans discussed above, increased by $392,000 for the six months ended June 30, 2007. Trust fees increased $175,000 in 2007 as a result of assets under management increasing from $798.6 million as of June 30, 2006 to $927.2 million as of June 30, 2007. Service charges and fees were up $398,000 in 2007. $173,000 was the result of fee income strategies. Debit card and point of sale (POS) pin interchange fees increased during the same period by $198,000 due to volume of activity. Rental revenue on tax credit real estate decreased $96,000 for the six-month period ended June 30, 2007. This decrease was due to adjustments recorded upon receipt of the 2006 audited financial statements for the tax credit properties. Other noninterest income decreased $85,000 as of June 30, 2007 compared to 2006. Included in 2006 other income was a one-time $79,000 sales tax refund.

 

 

Page 20 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the six months ended June 30, 2007 and 2006 (continued)

 

Other Expenses

 

Other expenses increased $737,000 in 2007 to $17,533,000 from the same period in 2006. This increase of 4.39% included $546,000 in salaries and benefits. Direct salary expense was up $376,000, or 5.57%, due to annual pay adjustments and the addition of employees in 2007. Medical expense for employees’ health insurance increased $47,000 due to a premium increase of 6.90%. Furniture and equipment expense increased $110,000 in the six months ended June 30, 2007 compared to the same period in 2006. This variance is due to a $134,000 increase in software maintenance contract expense. Advertising and business development expenses decreased $44,000 as of June 30, 2007. The decrease is primarily the result of office promotions held in 2006 for the retail areas of the Bank.

 

Outside services increased $16,000 from 2006. Outside services include professional fees, courier services and ATM fees and processing charges for the merchant credit card program, retail credit cards and other data processing services. The credit card, merchants’ card and debit card processing charges increased $54,000 due to the increase in the volume of activity. Professional fees decreased $53,000 in part due to fees of $30,000 paid to an outside consultant in 2006 for a sales tax audit and expanded information security testing.

 

Income Taxes

 

Federal and state income tax expenses were $3,604,000 and $3,465,000 for the six months ended June 30, 2007 and 2006, respectively. Income taxes as a percentage of income before taxes were 30.87% in 2007 and 30.93% in 2006. The amount of tax credits was $280,000 for the six month period for both 2007 and 2006.

 

 

Page 21 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the three months ended June 30, 2007 and 2006  

 

Net Income

 

Net income increased to $4,067,000 for the three months ended June 30, 2007 from $3,790,000 for the same period in 2006, an increase of 7.31%. Earnings per share, both basic and diluted, increased for the three months ended June 30, 2007 compared to the same period in 2006. For the three-month period ended June 30, 2007, basic and diluted earnings per share were $0.90. For the three months ended June 30, 2006, basic and diluted earnings per share were $0.83. Return on average equity was 13.61% for the three months ended June 30, 2007 compared to 13.64%, for the same period in 2006. Return on average assets was 1.03% in 2007 and 2006.

 

Net Interest Income

 

Net interest income increased for the three month period ended June 30, 2007 by $195,000 from the similar period in 2006. The net interest margin in 2007 was 3.24% compared to 3.37% in 2006. The decrease is primarily due to an increase in rates on core deposit accounts, including insured money market accounts and short-term certificates of deposits. These rates were increased due to the upward movement of the federal fund rates. Rates paid on repurchase agreements and federal funds borrowed also increased. The increase in the volume of interest earning assets accounted for a significant portion of the net interest income improvement. Net interest income changes on a tax-equivalent basis for the three months ended June 30, 2007 and 2006 are as follows:

 

Change in
Average Balance
Change in
Average Rate
Increase (Decrease) in Net Interest Income
             
 
Volume Changes Rate Changes Net Change





(Amounts in Thousands)
                                   
Interest income:                                  
     Loans, net     $ 85,649     0.24 % $ 1,404   $ 785   $ 2,189  
     Taxable securities       (16,178 )   0.70     (142 )   194     52  
     Nontaxable securities       6,129     0.05     83     11     94  
     Federal funds sold       9,550     0.83     98     24     122  

 


      $ 85,150         $ 1,443   $ 1,014   $ 2,457  

 


Interest expense:    
     Interest-bearing demand deposits     $ 20,301     0.59   $ (47 ) $ (242 ) $ (289 )
     Savings deposits       (12,355 )   0.35     142     (311 )   (169 )
     Time deposits       77,164     0.79     (755 )   (1,132 )   (1,887 )
     Short-term borrowings       (24,761 )   (0.22 )   335     (36 )   299  
     FHLB borrowings       13,774         (174 )   1     (173 )

 


      $ 74,123         $ (499 ) $ (1,720 ) $ (2,219 )

 


Change in net interest income                 $ 944   $ (706 ) $ 238  



 

 

Page 22 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the three months ended June 30, 2007 and 2006  

 

A summary of the net interest spread and margin is as follows:

 

  (Tax Equivalent Basis) 2007
2006
 
   
 
 
                   
  Yield on average interest-earning assets       6.54 %   6.24 %
  Rate on average interest-bearing liabilities       3.86     3.36  


  Net interest spread       2.68 %   2.88 %
  Effect of noninterest-bearing funds       0.56     0.49  


  Net interest margin (tax equivalent interest income
     divided by average interest-earning assets)
      3.24 %   3.37 %


 

Provision for Loan Losses

 

The provision for loan losses was $954,000 for the quarter ended June 30, 2007 compared to $1,054,000 for the comparable quarter in 2006, a decrease of $100,000. As discussed in connection with the results of operations for the six months, the allowance for loan losses was decreased due to management’s analysis of the outstanding loans at June 30, 2007. The provision for loan losses was larger in the three-month period ended June 30, 2006 due to loan growth of $53.3 million compared to loan growth of $9.7 million in the same period in 2007. In addition, loans classified as potential watch, watch or problem loans increased $13.2 million in the second quarter of 2006 compared to a decrease of $0.7 in these categories during the second quarter of 2007.

 

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the three months ended June 30, 2007 and 2006, recoveries were $259,000 and $281,000, respectively; and charge-offs were $773,000 in 2007 and $385,000 in 2006. The allowance for loan losses totaled $18,850,000 at June 30, 2007 compared to $17,100,000 at June 30, 2006. The allowance represented 1.43% and 1.37% of outstanding loans at June 30, 2007 and June 30, 2006, respectively.

 

Other Income

 

Total other income was $4,136,000 and $3,772,000 for the three months ended June 30, 2007 and 2006. Net gain on sale of loans increased by $99,000 in the quarter ended June 30, 2007 as compared to the same quarter in 2006 due to an increase in the volume of loans sold in 2007. The Trust Department fees for 2007 were $90,000 higher than 2006 due to the growth of assets under management. Service charges and fees were up $259,000 in the three months ended June 30, 2007. $131,000 was the result of fee income strategies. Debit card and point of sale (POS) pin interchange fees increased $105,000 during the same period due to the volume of activity. Other noninterest income decreased $84,000 in 2007. Included in the second quarter other income was the one-time $79,000 sales tax refund noted in the six month discussion above.

 

Other Expenses

 

Total expenses for the 2007 quarter compared to the 2006 quarter increased $247,000 to $8,921,000. Salaries and employee benefits increased $207,000 for the quarter ended June 30, 2007 compared to 2006. Direct salary expense was up $143,000, or 4.16%, due to annual pay adjustments and additional employees in 2007. Furniture and equipment expense increased $67,000 in the three months ended June 30, 2007 as compared to 2006. This variance was due to a $76,000 increase in software maintenance contract expense. Advertising and business development expenses decreased $66,000 in comparing the quarters. The decrease is due to office promotions held in 2006 for the retail area of the Bank.

 

 

Page 23 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

Discussion of operations for the three months ended June 30, 2007 and 2006 (continued)

 

Outside services increased $23,000 from the second quarter of 2006. Credit card, merchants’ card and debit card processing charges increased $29,000 for the three-month period ended June 30, 2007 due to volume of card activity. Professional fees decreased $25,000 in 2007 in part due to the $30,000 in fees paid to an outside consultant in 2006, as noted in the six month discussion above.

 

Income Taxes

 

Income tax expense as a percentage of income before taxes increased to 30.75% in 2007 from 30.60% in 2006. Income tax expense was $135,000 more in 2007 compared to 2006 primarily due to the $412,000 increase in income before income taxes. The amount of tax credits was $140,000 in the second quarters of both 2007 and 2006.

 

 

 

Page 24 of 35

 


 

HILLS BANCORPORATION

 

Item 2.  Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

 

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 12.27% of the Company’s total assets at June 30, 2007, compared to 11.48% at December 31, 2006.

 

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of June 30, 2007, the Company had borrowed $245.4 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. This includes two new advances in June 2007, each for $15 million. Also, a $20 million advance matured in June 2007. These advances were used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $189 million at June 30, 2007.

 

As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago. As of June 30, 2007, $8 million had been borrowed from the Federal Reserve Bank on a short-term basis. These funds were repaid by the Company on July 2, 2007. The Company also has lines of credit with two banks totaling $125 million. Those two lines of credit 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 sources of liquidity for the Company which management considered sufficient at June 30, 2007.

 

As of June 30, 2007, investment securities with a carrying value of $53,015,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2006, investment securities with a carrying value of $59,063,000 were pledged.

 

Contractual Obligations

 

As of June 30, 2007, there had been no material changes in the Company’s contractual obligations from those disclosed in its Annual Report in Form 10-K for the year ended December 31, 2006.

 

 

 

Page 25 of 35

 


 

HILLS BANCORPORATION

 

Item 3.   Quantitative and Qualitative Disclosures About Market Risk

 

Market Risk Management

 

The Company’s primary market risk exposure is to changes in interest rates. The Company’s asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company’s control, such as market interest rates and competition, may also have an impact on the Company’s interest income and interest expense. In the absence of other factors, the Company’s overall yield on interest-earning assets will increase, as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Conversely, the Company’s yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.

 

Asset/Liability Management

 

The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.

 

In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company’s operations, management has implemented an asset/liability program designed to mitigate the Company’s interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of savings or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

 

Net interest income should decline as interest rates increase, while net interest income should increase as interest rates decline. Generally, during periods of increasing interest rates, the Company’s interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company’s interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company’s net interest income.

 

Although there has been no material change in the Company’s assets and liability position since December 31, 2006, interest expense during the six months ended June 30, 2007 increased at a faster pace than the comparable increase in interest income. Correspondingly, the Company’s net interest margin decreased from 3.39% for the six months ended June 30, 2006 to 3.23% for the same period in 2007. As indicated elsewhere in this report, despite this decline in net interest margin, the Company’s net interest income increased in the six months ended June 30, 2007 as compared to the same period in 2006 due to an increase of approximately $100 million, or approximately 7.15%, in average earning assets.

 

 

 

Page 26 of 35

 


 

HILLS BANCORPORATION

 

Item 4. Controls and Procedures

 

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in the Securities Exchange Act of 1934 Rule 13a-15(f). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the first six months of 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

 

 

 

 

 

 

Page 27 of 35

 


 

 

HILLS BANCORPORATION

PART II - OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

No material legal proceedings are pending.

 

Item 1A.

Risk Factors

 

There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended June 30, 2007:

 


 
Period Total number of
shares purchased
Average price
paid per share
Total number of shares
purchased as part of
publicly announced plans
or programs
Maximum number of
shares that may yet be
purchased under the
plans or programs (1)

 
April 1 to April 30       138   $ 51.00     76,004     673,996  

 
May 1 to May 31       4,720     52.00     80,724     669,276  

 
June 1 to June 30       1,825     52.00     82,549     667,451  

 
Total       6,683   $ 51.98     82,549     667,451  

 

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization will expire on December 31, 2009. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory and legal factors.

 

Item 3.

Defaults upon Senior Securities

 

Hills Bancorporation has no senior securities.

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

The Annual Meeting of Shareholders was held on April 16, 2007. The only matter voted was for the election of directors. The following individuals were elected to serve as Directors of the Company for a three year term at the Annual Meeting. The results of the voting by individuals and those withholding authority are as follows:

 

  For     Withhold Authority   Term
  1.  Michael S. Donovan       3,120,684     31,243   1 year to 2009
  2.  Michael E. Hodge       3,119,634     32,293   2 years to 2010
  3.  Richard W. Oberman       3,093,409     58,518   2 years to 2010
  4.  John W. Phelan       3,115,824     36,103   2 years to 2010
  5.  Sheldon E. Yoder, D.V.M.       3,120,684     31,243   2 years to 2010

 

 

Page 28 of 35

 


 

HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

 

 

Item 5.

Other Information

 

None

 

Item 6.

Exhibits

 

31

Certifications under Section 302 of the Sarbanes-Oxley Act of 2002

 

32

Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

 

 

Page 29 of 35

 


 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

        HILLS BANCORPORATION
     
Date: 8/7/07   By: /s/ Dwight O. Seegmiller


          Dwight O. Seegmiller, Director, President and Chief Executive Officer
     
     
Date: 8/7/07   By: /s/ James G. Pratt


    James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

 

 

 

Page 30 of 35

 


 

 

HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED JUNE 30, 2007

 


 Exhibit
Number
  Description   Page Number
In The Sequential
Numbering System
June 30, 2007 Form 10-Q

         
31   Certifications under Section 302 of the Sarbanes-Oxley Act of 2002   32 – 33 of 35
         
32   Certifications under Section 906 of the Sarbanes-Oxley Act of 2002   34 – 35
 

         

 

 

Page 31 of 35