UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

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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 December 31, 2006

Commission File Number: 0-19972

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HF FINANCIAL CORP.

(Exact name of registrant as specified in its charter.)

 

(605)  333-7556

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES  X      NO___

Indicate 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.

LARGE ACCELERATED FILER____     ACCELERATED FILER____     NON-ACCELERATED FILER   X

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.

As of February 8, 2007 there were 3,978,584 issued and outstanding shares of the Registrant’s Common Stock, with $.01 par value per share.

HF FINANCIAL CORP.

Form 10-Q

Table of Contents

		Page Number
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited):
	Consolidated Statements of Financial Condition
	As of December 31, 2006 and June 30, 2006	1
	Consolidated Statements of Income for the
	Six Months Ended December 31, 2006 and 2005	2
	Consolidated Statements of Cash Flows for the
	Six Months Ended December 31, 2006 and 2005	3
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	39
Item 4.	Controls and Procedures	40
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings	41
Item 1A.	Risk Factors	41
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	41
Item 4.	Submission of Matters to a Vote of Security Holders	42
Item 6.	Exhibits	43
Form 10-Q	Signature Page	44

 

PART I – FINANCIAL INFORMATION

Item 1.             Financial Statements

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in Thousands)

		December 31, 2006				June 30, 2006
		(Unaudited)				(Audited)
ASSETS
Cash and cash equivalents		$	47,070			$	27,037
Securities available for sale		146,369				145,518
Federal Home Loan Bank stock		5,475				5,647
Loans held for sale		8,711				7,623
Loans and leases receivable		748,928				727,260
Allowance for loan and lease losses		(5,869		)		(5,657		)
Net loans and leases receivable		743,059				721,603
Accrued interest receivable		8,618				6,880
Office properties and equipment, net of accumulated depreciation		15,697				14,459
Foreclosed real estate and other properties		1,676				1,889
Cash value of life insurance		13,265				13,013
Servicing rights		10,784				5,648
Goodwill, net		4,951				4,951
Other assets		6,343				7,026
Total assets		$	1,012,018			$	961,294
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits		$	808,836			$	769,002
Advances from Federal Home Loan Bank
and other borrowings		90,500				91,620
Subordinated debentures payable to trusts		27,837				27,837
Advances by borrowers for taxes and insurance		10,009				6,969
Accrued expenses and other liabilities		14,237				9,808
Total liabilities		951,419				905,236
STOCKHOLDERS’ EQUITY
Preferred stock, $.01 par value, 500,000 shares authorized,
none outstanding		- - - -				- - - -
Series A Junior Participating Preferred Stock, $1.00 stated value,
50,000 shares authorized, none outstanding		- - - -				- - - -
Common stock, $.01 par value, 10,000,000 shares authorized,
5,955,170 and 5,926,496 shares issued
at December 31, 2006 and June 30, 2006, respectively		59				59
Common stock subscribed for but not issued,
4,078 shares at June 30, 2006		- - - -				65
Additional paid-in capital		20,226				19,384
Retained earnings, substantially restricted		70,565				68,179
Accumulated other comprehensive income (loss), net
of related deferred tax effect		(1,084		)		(2,462		)
Less cost of treasury stock, 1,977,836 and 1,977,836 shares
at December 31, 2006 and June 30, 2006, respectively		(29,167		)		(29,167		)
Total stockholders’ equity		60,599				56,058
Total liabilities and stockholders’ equity		$	1,012,018			$	961,294

 

See accompanying notes to unaudited consolidated financial statements.

Page 1

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HF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except Per Share Data)
(Unaudited)

 

		Three Months Ended December 31,								Six Months Ended December 31,
		2006				2005				2006				2005
Interest, dividend and loan fee income:
Loans and leases receivable		$	13,728			$	11,593			$	26,968			$	22,714
Investment securities and interest-earning deposits		1,935				1,550				3,773				2,901
		15,663				13,143				30,741				25,615
Interest expense:
Deposits		7,359				4,793				13,900				9,089
Advances from Federal Home Loan Bank and other borrowings		2,244				1,957				4,363				3,798
		9,603				6,750				18,263				12,887
Net interest income		6,060				6,393				12,478				12,728
Provision for losses on loans and leases		461				3,630				752				4,092
Net interest income after provision for losses on loans and leases		5,599				2,763				11,726				8,636
Noninterest income:
Gain on sale of branches, net		2,763				- - - -				2,763				- - - -
Fees on deposits		1,315				1,170				2,508				2,346
Loan servicing income		441				257				770				528
Gain on sale of loans, net		260				271				456				567
Trust income		230				200				446				395
Gain on sale of land, net		- - - -				3,557				- - - -				3,557
Other		413				534				823				981
		5,422				5,989				7,766				8,374
Noninterest expense:
Compensation and employee benefits		4,478				4,212				8,634				8,515
Occupancy and equipment		958				829				1,896				1,609
Advertising		704				252				1,147				431
Check and data processing expense		567				529				1,119				1,059
Other		984				870				1,804				1,752
		7,691				6,692				14,600				13,366
Income before income taxes		3,330				2,060				4,892				3,644
Income tax expense		1,219				761				1,684				1,322
Net income		$	2,111			$	1,299			$	3,208			$	2,322
Comprehensive income		$	2,254			$	715			$	4,443			$	1,576
Cash dividends declared per share (1)		$	0.1050			$	0.1023			$	0.2075			$	0.2023
Earnings per share:(1)
Basic		$	0.53			$	0.33			$	0.81			$	0.60
Diluted		$	0.52			$	0.33			$	0.79			$	0.58

 

(1) Retroactively adjusted for the 10% stock dividend paid on April 24, 2006 to stockholders of record as of April 10, 2006

See accompanying notes to unaudited consolidated financial statements.

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HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)
(Unaudited)

		Six Months Ended December 31,
		2006				2005
Cash flows from operating activities
Net income		$	3,208			$	2,322
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for losses on loans and leases		752				4,092
Depreciation		803				738
Amortization of discounts and premiums on securities and other		971				1,030
Stock based compensation		452				292
Deferred income taxes (credits)		(572		)		(985		)
Loans originated for resale		(43,241		)		(55,716		)
Proceeds from the sale of loans		38,353				54,900
(Gain) on sale of loans, net		(456		)		(474		)
(Gain) on sale of land		- - - -				(3,557		)
(Gain) on sale of branches		(2,763		)		- - - -
Losses and provision for losses on sales of foreclosed real estate and other properties, net		32				21
(Gain) loss on disposal of office properties and equipment, net		(7		)		20
Change in other assets and liabilities		5,334				(1,640		)
Net cash provided by operating activities		2,866				1,043
Cash flows from investing activities
Loan participations purchased		(18,815		)		- - - -
Loans and leases originated and held		(204,380		)		(200,612		)
Principal collected on loans and leases		200,461				175,857
Proceeds from sale of land		- - - -				4,863
Proceeds from sale of loans associated with branch sales		4,256				- - - -
Securities available for sale:
Sales and maturities and repayments		18,668				24,005
Purchases		(17,485		)		(31,955		)
Purchase of Federal Home Loan Bank stock		(2,658		)		(2,015		)
Redemption of Federal Home Loan Bank stock		2,830				3,069
Proceeds from sale of office properties and equipment		9				2
Proceeds from sale of office properties and equipment associated with branch sales		341				- - - -
Purchase of office properties and equipment		(2,384		)		(1,523		)
Purchase of servicing rights		(5,514		)		(689		)
Purchase of cash value of life insurance		- - - -				- - - -
Proceeds from sale of foreclosed real estate and other properties, net		581				139
Net cash (used in) investing activities		(24,090		)		(28,859		)

 

See accompanying notes to unaudited consolidated financial statements.

 

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HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(Dollars in Thousands)
(Unaudited)

		Six Months Ended December 31,
		2006				2005
Cash flows from financing activities
Net increase in deposit accounts		$	73,397			$	44,495
Proceeds of advances from Federal Home Loan Bank and other borrowings		492,902				260,083
Payments on advances from Federal Home Loan Bank and other borrowings		(494,022		)		(272,267		)
Proceeds from issuance of subordinated debentures		10,000				- - - -
Deposit account disbursements associated with branch sales		(33,563		)		- - - -
Redemption of subordinated debentures		(10,000		)		- - - -
Increase in advances by borrowers		3,040				487
Proceeds from issuance of common stock		325				296
Cash dividends paid		(822		)		(786		)
Net cash provided by financing activities		41,257				32,308
Increase in cash and cash equivalents		20,033				4,492
Cash and cash equivalents
Beginning		27,037				18,248
Ending		$	47,070			$	22,740
Supplemental Disclosures of Cash Flows Information
Cash payments for interest		$	17,013			$	11,931
Cash payments for income and franchise taxes, net		396				1,772

 

See accompanying notes to unaudited consolidated financial statements.

 

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HF FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For The Six Months Ended December 31, 2006 and 2005

(Unaudited)

NOTE 1.                                                 SELECTED ACCOUNTING POLICIES

Basis of presentation:

The consolidated financial information of HF Financial Corp. (the “Company”) and its wholly-owned subsidiaries included in this Quarterly Report on Form 10-Q is unaudited.  However, in the opinion of management, adjustments (consisting of normal recurring adjustments) necessary for a fair presentation for the interim periods have been included.  Results for any interim period are not necessarily indicative of results to be expected for the fiscal year.  Interim consolidated financial statements and the notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2006 (“Fiscal 2006”), filed with the Securities and Exchange Commission.  The accounting and reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practice within the industry.

The interim consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, Home Federal Bank (the “Bank”), HF Financial Group, Inc. (“HF Group”) and HomeFirst Mortgage Corp. (the “Mortgage Corp.”), and the Bank’s wholly-owned subsidiaries, Mid America Capital Services, Inc. (“Mid America Capital”), Hometown Insurors, Inc. (“Hometown”), Home Federal Securitization Corp. (“HFSC”), Mid-America Service Corporation and PMD, Inc.  The interim consolidated financial statements reflect the deconsolidation of the wholly-owned subsidiary trusts of the Company, HF Financial Capital Trust I (“Trust I”), HF Financial Capital Trust II (“Trust II”), HF Financial Capital Trust III (“Trust III”), HF Financial Capital Trust IV (“Trust IV”) and HF Financial Capital Trust V (“Trust V”). Trust V was formed during the fiscal second quarter ended December 31, 2006.  See Note 10 of “Notes to Consolidated Financial Statements.”  All intercompany balances and transaction have been eliminated in consolidation.

Stock-based compensation:  In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” which requires all companies to measure compensation cost for all share-based payments (including stock options) at fair value and to record such expense in their consolidated financial statements.  SFAS No. 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”.

The Company adopted SFAS No. 123R effective as of July 1, 2005, using the Black-Scholes option-pricing model and the modified prospective method in which compensation cost is recognized for all awards granted subsequent to the Company’s adoption of this statement as well as for the unvested portion of awards outstanding as of the Company’s adoption of this statement.  Prior to July 1, 2005, the Company accounted for stock-based compensation in accordance with APB No. 25 and related interpretations. As such, no stock-based employee compensation cost was recognized for grants under the Company’s stock option and incentive plans, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  These stock option and incentive plans are described more fully in Part II, Item 8 “Financial Statements and Supplementary Data” of the Company’s Annual Report on Form 10-K for Fiscal 2006, under Note 17 of “Notes to Consolidated Financial Statements.”

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NOTE 2.                                                 REGULATORY CAPITAL

The following table sets forth the Bank’s compliance with its minimum capital requirements for a well-capitalized institution at December 31, 2006:

 

NOTE 3.                                                 EARNINGS PER SHARE

Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding  (the denominator) during the period.  Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. The weighted average number of basic common shares outstanding for the three months ended December 31, 2006 and 2005 was 3,968,451 and 3,931,699, respectively.  The weighted average number of basic common shares outstanding for the six months ended December 31, 2006 and 2005 was 3,964,261 and 3,889,358, respectively.

Dilutive earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive options outstanding had been exercised. The weighted average number of common and dilutive potential common shares outstanding for the three months ended December 31, 2006 and 2005 was 4,046,493 and 4,015,316, respectively.  The weighted average number of common and dilutive potential common shares outstanding for the six  months ended December 31, 2006 and 2005 was 4,040,227 and 3,977,091, respectively.

All earnings per share data and number of common shares outstanding have been retroactively adjusted for the 10% stock dividend paid on April 24, 2006 to stockholders of record as of April 10, 2006.

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NOTE 4.                                                 INVESTMENTS IN SECURITIES

The amortized cost and fair values of investments in securities, all of which are classified as available for sale according to management’s intent, are as follows:

 

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The following table presents the fair value and age of gross unrealized losses by investment category at December 31, 2006 in accordance with FASB Staff Position (FSP) No. FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which supersedes Emerging Issues Task Force Issue No. 03-1:

 

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Management does not believe any individual unrealized losses as of December 31, 2006 represent an other-than-temporary impairment.  The unrealized losses reported for mortgage-backed securities relate to securities issued by the Federal National Mortgage Association (“FNMA”), the Government National Mortgage Association and the Federal Home Loan Mortgage Corporation (“FHLMC”).  These unrealized losses in total are primarily attributable to changes in interest rates and the contractual cashflows of those investments are guaranteed by an agency of the U.S. government.  As a group, the unrealized losses were less than 1.9% of its respective amortized cost basis at December 31, 2006.  Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be at maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2006.

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NOTE 5.                                                 SEGMENT REPORTING

Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance.  The Company’s reportable segments are “banking” (including leasing activities) and “other”.  The “banking” segment is conducted through the Bank and Mid America Capital and the “other” segment is composed of smaller nonreportable segments, the Company and inter-segment eliminations.

The management approach is used as the conceptual basis for identifying reportable segments and is based on the way that management organizes the segments within the enterprise for making operating decisions, allocating resources and monitoring performance, which is primarily based on products.

 

 

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NOTE 6.                                                 DEFINED BENEFIT PLAN

The Company has a noncontributory (cash balance) defined benefit pension plan covering all employees of the Company and its wholly-owned subsidiaries who have attained the age of 21 and have completed 1,000 hours in a plan year.  The benefits are based on 6% of each eligible participant’s annual compensation, plus income earned in the accounts at a rate determined annually based on 30-year treasury note rates.  The Company’s funding policy is to make the minimum annual required contribution plus such amounts as the Company may determine to be appropriate from time to time.  One hundred percent vesting occurs after five years with a normal retirement age of 65.  Information relative to the components of net periodic benefit cost for the Company’s defined benefit plan is presented below:

 

The Company previously disclosed in its consolidated financial statements for Fiscal 2006, which are included in Part II, Item 8 “Financial Statements and Supplementary Data” of the Company’s Annual Report on Form 10-K for Fiscal 2006, that it contributed $610,000 to fund its qualified pension plan.  During the first quarter of the fiscal year ending June 30, 2007 (“Fiscal 2007”), the Company made contributions of $621,000 to fund its qualified pension plan.  The Company anticipates no additional contributions for Fiscal 2007.

NOTE 7.                                                 SELF-INSURED HEALTHCARE PLAN

The Company has had a self-insured health plan for its employees, subject to certain limits, since January 1994.  The Bank is named the plan administrator for this plan and has retained the services of an independent third party administrator to process claims and handle other duties for this plan.  The third party administrator does not assume liability for benefits payable under this plan.

The Company assumes the responsibility for funding the plan benefits out of general assets, however employees cover some of the costs of covered benefits through contributions, deductibles, co-pays and participation amounts.  An employee is eligible for coverage upon completion of 30 calendar days of regular employment.  The plan, which is on a calendar year basis, is intended to comply with, and be governed by, the Employee Retirement Income Security Act of 1974, as amended.

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Total net healthcare costs are inclusive of health claims expenses and administration fees offset by stop loss and employee reimbursement.  Reported below is a summary of net healthcare costs by quarter for the fiscal years ended June 30, 2006 and 2007.

 

NOTE 8.          FASB STATEMENT NO. 140

During the third quarter of Fiscal 2006, the Company completed a line item change of its income recorded on originated mortgage servicing rights for loans sold to South Dakota Housing Development Authority.  This process was done upon a fuller interpretation of Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” as issued by the FASB.   All periods presented have been revised in presentation to reflect this line item and there was no change to net income, earnings per share, or recorded value of servicing rights as a result of this line item change.  The following table reflects the effects of the line item change on the Company’s consolidated statements of income for the three and six months ended December 31, 2006 and 2005.

 

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NOTE 9.          STOCK-BASED COMPENSATION PLANS

The fair value of each incentive stock option grant and stock appreciation right is estimated at the grant date using the Black-Scholes option-pricing model.  The following weighted average assumptions were used for grants in the six months ended December 31, 2006 and 2005:

 

Stock option and stock appreciation right activity for the six months ended December 31 follows:

 

 

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The weighted-average grant date fair value of options and appreciation rights granted during the six months ended December 31, 2006 and 2005 was $3.11 and $3.83, respectively.  The total intrinsic value of options exercised during the six months ended December 31, 2006 and 2005 was $107,000 and $102,000 respectively.  As of December 31, 2006, there was $50,000 of total unrecognized compensation cost related to nonvested stock option awards.  The cost is expected to be recognized over a period of two years.  Cash received from the exercise of options for the six months ended December 31, 2006 and 2005 was $295,000 and $191,000, respectively.  The tax benefit realized for the tax deductions from cashless option exercises totaled $30,000 and $18,000 for the six months ended December 31, 2006 and 2005, respectively.  The Company generally uses treasury shares to satisfy stock option exercises.

Restricted share activity for the six months ended December 31 follows:

 

Pretax compensation expense recognized for restricted shares for the six months ended December 31, 2006 and 2005 was $234,000 and $196,000, respectively.  The tax benefit for the six months ended December 31, 2006 and 2005 was $80,000 and $67,000, respectively.  As of December 31, 2006, there was $1.6 million of total unrecognized compensation cost related to restricted shares granted under the Company’s 2002 Stock Option and Incentive Plan, as amended (“the Plan”).  That cost is expected to be recognized over a weighted-average period of five years.  The total fair value of shares vested during the six months ended December 31, 2006 and 2005 was $230,000 and $172,000, respectively.

The Company has a Director Restricted Stock Plan which provides that awards of restricted shares of the Company’s common stock be made to outside directors of the Company.  The plan is designed to allow for payment of the annual retainer fee in shares of the Company’s common stock, with the inclusion of an annual cost of living adjustment based on the Consumer Price Index.  Each outside director is entitled to all voting, dividend and distribution rights during the restriction period.  The effective date of the plan was July 1, 1997.  The plan has 90,750 shares allocated to it and is in effect for a period of ten years.  During the six months ended December 31, 2006 and 2005, 4,824 and 6,571 shares were awarded and $49,000 and $48,000 of expense was incurred under the plan, respectively, as the annual retainer for the Company’s Board of Directors.

These stock option and incentive plans are described more fully in Part II, Item 8 “Financial Statements and Supplementary Data” of the Company’s Annual Report on Form 10-K for Fiscal 2006, under Note 17 of “Notes to Consolidated Financial Statements.”

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NOTE 10.                       SUBORDINATED DEBENTURES PAYABLE TO TRUSTS

On December 7, 2006, the Company issued 10,000 shares totaling $10.0 million of Company Obligated Mandatorily Redeemable Preferred Securities of Trust V.  Trust V was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company.  These subordinated debentures constitute the sole asset of Trust V.  The securities provide for cumulative cash distributions calculated at a rate based on three-month LIBOR plus 1.83% adjusted quarterly.  The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive  quarterly periods, but not beyond March 1, 2037.  At the end of the deferral period, all accumulated and unpaid distributions must be paid.  The capital securities must be redeemed on March 1, 2037; however, the Company has the option to shorten the maturity date to a date not earlier than March 1, 2012.  Holders of the capital securities have no voting rights, are unsecured, and rank junior in priority of the payment to all of the Company’s indebtedness and senior to the Company’s capital stock.

On December 8, 2006, the Company exercised its option to redeem $10.0 million of Company Obligated Mandatorily Redeemable Preferred Securities of Trust I.

NOTE 11.       SALE OF BRANCHES

            During the second quarter of Fiscal 2007, the Bank closed on the sale of three branches and their associated book of business, along with one physical location, to Great Western Bank.  The Bank recognized a gain on sale of $2.8 million that resulted in the sale of $4.2 million in loans and $33.6 million in deposits.

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q and other reports issued by the Company, including reports filed with the Securities and Exchange Commission, contain “forward-looking statements” that deal with future results, expectations, plans and performance.  In addition, the Company’s management may make forward-looking statements orally to the media, securities analysts, investors or others.  These forward-looking statements might include one or more of the following:

*                 Projections of income, loss, revenues, earnings or losses per share, dividends, capital expenditures, capital structure, tax benefit or other financial items.

*                 Descriptions of plans or objectives of management for future operations, products or services, transactions, investments and use of subordinated debentures payable to trusts.

*                 Forecasts of future economic performance.

*                 Use and descriptions of assumptions and estimates underlying or relating to such matters.

Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.  They often include words such as “optimism,” “look-forward,” “bright,” “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.”

Forward-looking statements about the Company’s expected financial results and other plans are subject to certain risks, uncertainties and assumptions.  These include, but are not limited to, the risks discussed in Part I, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for Fiscal 2006 and the following: possible legislative changes and adverse economic, business and competitive conditions and developments (such as shrinking interest margins and continued short-term rate environments); deposit outflows; reduced demand for financial services and loan products; changes in accounting policies or guidelines, or in monetary and fiscal policies of the federal government; changes in credit and other risks posed by the Company’s loan portfolios; the ability or inability of the Company to manage interest rate and other risks; unexpected or continuing claims against the Company’s self-insured health plan; the Company’s use of trust preferred securities; the ability or inability of the Company to successfully enter into a definitive agreement for and close anticipated transactions; technological, computer-related or operational difficulties; adverse changes in securities markets; results of litigation; or other significant uncertainties.

Forward-looking statements speak only as of the date they are made.  The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.

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Executive Summary

The Company’s net income for the second quarter of Fiscal 2007 was $2.1 million, or $0.52 per diluted share, compared to $1.3 million, or $0.33 per diluted share, for the second quarter of Fiscal 2006.  For the first six months of Fiscal 2007, net income was $3.2 million, or $0.79 per diluted share, compared to $2.3 million, or $0.58 per diluted share, for the first six months of Fiscal 2006.  Return on average equity was 11.05% at December 31, 2006 compared to 8.59% at December 31, 2005.

As previously announced, the Company closed on the sale of three branches, their associated book of business and one physical location in December 2006.  The gain on sale recognized was $2.8 million, which increased diluted earnings per share by $0.42.  In addition, during the second quarter of Fiscal 2007, the Company expensed $290,000 of unamortized debt issuance costs relating to the redemption of the Trust I trust preferred securities, which reduced diluted earnings per share by $0.05.  Comparatively, in December 2005, the Company closed on a land sale.  The gain on sale recognized was $3.6 million, which increased diluted earnings per share by $0.65.  In addition, during the second quarter of fiscal 2006, there were additional provisions to the loan loss allowance of $3.1 million, for a large impaired commercial participation loan, which was sold in December 2005.  This reduced diluted earnings per share by $0.54.

The net interest margin on a fully taxable equivalent basis for the six months ended December 31, 2006 was 2.76%, compared to 3.03% for the same period a year ago, a decline of 27 basis points.  The increase over the same period last year in interest rates for the Company’s variable priced trust preferred securities tied to LIBOR, and the aforementioned expense of debt issuance costs, caused a decrease in margin of nine basis points.  During the six months ended December 31, 2006, $1.0 million in loans were placed into nonaccrual resulting in a reversal of $125,000 in interest income.  This action had the effect of lowering the net interest margin by eight basis points.  Comparatively, for the same period a year ago, $1.9 million in loans were placed into nonaccrual with a reversal of $89,000 in interest income.

Net interest income for the first six months of Fiscal 2007 was $12.5 million, a decrease of  $250,000, or 2.0%, over the same period a year ago.  Net interest income decreased $333,000, or 5.2%, to $6.1 million for the three months ended December 31, 2006 from $6.4 million for same period in the prior fiscal year.  For the six months ended December 31, 2006, average interest-earning assets and average interest-bearing liabilities increased 8.5% and 8.1%, respectively, compared to the same period a year ago.  Yields on earning assets increased to 6.67% in the first six months of Fiscal 2007, compared to 6.03% a year ago, an increase of 64 basis points.  For the same time period, cost of funds increased to 4.40%, compared to 3.36%, an increase of 104 basis points.

Net interest margin ratio may vary due to many factors, including Federal Reserve policies for short-term interest rates, competitive and economic factors and customer preferences for various products and services.  From December 31, 2005 to June 30, 2006, the Federal Reserve increased short-term interest rates four times at 25 basis points each, for a total increase of 100 basis points, however, there has been no change since June 2006.  The flattening and subsequent inversion of the treasury yield curve caused by increasing short-term rates and lagging and declining long-term rates continued to affect the Company’s net interest margin ratio during the quarter.  This inverted yield curve is evidenced by the interest rate spread of 25 basis points between the 3-month Treasury and the 10-year Treasury at December 31, 2005, decreasing to a negative 36 basis points at December 31, 2006.

The Company had previously issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings.  Interest expense on the $27.8 million of trust preferred securities outstanding increased to $1.6 million for the six months ended December 31, 2006, compared to $1.1 million for the same period a year ago, an increase of $502,000 or 47.6%.  The average rate paid on these securities increased 358 basis points, from 7.52% at December 31, 2005 to 11.10% at December 31, 2006.  In December 2006, the Company refinanced $10.0 million of trust preferred securities, originally issued in November 2001.  The funding was calculated at a rate based on three-month LIBOR plus 1.83%, compared to the existing six-month LIBOR plus 3.75%.  As a result of this refinancing, the Company expensed $290,000 of unamortized debt issuance costs.  Excluding this expense, the overall cost on the trust preferred securities was 9.03%, compared to 11.10%, a 207 basis point decrease.

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The allowance for loan and lease losses increased to $5.9 million at December 31, 2006, compared to $5.2 million at December 31, 2005, an increase of $695,000 or 13.4%.  The ratio of allowance for loan and lease losses to total loans and leases was 0.77% as of December 31, 2006 compared to 0.73% at December 31, 2005.  Total nonperforming assets at December 31, 2006 were $4.5 million as compared to $4.6 million a year ago, a decrease of $137,000 or 3.0%.  The ratio of nonperforming assets to total assets decreased to 0.44% at December 31, 2006, compared to 0.50% at December 31, 2005.  The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience.  This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time.

Total deposits at December 31, 2006 were $808.8 million, an increase of $83.1 million, or 11.5%, from December 31, 2005.  Interest expense on these deposits was $13.9 million for the six months ended December 31, 2006, an increase of $4.8 million, or 52.9%, over the same period a year ago.  In-market deposits increased from $684.9 million at December 31, 2005 to $693.1 million at December 31, 2006, an increase of $8.2 million, or 1.2%.  For the same period, out-of-market deposits increased from $40.8 million to $115.7 million, respectively.  Public funds have increased, from $107.7 million at December 31, 2005 to $121.1 million at December 31, 2006.  The primary factor affecting interest expense was the increase in volume of certificates of deposits by $94.6 million, or 31.7%, from December 31, 2005, to December 31, 2006.  Out-of-market certificates of deposits accounted for $74.9 million or nearly 80% of this increase.  Interest expense for certificates of deposits increased by $3.3 million or 68.5% in the first six months of fiscal 2007, compared to the same period in the prior fiscal year, driving its cost of funds to 4.48% from 3.33%.

In October 2006, the Company announced an increase in its quarterly cash dividend, from 10.25 cents per share to 10.50 cents per share, resulting in an annualized increase of 2.4%.

The total risk-based capital ratio of 10.85% at December 31, 2006 is above the 10.66% at December 31, 2005, an increase of 19 basis points.  This continues to place the Bank in the “well capitalized” category within OTS regulation at December 31, 2006 and is consistent within the “well capitalized” OTS category in which the Company plans to operate.  The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages and student loans and a loan securitization.

Noninterest income was $5.4 million for the quarter ended December 31, 2006 compared to $6.0 million at December 31, 2005, a decrease of $567,000 or 9.5%.  Excluding the aforementioned one-time gains attributable to the land sale and branch sales, noninterest income for the quarter ended December 31, 2006 was $2.6 million, compared to $2.4 million, an increase of $227,000 or 9.3% from the same period a year ago.  The primary factor affecting noninterest income was an increase of $184,000 in loan servicing income due to the purchase of mortgage servicing rights at September 30, 2006 and an increase of $145,000 in fees on deposits.

Noninterest expense was $7.7 million for the quarter ended December 31, 2006 compared to $6.7 million at December 31, 2005, an increase of $999,000 or 14.9%.  The primary factors affecting noninterest expense include increases of $452,000 in marketing expenses associated with several deposit product package programs, $129,000 in occupancy and equipment costs relating to several new branches opened one year or less, and $266,000 in employee compensation and benefits.

General

The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income.  Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk.  The Company’s net income is derived by managing net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses.  The primary source of revenues comes from the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding).  The net interest margin is affected by regulatory,

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economic and competitive factors that influence interest rates, loan demand and deposit flows.  Fees earned include charges for deposit services, trust services and loan services.  Personnel costs are the primary expenses required to deliver the services to customers.  Other costs include occupancy and equipment and general and administrative expenses.

Financial Condition Data

At December 31, 2006, the Company had total assets of $1.0 billion, an increase of $50.7 million from the level at June 30, 2006.  The increase in assets was due primarily to increases in net loans and leases receivable of $21.5 million, cash and cash equivalents of $20.0 million and loan servicing rights of $5.1 million.  The increase in liabilities of $46.2 million from June 30, 2006 to December 31, 2006 was primarily due to increases in deposits of $39.8 million, accrued expenses and other liabilities of $4.4 million and advances by borrowers for taxes and insurance of $3.0 million.  In addition, stockholders’ equity increased $4.5 million to $60.6 million at December 31, 2006 from $56.1 million at June 30, 2006, primarily due to net income of $3.2 million and decrease of accumulated other comprehensive loss of $1.4 million.

The increase in net loans and leases receivable of $21.5 million was due primarily to an increase in purchases and originations over sales, amortization and repayments of principal.  In addition, net deferred (fees), costs and discounts decreased $126,000 from the levels at June 30, 2006 to $757,000 at December 31, 2006.

Cash and cash equivalents increased $20.0 million due primarily to an increase in deposits of $39.8 million resulting primarily from seasonal fluctuation in public fund deposits.

Loan servicing rights increased $5.1 million primarily due to the purchase of $4.9 million in mortgage servicing rights from Great Western Bank at the end of the first quarter of fiscal 2007.

The $39.8 million increase in deposits was due to increases in out-of-market certificates of deposit of $57.8  million, in-market certificates of deposit of $15.2 million and interest-bearing checking accounts of $7.6 million offset by decreases in savings accounts of $28.1 million, money market accounts of $11.9 million and noninterest-bearing checking accounts of $831,000.  The $28.1 million decrease in savings accounts was primarily due to temporary fluctuations experienced with one public fund entity, while the increase in certificates of deposit was primarily driven by commercial business accounts.

Accrued expenses and other liabilities increased $4.4 million from the level at June 30, 2006 in part due to an increase in accrued income taxes payable of $1.8 million resulting primarily from the Company’s net income of $3.2 million for the six months ended December 31, 2006.

Advances by borrowers for taxes and insurance increased $3.0 million primarily due to the purchase of $4.9 million in mortgage servicing rights during the first quarter of fiscal 2007 which resulted in an increase in escrow accounts for taxes and insurance of $3.7 million.

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During the time period of fiscal years 2002 through 2004, the Company issued a total of $27.8 million in subordinated debentures payable to trusts at various times through its trust subsidiaries.  Each of the issuances included an option  to shorten the maturity date at a specific time as stated in the contract.  The issuance of $10.0 million of Company Obligated Mandatorily Redeemable Preferred Securities of Trust I on November 28, 2001 included an option to shorten the maturity date to December 8, 2006.  The Company exercised this option to redeem $10.0 million of trust preferred securities.  Also during the second quarter of Fiscal 2007, the Company issued $10.0 million of Company Obligated Mandatorily Redeemable Preferred Securities of Trust V.  The new funding is calculated at a rate based on three-month LIBOR plus 1.83%, compared to the original issuance which is based on six-month LIBOR plus 3.75%.  The unamortized amount of $290,000 deferred debt issuance costs related to the original issuance was expensed.

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The following tables show the composition of the Company’s loan and lease portfolio and deposit accounts:

 

(1) Excludes $6,883 and $6,980 loans held for sale at December 31, 2006 and June 30, 2006, respectively.

(2) Includes $3,388 tax exempt leases at December 31, 2006 and June 30, 2006.

(3) Excludes $223 commercial loans held for sale at December 31, 2006 and June 30, 2006.

(4) Excludes $1,604 and $420 student loans held for sale at December 31, 2006 and June 30, 2006, respectively.

(5) Includes deferred loan fees and discounts and undisbursed portion of loans in process.

 

 

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Analysis of Net Interest Income

Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities.  Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.

Average Balances, Interest Rates and Yields.  The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin.  The table does not reflect any effect of income taxes.  Average balances consist of daily average balances for the Bank with simple average balances for all other subsidiaries of the Company.  The average balances include nonaccruing loans and leases.  The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.

		Three Months Ended December 31,
		2006						2005
		Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate		Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate
		(Dollars in Thousands)
Interest-earning assets:
Loans and leases receivable (1) (3)		$        762,367		$        13,728		7.14%		$         692,818		$         11,593		6.64%
Investment securities (2) (3)		157,222		1,860		4.69%		150,788		1,491		3.92%
FHLB stock		6,657		75		4.47%		7,289		59		3.21%
Total interest-earning assets		926,246		$        15,663		6.71%		850,895		$         13,143		6.13%
Noninterest-earning assets		71,653						73,186
Total assets		$        997,899						$         924,081
Interest-bearing liabilities:
Deposits:
Checking and money market		$        277,185		$          2,676		3.83%		$         272,261		$           1,987		2.90%
Savings		38,123		207		2.15%		48,872		257		2.09%
Certificates of deposit		383,073		4,476		4.64%		292,653		2,549		3.46%
Total interest-bearing deposits		698,381		7,359		4.18%		613,786		4,793		3.10%
FHLB advances and other borrowings		111,084		1,332		4.76%		127,876		1,414		4.39%
Subordinated debentures payable to trusts (4)		27,837		912		13.00%		27,837		543		7.74%
Total interest-bearing liabilities		837,302		9,603		4.55%		769,499		6,750		3.48%
Noninterest-bearing deposits		77,757						80,529
Other liabilities		23,836						19,705
Total liabilities		938,895						869,733
Equity		59,004						54,348
Total liabilities and equity		$        997,899						$         924,081
Net interest income; interest rate spread (5)				$          6,060		2.16%				$           6,393		2.65%
Net interest margin (5) (6)						2.60%						2.98%
Net interest margin, TE (7)						2.66%						3.02%

 

(3)  Yields do not reflect the tax-exempt nature of loans, equipment leases and municipal securities.

(4)  Includes $290 expense in December 2006 for unamortized debt issuance costs.

(5)  Percentages for the three months ended December 31, 2006 and December 31, 2005 have been annualized.

(6)  Net interest margin is net interest income divided by average interest-earning assets.

(7)  Net interest margin expressed on a fully taxable equivalent basis.

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		Six Months Ended December 31,
		2006						2005
		Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate		Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate
		(Dollars in Thousands)
Interest-earning assets:
Loans and leases receivable (1) (3)		$        753,432		$        26,968		7.10%		$         688,398		$         22,714		6.55%
Investment securities (2) (3)		154,397		3,619		4.65%		147,326		2,834		3.82%
FHLB stock		6,816		154		4.48%		7,133		67		1.86%
Total interest-earning assets		914,645		$        30,741		6.67%		842,857		$         25,615		6.03%
Noninterest-earning assets		67,087						70,140
Total assets		$        981,732						$         912,997
Interest-bearing liabilities:
Deposits:
Checking and money market		$        278,628		$          5,314		3.78%		$         270,476		$           3,774		2.77%
Savings		40,939		468		2.27%		50,078		497		1.97%
Certificates of deposit		359,060		8,118		4.48%		287,060		4,818		3.33%
Total interest-bearing deposits		678,627		13,900		4.06%		607,614		9,089		2.97%
FHLB advances and other borrowings		116,476		2,806		4.78%		126,090		2,743		4.32%
Subordinated debentures payable to trusts (4)		27,837		1,557		11.10%		27,837		1,055		7.52%
Total interest-bearing liabilities		822,940		18,263		4.40%		761,541		12,887		3.36%
Noninterest-bearing deposits		78,596						78,016
Other liabilities		22,124						19,360
Total liabilities		923,660						858,917
Equity		58,072						54,080
Total liabilities and equity		$        981,732						$         912,997
Net interest income; interest rate spread (5)				$        12,478		2.27%				$         12,728		2.67%
Net interest margin (5) (6)						2.71%						3.00%
Net interest margin, TE (7)						2.76%						3.03%

 

(1)  Includes loan fees and interest on accruing loans and leases past due 90 days or more.

(2)  Includes federal funds sold.

(3)  Yields do not reflect the tax-exempt nature of loans, equipment leases and municipal securities.

(4)  Includes $290 expense in December 2006 for unamortized debt issuance costs.

(5)  Percentages for the six months ended December 31, 2006 and December 31, 2005 have been annualized.

(6)  Net interest margin is net interest income divided by average interest-earning assets.

(7)  Net interest margin expressed on a fully taxable equivalent basis.

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Rate/Volume Analysis of Net Interest Income

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  It distinguishes between the increases and decreases due to fluctuating outstanding balances that are due to the levels and volatility of interest rates.  For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume).  For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.

		Three Months Ended December 31,						Six Months Ended December 31,
		2006 vs 2005						2006 vs 2005
		Increase						Increase
		(Decrease)		Increase		Total		(Decrease)		Increase		Total
		Due to		Due to		Increase		Due to		Due to		Increase
		Volume		Rate		(Decrease)		Volume		Rate		(Decrease)
		(Dollars in Thousands)
Interest-earning assets:
Loans and leases receivable (1)		$         1,164		$            971		$         2,135		$         2,146		$         2,108		$         4,254
Investment securities (2)		64		305		369		136		649		785
FHLB stock		(5	)	21		16		(5	)	92		87
Total interest-earning assets		$         1,223		$         1,297		$         2,520		$         2,277		$         2,849		$         5,126
Interest-bearing liabilities:
Deposits:
Checking and money market		$              36		$            653		$            689		$            114		$         1,426		$         1,540
Savings		(57	)	7		(50	)	(91	)	62		(29	)
Certificates of deposit		788		1,139		1,927		1,208		2,092		3,300
Total interest-bearing deposits		767		1,799		2,566		1,231		3,580		4,811
FHLB advances and other borrowings		(186	)	104		(82	)	(209	)	272		63
Subordinated debentures payable to trusts		-		369		369				502		502
Total interest-bearing liabilities		$            581		$         2,272		$         2,853		$         1,022		$         4,354		$         5,376
Net interest income increase						$          (333	)					$          (250	)

 

(1)  Includes loan fees and interest on accruing loans and leases past due 90 days or more.

(2)  Includes federal funds sold.

 

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