UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

 

FORM 10-Q

 

ý        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period ended September 30, 2005

 

Commission File Number: 0-19972

 

 

HF FINANCIAL CORP.

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

 

Delaware		46-0418532
(State or other jurisdiction of		(I.R.S. Employer Identification Number)
incorporation or organization)
225 South Main Avenue,
Sioux Falls, SD		57104
(Address of principal executive office)		(ZIP Code)
(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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes o  No ý

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)
YES o  NO ý

 

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

 

As of November 9, 2005 there were 3,574,124 issued and outstanding shares of the Registrant’s Common Stock, with $.01 par value.

 

 

HF FINANCIAL CORP.

 

Form 10-Q

 

Table of Contents

 

PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited):
	Consolidated Statements of Financial Condition As of September 30, 2005 and June 30, 2005
	Consolidated Statements of Income for the Three Months Ended September 30, 2005 and 2004
	Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2005 and 2004
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
Form 10-Q	Signature Page

 

 

PART I  - FINANCIAL INFORMATION

 

Item 1.           Financial Statements

 

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in Thousands)

 

		September 30, 2005			June 30, 2005
		(Unaudited)			(Audited)
ASSETS
Cash and cash equivalents		$	19,093		$	18,248
Securities available for sale		149,960			142,429
Federal Home Loan Bank stock		7,236			7,699
Loans held for sale		17,265			10,238
Loans and leases receivable		678,124			675,657
Allowance for loan and lease losses		(5,321		)	(5,076		)
Net loans and leases receivable		672,803			670,581
Accrued interest receivable		6,309			5,087
Office properties and equipment, net of accumulated depreciation		13,451			12,978
Foreclosed real estate and other properties		1,446			1,387
Cash value of life insurance		12,651			12,530
Servicing rights		5,344			5,211
Goodwill, net		4,951			4,951
Other assets		7,409			6,535
Total assets		$	917,918		$	897,874
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits		$	677,291		$	681,216
Advances from Federal Home Loan Bank and other borrowings		135,226			119,664
Subordinated debentures payable to trusts		27,837			27,837
Advances by borrowers for taxes and insurance		10,747			6,446
Accrued expenses and other liabilities		12,343			9,076
Total liabilities		863,444			844,239
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, 5,549,892 and 5,462,066 shares issued at September 30, 2005 and June 30, 2005, respectively		55			55
Common stock subscribed for but not issued, 66,644 shares at June 30, 2005		—			1,266
Additional paid-in capital		20,858			19,190
Retained earnings, substantially restricted		65,906			65,267
Deferred compensation		(2,180		)	(2,140		)
Accumulated other comprehensive income (loss), net of related deferred tax effect		(998		)	(836		)
Less cost of treasury stock, 1,977,836 and 1,977,836 shares at September 30, 2005 and June 30, 2005, respectively		(29,167		)	(29,167		)
Total stockholders’ equity		54,474			53,635
Total liabilities and stockholders’ equity		$	917,918		$	897,874

 

See accompanying notes to unaudited consolidated financial statements.

 

1

 

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except Per Share Data)

(Unaudited)

 

		Three Months Ended
		September 30,
		2005			2004
Interest, dividend and loan fee income:
Loans and leases receivable		$	11,121		$	9,734
Investment securities and interest-earning deposits		1,351			956
		12,472			10,690
Interest expense:
Deposits		4,296			2,771
Advances from Federal Home Loan Bank and other borrowings		1,841			1,379
		6,137			4,150
Net interest income		6,335			6,540
Provision for losses on loans and leases		462			179
Net interest income after provision for losses on loans and leases		5,873			6,361
Noninterest income:
Fees on deposits		1,176			1,120
Loan servicing income		312			372
Gain on sale of loans, net		255			102
Trust income		195			159
Gain on sale of securities, net		—			13
Other		447			432
		2,385			2,198
Noninterest expense:
Compensation and employee benefits		4,303			3,998
Occupancy and equipment		780			783
Other		1,591			1,550
		6,674			6,331
Income before income taxes		1,584			2,228
Income tax expense		561			768
Net income		$	1,023		$	1,460
Comprehensive income		$	861		$	2,425
Cash dividends paid per share		$	0.1100		$	0.1075
Earnings per share:
Basic		$	0.29		$	0.41
Diluted		$	0.29		$	0.41

 

See accompanying notes to unaudited consolidated financial statements.

 

2

 

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)

 

		Three Months Ended September 30,
		2005			2004
Cash flows from operating activities
Net income		$	1,023		$	1,460
Adjustments to reconcile net income to net cash (used in) operating activities:
Provision for losses on loans and leases		462			179
Depreciation		361			359
Amortization of discounts and premiums on securities and other		516			422
Stock based compensation		184			152
Deferred income taxes (credits)		(4		)	(22		)
Loans originated for resale		(32,772		)	(20,632		)
Proceeds from the sale of loans		27,172			15,092
(Gain) on sale of loans, net		(255		)	(102		)
Realized (gain) on sale of securities, net		—			(13		)
Losses and provision for losses on sales of foreclosed real estate and other properties, net		14			26
(Gain) on disposal of office properties and equipment, net		(2		)	—
Change in other assets and liabilities		1,156			(163		)
Net cash (used in) operating activities		(2,145		)	(3,242		)
Cash flows from investing activities
Loans and leases purchased		—			(843		)
Loans and leases originated and held		(85,281		)	(65,394		)
Principal collected on loans and leases		81,191			49,018
Securities available for sale:
Sales and maturities and repayments		10,535			19,599
Purchases		(18,655		)	(7,805		)
Purchase of Federal Home Loan Bank stock		(1,342		)	(1,272		)
Redemption of Federal Home Loan Bank stock		1,805			356
Proceeds from sale of office properties and equipment		2			—
Purchase of office properties and equipment		(834		)	(292		)
Purchase of servicing rights		(284		)	(313		)
Proceeds from sale of foreclosed real estate and other properties, net		121			270
Net cash (used in) investing activities		(12,742		)	(6,676		)

 

See accompanying notes to unaudited consolidated financial statements.

 

3

 

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(Dollars in Thousands)

(Unaudited)

 

		Three Months Ended September 30,
		2005			2004
Cash flows from financing activities
Net (decrease) in deposit accounts		$	(3,925	)	$	(15,750	)
Proceeds of advances from Federal Home Loan Bank and other borrowings		145,678			119,759
Payments on advances from Federal Home Loan Bank and other borrowings		(130,116		)	(98,624		)
Increase in advances by borrowers		4,301			2,097
Purchase of treasury stock		—			(673		)
Proceeds from issuance of common stock		178			88
Cash dividends paid		(384		)	(381		)
Net cash provided by financing activities		15,732			6,516
Increase (decrease) in cash and cash equivalents		845			(3,402		)
Cash and cash equivalents
Beginning		18,248			20,474
Ending		$	19,093		$	17,072
Supplemental Disclosures of Cash Flows Information
Cash payments for interest		$	5,420		$	3,854
Cash payments for income and franchise taxes, net		919			325

 

See accompanying notes to unaudited consolidated financial statements.

 

4

 

HF FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For The Three Months Ended September 30, 2005 and 2004

(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, 2005 (“Fiscal 2005”), 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 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”) and HF Financial Capital Trust IV (“Trust IV”).  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 2005, under Note 17 of “Notes to Consolidated Financial Statements.”

 

5

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123R to stock-based employee compensation for the quarter ended September 30, 2004.

 

		Three Months Ended September 30,
		2005			2004
Net income, as reported (1)		$	1,023		$	1,460
Add: Total stock-based employee compensation expense included in reported net income, net of related tax effects					31
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2)					(72		)
Pro forma net income		$	1,023		$	1,419
Basic earnings per share:
As reported		$	0.29		$	0.41
Pro forma					0.40
Diluted earnings per share:
As reported		0.29			0.41
Pro forma					0.39

 

(1)   Includes expense related to stock-based employee compensation for the three months ended September 30, 2005 due to the adoption of SFAS No. 123R.

(2)   Includes expense related to restricted stock reported in net income.

 

NOTE 2.                                                 REGULATORY CAPITAL

 

The following table sets forth the Bank’s compliance with its minimum capital requirements for a well-capitalized institution at September 30, 2005:

 

 

6

 

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 month periods ended September 30, 2005 and 2004 was 3,497,287 and 3,533,847, 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 month periods ended September 30, 2005 and 2004 was 3,582,070 and 3,604,681, respectively.

 

NOTE 4.                                                 CONSUMER AUTOMOBILE LOAN SECURITIZATION

 

On January 31, 2003, the Bank securitized and sold motor vehicle installment loans with principal balances totaling $50.0 million through HFSC and Home Federal Automobile Securitization Trust 2003-A (“Automobile Securitization Trust”).  As part of the sales transaction, the Bank retains servicing responsibilities.  In addition, the Bank retains the rights to cash flows remaining after investors in the Automobile Securitization Trust have received their contractual payments and has pledged a $1.5 million reserve fund to the Automobile Securitization Trust.  These retained interests are subordinated to investors’ interests.  The investors and Automobile Securitization Trust have no recourse to the Bank’s other assets for failure of debtors to pay when due.  The pass through rate to investors is 2.65%.

 

The gain recognized on the sale of these loans was determined by allocating the carrying amount of the loans between the loans sold and the interests retained.  The Bank determined that 50 basis points of the 100 basis points servicing contract represented was excess servicing and was capitalized as part of the transaction utilizing a market discount rate of 10.0%.  This asset is amortized in proportion to, and over the period of, estimated net servicing income.

 

The Company has the option to execute a cleanup call when the total outstanding balance is at 10% or less of the original pool balance, or $5.0 million.  Based on management’s estimates, this cleanup call could be executed in the second quarter of the current fiscal year ending June 30, 2006 (“Fiscal 2006”).

 

7

 

Key economic assumptions used and the sensitivity of fair value of the retained interest as of September 30, 2005 are as follows:

 

		Retained			Servicing
		Interest			Rights
		(Dollars in Thousands)
Fair Value		$	1,525		$	4
Weighted average life (in years)		1.67			1.67
Prepayment speed (ABS annual rate):		20.40		%	20.40		%
Impact on fair value of 10% adverse change		$	—		$	—
Impact on fair value of 20% adverse change		(1		)	—
Credit losses (annual rate):		1.13		%	1.13		%
Impact on fair value of 10% adverse change		$	(1	)	$	—
Impact on fair value of 20% adverse change		(2		)	—
Discount rate:		5.26		%	10.00		%
Impact on fair value of 10% adverse change		$	(1	)	$	—
Impact on fair value of 20% adverse change		(3		)	—

 

These sensitivities are hypothetical and should be used with caution.  Changes in fair value based on a 10.0% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear.  Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption.  In reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.

 

8

 

NOTE 5.                              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:

 

 

 

9

 

The following table presents the fair value and age of gross unrealized losses by investment category at September 30, 2005 in accordance with Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”

 

 

Management does not believe any individual unrealized losses as of September 30, 2005 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 are primarily attributable to changes in interest rates and as a group were less than 1.3% of its respective amortized cost basis at September 30, 2005.  The Company has the ability to hold the securities to maturity or for a time necessary to recover the amortized cost.

 

The Company invests in investment securities issued by FNMA and FHLMC.  FNMA and FHLMC are government-sponsored enterprises (“GSEs”).  GSE, as defined in the Omnibus Budget Reconciliation Act of 1990, refers to a private corporation that operates under a charter granted by Congress.  The majority of the members of the board of directors of a GSE must be elected by the private shareholders, though some portion may be appointed by Congress or the President.  The central function of a GSE is to serve as a financial intermediary, making loans or issuing loan guarantees to borrowers or sectors identified in the enabling legislation.  A GSE may raise funds in a variety of ways, but in no case are the liabilities of the GSE to be backed by the full faith and credit of the federal government.  The legislation specifically states that a GSE does not have the power to tax or regulate and cannot make financial commitments in the name of the federal government and that members of its staff are not employees of the federal government.  However, management believes that GSEs are generally perceived by the credit markets to have an implicit federal government guarantee backing its obligations.

 

Management cannot predict the role of GSEs in the future or how Congress would respond to accounting or credit issues that may affect GSEs.  Management presently expects to continue to invest in investment securities issued by FNMA and FHLMC in the normal course of business.  If Congress would ever eliminate the implicit guarantee associated with securities issued by GSEs, the outcome would most likely be adverse to the Company.

 

10

 

NOTE 6.                                                 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.

 

Three Months Ended September 30, 2005		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	7,142		$	(807	)	$	6,335
Intersegment interest income		(298		)	298			—
Provision for losses on loans and leases		(462		)	—			(462		)
Noninterest income		2,436			(51		)	2,385
Intersegment noninterest income		(52		)	52			—
Noninterest expense		(6,480		)	(194		)	(6,674		)
Intersegment noninterest expense		1			(1		)	—
Income (loss) before income taxes		$	2,287		$	(703	)	$	1,584
Total assets at September 30, 2005		$	916,639		$	1,279		$	917,918

 

Three Months Ended September 30, 2004		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	7,155		$	(615	)	$	6,540
Intersegment interest income		(246		)	246			—
Provision for losses on loans and leases		(179		)	—			(179		)
Noninterest income		2,224			(26		)	2,198
Intersegment noninterest income		(92		)	92			—
Noninterest expense		(6,053		)	(278		)	(6,331		)
Intersegment noninterest expense		1			(1		)	—
Income (loss) before income taxes		$	2,810		$	(582	)	$	2,228
Total assets at September 30, 2004		$	853,885		$	3,322		$	857,207

 

11

 

NOTE 7.                                                 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:

 

		Three Months Ended
		September 30,
		2005			2004
Service cost		$	116,367		$	113,535
Interest cost		91,238			91,585
Expected return on plan assets		(93,185		)	(92,629		)
Amortization of prior losses		—			8,297
Accretion of prior service cost		—			—
Amortization of transition asset		2,908			2,908
Total costs recognized in expense		$	117,328		$	123,696

 

The Company previously disclosed in its consolidated financial statements for Fiscal 2005, 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 2005, that it contributed $662,000 to fund its qualified pension plan.  During the quarter ended September 30, 2005, the Company made contributions of $610,000 to fund its qualified pension plan.  The Company anticipates no additional contributions for Fiscal 2006.

 

NOTE 8.                                                 SUBSEQUENT EVENTS

 

On July 20, 2005, the Company determined as doubtful as of June 30, 2005, certain loan participation interests in the aggregate amount of $4.12 million that the Bank owns as a participant in a loan to a certain borrower based in South Dakota.  The Bank is a participant in the loan with several other banks.  The downgrade by the Company of the loan interests to doubtful caused the loan interests to be impaired and, accordingly, a material charge for impairment with respect to the loan interests was necessary under generally accepted accounting principles.  In connection with such determination, the Company recorded a total impairment of approximately $1.75 million in provisions for loan losses as of June 30, 2005, relating to the loan interests.

 

On November 7, 2005, the participants in the loan, including the Bank, agreed to sell their interests in the loan to a third party.  Accordingly, the Company will record a charge of approximately $1.05 million in its second quarter of Fiscal 2006 and will reclassify the loan interests as held for sale until the completion of the sale of the loan, which is expected to occur over the next several months.

 

12

 

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 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.

 

13

 

Executive Summary

 

The Company’s net income for the first quarter of Fiscal 2006 was $1.0 million, or $0.29 per diluted share, compared to $1.5 million, or $0.41 per diluted share for the first quarter of Fiscal 2005.  Return on average equity was 7.59% at September 30, 2005 compared with 11.16% at September 30, 2004.

 

As previously reported, the Company downgraded a $4.1 participation loan as of June 30, 2005.  A provision for loan and lease losses charge of $2.0 million, including a $1.8 million impaired loan valuation allowance, was recorded as of June 30, 2005.  On November 7, 2005, the participants in the loan, including the Bank, agreed to sell their interests in the loan to a third party.  Accordingly, the Company will record a charge of approximately $1.05 million in its second quarter of Fiscal 2006 and will reclassify the loan interests as held for sale until the completion of the sale of the loan, which is expected to occur over the next several months.  See Note 8 of the “Notes to Consolidated Financial Statements” which is included in Part I, Item 1 “Financial Statements” of this Form 10-Q for additional information.

 

Net interest income for the first three months ended September 30, 2005 was $6.3 million, a decrease of $205,000, or 3.1%, over the same period a year ago.  This decrease in net interest income was due to approximately $84,000 in lost income resulting from the aforementioned participation loan, $66,000 in loans placed into nonaccrual during the quarter and a decrease of $28,000 from the reduction in the Federal Home Loan Bank dividend rate.  For the three months ended September 30, 2005, average interest-earning assets increased in volume 6.3% and average interest-bearing liabilities increased in volume 6.4%.

 

The net interest margin for the three months ended September 30, 2005 was 3.01%, compared to 3.30% for the same period a year ago, a decline of 29 basis points.  The flattening of the treasury yield curve caused by increasing short-term rates and lagging long-term rates continued to affect the Company’s net interest margin ratio during the quarter.  The increase in interest rates for variable priced trust preferred securities tied to LIBOR caused a decrease in margin of six basis points.  Variability of the net interest margin ratio may be affected by many aspects, including Federal Reserve policies for short-term interest rates, competitive and economic factors and customer preferences for various products and services.  From September 30, 2004 to September 30, 2005, the Federal Reserve increased short-term interest rates seven times at 25 basis points each, for a total increase of 175 basis points.

 

Total deposits at September 30, 2005 were $677.3 million, an increase of $34.3 million, or 5.3%, from September 30, 2004.  Interest expense on these deposits was $4.3 million for the quarter ended September 30, 2005, which is an increase of $1.5 million, or 55.0%, over the same period a year ago.  In-market deposits increased from $597.3 million at September 30, 2004 to $636.0 million at September 30, 2005, an increase of $38.7 million, or 6.5%.  For the same period, out-of-market deposits decreased from $45.7 million to $41.3 million, respectively.  The primary factor affecting interest expense has been money market accounts.  The volume of money market accounts increased by $10.2 million, or 4.9%, from September 30, 2004, to September 30, 2005.  Interest expense for these accounts also increased by $796,000, or 95.7%, compared to the same period in the prior fiscal year.  At September 30, 2005, approximately 74% of all money market accounts were indexed with a monthly reset, tied to the 91-day Treasury bill, compared to approximately 36% at September 30, 2004.  With the actions taken by the Federal Reserve, the 91-day Treasury bill has risen significantly from 1.70% at September 30, 2004 to 3.54% at September 30, 2005, an increase of 184 basis points.

 

Nonperforming assets at September 30, 2005 were $8.7 million in comparison to $2.4 million a year ago, an increase of $6.3 million or 267.9%.  The ratio of nonperforming assets to total assets increased to 0.94% at September 30, 2005, compared to 0.27% at September 30, 2004.  The allowance for loan and lease losses increased to $5.3 million at September 30, 2005 compared to $3.6 million at September 30,

 

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2004, an increase of $1.7 million or 48.3%.  As a result of increases in nonperforming assets and the allowance for loan and lease losses, the ratio of allowance for loan and lease losses to nonperforming loans and leases decreased from 155.77% at September 30, 2004 to 62.42% at September 30, 2005.

 

Despite the downgrade of the participation loan, asset quality is and continues to be a primary focus for the Company.  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.

 

As publicly announced in April 2005, the Company renewed its annual stock buyback program for the period from May 1, 2005 to April 1, 2006.  During the first quarter ended September 30, 2005, the Company did not repurchase any shares, as compared to 42,700 shares repurchased during the quarter ended September 30, 2004.  Under the current stock buyback program, the Company has repurchased a total of 47,300 shares.  In October 2005, the Company announced an increase in its quarterly cash dividend, from 11.0 cents to 11.25 cents per share, resulting in an annualized increase of 2.3%.

 

The total risk-based capital ratio of 10.66% at September 30, 2005 is above the 10.47% at September 30, 2004, an increase of 19 basis points.  This continues to place the Bank in the “well capitalized” category within OTS regulation at September 30, 2005 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.

 

The Company focuses on balancing operating costs with operating revenue levels in order to provide better efficiency ratios over time and continues to review its operations for ways to reduce its cost structure while continuing to support long-term revenue enhancements.  Noninterest expense was $6.7 million for the quarter ended September 30, 2005 compared to $6.3 million at September 30, 2004, an increase of 5.4%.  Compensation and employee benefits expense accounted for an increase of $305,000 due to increases in employee compensation and net healthcare costs.  However, noninterest income was $2.4 million for the quarter ended September 30, 2005 compared to $2.2 million for the quarter ended September 30, 2004, an increase of 8.5%.  This increase was driven primarily by increasing gains on sale of single-family mortgage loans, with additional increases reported for fees on deposits and trust income.

 

The Company adopted FAS 123R effective as of July 1, 2005.  As a result, the Company recognized $39,000 in stock option expense for the three months ended September 30, 2005 compared to no expense recognized for stock options granted under the Company’s stock option and incentive plans for the same quarter in the prior fiscal year.  The Company also recognized $88,000 in restricted stock expense for the three months ended September 30, 2005, compared to $31,000 for the same period a year ago.

 

The operating efficiency ratio at September 30, 2005 was 72.41%, compared to 69.57% for the same time period a year ago, an increase of 284 basis points.  The operating efficiency ratio excludes the impact of net interest expense on the variable priced trust preferred securities.  The Company has issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings.  Net interest expense on the $27.8 million of trust preferred securities outstanding, increased to $497,000 for the first quarter ended September 30, 2005, compared to $362,000 for the same period a year ago, an increase of $135,000 or 37.3%.  The total efficiency ratio was 76.54% at September 30, 2005, compared to 72.45% for the same period a year ago, an increase of approximately 409 basis points.  It is the Company’s goal to move the operating efficiency ratio towards the 50% level over the long term.  Management believes that this can be accomplished through steady growth of the balance sheet and the containment of incremental operating expenses.

 

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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, 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 September 30, 2005, the Company had total assets of $917.9 million, an increase of $20.0 million from the level at June 30, 2005.  The increase in assets was due primarily to increases in securities available for sale of $7.5 million, loans held for sale of $7.0 million and net loans and leases receivable of $2.2 million.  The increase in liabilities of $19.2 million from June 30, 2005 to September 30, 2005 was primarily due to an increase in advances from the FHLB and other borrowings of $15.6 million offset by a decrease in deposits of $3.9 million.  In addition, stockholders’ equity increased $839,000 to $54.5 million at September 30, 2005 from $53.6 million at June 30, 2005 primarily due to net income of $1.0 million.

 

The increase in securities available for sale of $7.5 million was primarily the result of purchases of $18.7 million exceeding sales, maturities and repayments of $10.9 million.  The purchases of $18.7 million included variable-rate, mortgage-backed securities of $12.1 million.

 

The increase in loans held for sale of $7.0 million was primarily due to mortgage loans held for sale increasing from $9.8 million at June 30, 2005 to $15.3 million at September 30, 2005.  Student loans held for sale increased from $400,000 at June 30, 2005 to $2.0 million at September 30, 2005.

 

The increase in net loans and leases receivable of $2.2 million was due primarily to an increase in purchases and originations over sales, amortization and repayments of principal.  In addition, deferred fees and discounts decreased by $40,000.  This decrease was primarily due to decreases of $36,000 in indirect automobile loans that include prepaid dealer reserves and $30,000 for deferred fees and discounts on one-to four family residential mortgages.

 

Advances from the FHLB and other borrowings increased $15.6 million, which was primarily due to an increase in FHLB borrowings.  The increase in FHLB borrowings was primarily the result of a $3.9 million decrease in deposits and a $2.2 million increase in net loans and leases receivable.

 

The $3.9 million decrease in deposits was due to decreases in savings accounts of $18.9 million and noninterest bearing checking accounts of $7.4 million offset by increases in money market accounts of $10.7 million, in-market certificates of deposit of $6.9 million, out-of-market certificates of deposit of $4.5 million and interest bearing checking accounts of $295,000.

 

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The following tables show the composition of the Company’s loan and lease portfolio and deposit accounts at the dates indicated.

 

		At September 30, 2005					At June 30, 2005
					Percent of					Percent of
					Loans in					Loans in
		Amount			Each Category		Amount			Each Category
		(Dollars in Thousands)
One-to four-family (1)		$	93,894		13.84	%	$	96,496		14.28	%
Commercial business and real estate (2)		216,280			31.89	%	223,638			33.10	%
Multi-family real estate		34,047			5.02	%	34,123			5.05	%
Equipment finance leases		35,647			5.26	%	33,170			4.91	%
Consumer Direct (3) (4)		113,378			16.72	%	111,210			16.46	%
Consumer Indirect		94,713			13.97	%	93,984			13.91	%
Agricultural		78,709			11.61	%	74,010			10.95	%
Construction and development		11,456			1.69	%	9,026			1.34	%
Total Loans and Leases Receivable (5)		$	678,124		100.00	%	$	675,657		100.00	%

 

(1) Excludes $15,336 and $9,838 loans held for sale at September 30, 2005 and June 30, 2005, respectively.

(2) Includes $3,563 tax exempt leases at September 30, 2005.

(3) Includes mobile home loans.

(4) Excludes $1,929 and $400 student loans held for sale at September 30, 2005 and June 30, 2005, respectively.

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

 

		At September 30, 2005					At June 30, 2005
					Percent of					Percent of
					Deposits in					Deposits in
		Amount			Each Category		Amount			Each Category
		(Dollars in Thousands)
Noninterest bearing checking accounts		$	78,324		11.57	%	$	85,705		12.58	%
Interest bearing accounts		50,415			7.44	%	50,120			7.36	%
Money market accounts		219,807			32.45	%	209,116			30.70	%
Savings accounts		44,342			6.55	%	63,235			9.28	%
Certificates of deposit		284,403			41.99	%	273,040			40.08	%
Total Deposits		$	677,291		100.00	%	$	681,216		100.00	%

 

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 companies.  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.

 

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