Item 1. Business
GENERAL
Hills Bancorporation (the “Company”) is a holding company principally engaged, through its subsidiary bank, in the business of banking. The Company was incorporated December 12, 1982 and all operations are conducted within the state of Iowa. The Company became owner of 100% of the outstanding stock of Hills Bank and Trust Company, Hills, Iowa (“Hills Bank and Trust” or the “Bank”) as of January 23, 1984 when stockholders of Hills Bank and Trust exchanged their shares for shares of the Company. Effective July 1, 1996, the Company formed a new subsidiary, Hills Bank, which acquired for cash all the outstanding shares of a bank in Lisbon, Iowa. Subsequently an office of Hills Bank was opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon. Effective November 17, 2000, Hills Bank was merged into Hills Bank and Trust. On September 20, 1996, another subsidiary, Hills Bank Kalona, acquired cash and other assets and assumed the deposits of the Kalona, Iowa office of Boatmen’s Bank Iowa, N.A. Effective October 26, 2002, Hills Bank Kalona was merged into Hills Bank and Trust.
The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers. The Bank is actively engaged in all areas of commercial banking, including acceptance of demand, savings and time deposits; making commercial, real estate, agricultural and consumer loans; maintaining night and safe deposit facilities; and performing collection, exchange and other banking services tailored for individual customers. The Bank administers estates, personal trusts, and pension plans and provides farm management and investment advisory and custodial services for individuals, corporations and nonprofit organizations. The Bank makes commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans. In addition, the Bank earns substantial fees from originating mortgages that are sold in the secondary residential real estate market without mortgage servicing rights being retained.
The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring that, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment.
The Bank’s business is not seasonal, except that loan origination fees are driven by interest rate movements and are higher in a low rate environment. The Company had no employees as of December 31, 2003 and the Bank had 309 regular and 102 part-time employees.
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Item 1. Business (Continued)
Johnson County
The Bank’s primary trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa. These communities have a combined population of approximately 86,000. Johnson County, Iowa has a population of approximately 114,000. The University of Iowa in Iowa City has approximately 30,000 students and 24,500 full and part-time employees, including employees of The University of Iowa Hospitals and Clinics. Other principal employers in Johnson County include the following:
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Item 1. Business (Continued)
Linn County
The Bank also operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa. Lisbon has a population of approximately 1,900 and Mount Vernon, located two miles from Lisbon, has a population of 3,800. Both communities are strong economically and are within easy commuting distances to Cedar Rapids and Iowa City, Iowa. Cedar Rapids has a metropolitan population of approximately 154,000, including approximately 27,000 from Marion and is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of Iowa City on Interstate 380. The total population of Linn County is approximately 195,000.The largest employer in the Cedar Rapids area is Rockwell Collins, manufacturer of communications instruments, with about 6,300 employees. Other large employers in the Cedar Rapids area and their approximate number of employees are as follows:
Employer
Type of Business
Employees
Cedar Rapids, College, Linn-Mar, Marion and Grant Wood School Districts
Education
4,050
Maytag Appliances, Amana Iowa
Appliance Manufacturing
2,950
AEGON USA, Inc.
Insurance
2,500
IES Utilities
Electric Utility
2,300
St. Luke’s Hospital
Health Care
2,250
Hy-Vee Food Stores
Grocery Stores
1,950
McLeod*USA
Telecommunications
1,950
Mercy Medical Center
Health Care
1,700
MCI Communications, Inc
Long Distance Service
1,600
City of Cedar Rapids
City Government
1,300
Quaker Oats Company
Cereals and Chemicals
1,250
APAC Teleservices
Telemarketing
1,200
Kirkwood Community College
Education
1,150
Washington County
The Bank has an office located in Kalona, Iowa, which is in Washington County. Kalona is located approximately 20 miles south of Iowa City. Kalona has a population of approximately 2,300. The population of Washington County is approximately 21,000. Kalona is primarily an agricultural community, but it is located within easy driving distance for employment in Iowa City, Coralville and North Liberty (combined population 85,000) and Washington, Iowa (population 7,000).
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Item 1. Business (Continued)
COMPETITION
The financial services industry is highly competitive. The Bank must compete with financial services providers, such as banks, savings and loan associations, credit unions, finance companies, mortgage banking companies, insurance companies and money market and mutual fund companies. It also faces increased competition from non-banking institutions such as brokerage houses and insurance companies, as well as from financial services subsidiaries of commercial and manufacturing companies. Many of these competitors enjoy the benefits of fewer regulatory constraints and lower cost structures.
Effective March 13, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. This may significantly change the competitive environment in which the Company conducts business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties.
The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson and Linn County. A comparison of the number of office locations and deposits in the two counties as of June, 2003 is as follows:
THE ECONOMY
The Bank’s primary trade territory is Johnson County, Iowa. Linn County, Iowa is becoming an increasingly important market, and the Bank now has five offices open in Linn County. The Bank also has one office in Kalona in Washington County, Iowa. The table that follows shows the employment information as of December 31, 2003, regarding the labor force and unemployment levels in the three counties in which the Bank has office locations along with data on the United States and the State of Iowa.
Labor Force
Unemployed
Rate %
United States
146,878,000
8,398,000
5.72
%
State of Iowa
1,633,200
71,200
4.36
%
Johnson County
76,600
2,600
3.39
%
Linn County
118,300
5,100
4.31
%
Washington County
10,720
4.10
%
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Item 1. Business (Continued)
The unemployment rate for the Bank’s trade territory is favorable and the rate has historically been lower than both the United States and the State of Iowa. As discussed with the employment table of large employers in Johnson and Linn County, the University of Iowa’s impact on the local economy is very important in maintaining acceptable employment levels. Johnson and Linn County has been one of the strongest economic areas in Iowa and has had substantial economic growth in the past ten years. The largest segment of the employed population is employed in manufacturing, management, professional or related occupations.
The economies in the counties continue to be enhanced by local Iowa colleges and the University of Iowa. In addition to providing quality employment, they enroll students who provide economic benefits to the area. The following table indicates Fall 2003 enrollment.
The State of Iowa continues to collect decreasing tax revenues while spending continues to increase, and the Iowa legislature has required the University of Iowa to reduce spending in the last three fiscal years. The University has reacted to its budget constraints without significant lay-offs and has continued to review and reduce employment, when necessary, through attrition. However, salary increases at the University have been minimal.
The Bank also serves a number of smaller communities in Johnson, Linn and Washington counties that are more dependent upon the agricultural economy, which historically has been affected by commodity prices and weather. The average price per acre of farm land continues to be an important factor to consider when reviewing the local economy. The average acre in Iowa in 2003 was $2,275 compared to $2,083 in 2002. The range of average land prices in Johnson, Linn and Washington counties is between $2,546 and $2,926 per acre. The increase was 8.5% from 2002. The Bank’s total agricultural loans comprise about 4.3% of the Bank’s total loans.
SUPERVISION AND REGULATION
Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company can be affected not only by management decisions and general economic conditions but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities, including the Iowa Superintendent of Banking (the “Superintendent”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission (the “SEC”). The effect of applicable statues, regulations and regulatory policies can be significant and cannot be predicted with a high degree of certainty.
Federal and state laws and regulations generally applicable to financial institutions, such as the Company and its subsidiary Bank, regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends. The system of supervision and regulation applicable to the Company and its subsidiary Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds and the depositors, rather than the stockholders, of financial institutions.
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Item 1. Business (Continued)
The following is a summary of the material elements of the regulatory framework applicable to the Company and its subsidiary Bank. It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of the statutes, regulations and regulatory policies that are described. As such, the following is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies. Any change in applicable law, regulations or regulatory policies may have a material effect on the business of the Company and its subsidiary Bank.
Significant Regulatory Developments
The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act (the “Act”), was enacted on November 12, 1999. The Act allows eligible bank holding companies to engage in a wider range of non-banking activities and grants them greater authority to engage in securities and insurance activities. Under the Act, an eligible bank holding company that elects to become a financial holding company may engage in any activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity, or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. A financial service corporation can engage in a number of financial activities including insurance and securities underwriting and other agency activities, merchant banking and insurance company portfolio investment activities. Activities that are ancillary to financial activities are also allowed. Additionally, the Act amends the federal securities laws to incorporate functional regulation of bank securities and activities and provides for the functional regulation of insurance activities by establishing which insurance products banks and bank subsidiaries may provide as principal. National banks are also authorized by the Act to engage, through “financial subsidiaries,” in certain activities that are permissible for financial holding companies (as described above) and certain activities that the Secretary of the Treasury, in consultation with the Federal Reserve, determines are financial in nature or incidental to any such financial activity.
Various bank regulatory agencies have issued regulations as mandated by the Act. During June 2000, all of the federal bank regulatory agencies jointly issued regulations implementing the privacy provisions of the Act. In addition, the Federal Reserve issued interim regulations establishing procedures for bank holding companies to elect to become financial holding companies and listing the financial activities permissible for financial holding companies, as well as describing the extent to which financial holding companies may engage in securities and merchant banking activities. The Federal Reserve has issued an interim regulation regarding the parameters under which state member banks may establish and maintain financial subsidiaries. At this time, it is not possible to predict the impact the Act and its implementing regulations may have on the Company. As of the date of this filing, the Company has not applied for or received approval to operate as a financial holding company. In addition, the Bank has not applied for or received approval to establish financial subsidiaries.
In the area of privacy, the Act requires clear disclosure by all financial institutions of their privacy policies regarding the sharing of nonpublic information with both affiliates and third parties. Further, the Act requires a notice to consumers and an opportunity to “opt out” of sharing of nonpublic personal information with nonaffiliated third parties, subject to certain limited exceptions. The Act also reforms laws that regulate ATMs, Community Reinvestment Banks and Deposit Production Offices. Specifically, the Act requires ATM operators who impose a fee for use of an ATM by a non-customer to post a notice both on the machine and on the screen that a fee will be charged and the amount of the fee, and further requires a notice when ATM cards are issued that surcharges may be imposed by other parties when transactions are initiated from ATMs not operated by the card issuer. The Act also clarifies that nothing in the act repeals any provision of the Continuity Reinvestment Act (“CRA”); however, the Act requires full disclosure of all CRA agreements and reduces the frequency of CRA exams for small banks and savings and loans (those with no more than $250 million in assets). The Act allows community banks all the powers as a matter of right that large institutions have accumulated on an ad hoc basis, including the ability to underwrite municipal bonds in the future. Finally, the Act expands the prohibition of deposit production offices contained in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”) to include all branches of an out-of-state bank holding company.
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Regulation of the Company
General. The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended (the “BHCA”). Under the BHCA, the Company is subject to periodic examination by the Federal Reserve. The Company is also required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiaries as the Federal Reserve may require.
Source of Strength Policy. According to Federal Reserve Board policy, bank/financial holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank/financial holding company may not be able to provide support. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act, in the event of a loss suffered or anticipated by the FDIC - either as a result of default of a banking or thrift subsidiary of a bank/financial holding company such as the Company or related to FDIC assistance provided to a subsidiary in danger of default - the other banking subsidiaries of such bank/financial holding company may be assessed for the FDIC’s loss, subject to certain exceptions.
Investments and Activities. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after the acquisition, it would own or control more than 5% of the shares of the other bank or bank holding company (unless it already owns or controls the majority of such shares), (ii) acquiring all or substantially all of the assets of another bank or (iii) merging or consolidating with another bank holding company. Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located. On approving interstate acquisitions, however, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.
The BHCA also generally prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking . . . as to be a proper incident thereto.” Under current regulations of the Federal Reserve, the Company either directly or through non-bank subsidiaries would be permitted to engage in a variety of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment leasing, the operation of a computer service bureau (including software development) and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.
Federal law also prohibits any person from acquiring “control” of a bank holding company without prior notice to the appropriate federal bank regulator. “Control” is defined in certain cases as the acquisition of 10% or more of the outstanding shares of a bank or a bank holding company depending on the circumstances surrounding the acquisition.
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Item 1. Business (Continued)
Regulatory Capital Requirements
Regulatory guidelines define capital and spell out the minimum acceptable capital levels for banks. The purpose of these guidelines is to increase depositor protection and to reduce deposit insurance fund losses. Currently, the three federal banking agencies use a “risk-based” approach to gauge bank capital. Under this approach, the agencies define what is to be included in bank capital and establish the minimum capital a bank must have primarily to protect it from the risk inherent in its asset holdings.
Risk-based capital guidelines divide capital into core and supplemental capital. Core or Tier I capital is similar to what is normally thought of as capital in other businesses. It consists primarily of common and certain preferred stock, surplus and undivided profits. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. Supplemental or Tier 2 capital consists, within certain specified limits, of such things as the allowance for loan losses, hybrid capital instruments and subordinated debt. These supplemental items are often forms of debt that are subordinate to claims of depositors and the FDIC. As such, they provide depositor protection and are included in bank capital. The sum of Tier 1 and Tier 2 capital, less certain deductions, represents a bank’s total capital. In the capital guidelines, Tier 1 capital must constitute at least 50% of a bank’s total capital. Thus, the use of Tier 2 capital is limited by the “hard” equity in a bank’s capital structure.
As part of their capital adequacy assessment, the regulatory agencies convert a bank’s assets, including off-balance sheet items, to risk-equivalent assets. The purpose of this conversion is to quantify the relative risk, primarily credit risk, in these assets and to determine the minimum capital necessary to compensate for this risk. For example, assets that pose little risk, such as cash held at the bank’s offices and U. S. government securities, are weighted zero, meaning that no capital support is required for these assets. Assets that pose greater risk are weighted at 20%, 50% or 100% of their dollar value, indicating the level of capital support they require. Except for banks with large “off-balance sheet” asset positions, risk weighting will nearly always lower total assets requiring capital support. However, even if a bank held nothing but cash and U.S. securities, it would still be required to maintain capital support for these assets. The reason is that banks face more than credit risk (e.g., market risk), and these other risks require that banks maintain minimum levels of capital to protect the banks and their depositors.
The Federal Reserve’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: a risk-based requirement expressed as a percentage of total risk-weighted assets, and a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others.
The risk-based and leverage standards described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentration of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum levels. Current Federal Reserve minimum requirements for a well capitalized organization experiencing significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6% and total risk-based capital ratio of 10%. As of December 31, 2003, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a leverage ratio of 8.87%, with total Tier 1 risk-based capital ratio of 13.31% and a total risk-based capital ratio of 14.56%.
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Item 1. Business (Continued)
Dividends. The Iowa Business Corporation Act (“IBCA”) allows the Company to pay dividends only out of its surplus (as defined and computed in accordance with the provision of the IBCA) or if the Company has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Additionally, the Federal Reserve has issued a policy statement with regard to the payment of cash dividends by bank holding companies. The policy statement provides that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.
Federal Securities Regulation. The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.
Regulation of the Bank
General. The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by the FDIC’s Bank Insurance Fund (“BIF”). As an Iowa-chartered, FDIC insured bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the Superintendent of Banking of the State of Iowa (the “Superintendent”), as the chartering authority for Iowa banks, and the FDIC, as administrator of the BIF.
Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their respective levels of capital and results of supervisory evaluations. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy, pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern, pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. The Bank is currently paying the minimum assessment under the FDIC’s risk assessment system.
The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution (i) has engaged in or is engaging in unsafe or unsound practices, (ii) is in an unsafe or unsound condition to continue operations or (iii) has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. Management of the Company is not aware of any activity or condition that could result in termination of the deposit insurance of the Bank.
Capital Requirements. Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks. Changes in the capital structure of state banks are also approved by the Superintendent. State banks normally must have a primary capital to total assets ratio of six and one-half percent (6 ½ %). In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank. The Superintendent defines the term “primary capital” to mean the sum of stockholders’ equity and the allowance for loan losses less any intangible assets. In determining the primary capital ratio, the Superintendent uses the total assets as of the date of computation. At December 31, 2003, the primary capital to total assets ratio of the Bank exceeded the ratio required by the Superintendent.
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Item 1. Business (Continued)
Capital adequacy for banks took on an added dimension with the establishment of a formal system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). This system uses bank capital levels to trigger supervisory actions designed to quickly correct banking problems. Capital adequacy zones are used by the federal banking agencies to trigger these actions. The ratios and the definition of “adequate capital” are the same as those used by the agencies in their capital adequacy guidelines.
Federal law provides the federal banking regulators of the Bank with broad power to take prompt corrective action to resolve the problems of undercapitalized banking institutions. The extent of the regulators’ powers depends on whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation. Under prompt corrective action, banks that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions. For example, “undercapitalized banks” must restrict asset growth, obtain prior approval for business expansion, and have an approved plan to restore capital. “Critically undercapitalized banks” must be placed in receivership or conservatorship within 90 days unless some other action would result in lower long-term costs to the deposit insurance fund.
Depending upon the capital category to which an institution is assigned, the regulators’ corrective powers include: requiring the institution to submit a capital restoration plan; limiting the institution’s asset growth and restricting its activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions between the institution and its affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution. As of December 31, 2003, the Bank was well capitalized, as defined by FDIC regulations.
Community Investment and Consumer Protection Laws. The Community Reinvestment Act requires insured institutions to define the communities that they serve, identify the credit needs of those communities and adopt and implement a “Community Reinvestment Act Statement” pursuant to which they offer credit products and take other actions that respond to the credit needs of the community. The responsible federal banking regulator must conduct regular Community Reinvestment Act examinations of insured financial institutions and assign to them a Community Reinvestment Act rating of “outstanding,” “satisfactory,” “needs improvement” and “unsatisfactory.” In 2003, the Community Reinvestment Act rating of the Company’s banking subsidiary was either “outstanding” or “satisfactory.”
In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental Agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that in some cases prospective borrowers experience unlawful discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against some depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.
Recently, these governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act. These factors include evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
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Item 1. Business (Continued)
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of certain loan, to customers.
Supervisory Assessments. All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations. Effective July 1, 2002 the Superintendent changed the method of computation of the supervisory assessment from billing for each state examination completed based on an hourly rate, to billing on an annual basis based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required. For fiscal 2003 the assessment total was $90,215.
Dividends. The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits.
The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2003. Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.
Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company and its subsidiaries, on investments in the stock or other securities of the Company and its subsidiaries and the acceptance of the stock or other securities of the Company or its subsidiaries as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal stockholders of the Company, and to “related interests” of such directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal stockholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.
Safety and Soundness Standards. The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.
In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.
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Item 1. Business (Continued)
Branching Authority. Historically, Iowa’s intrastate branching statutes have been rather restrictive when compared with those of other states. Iowa’s intrastate branching statutes were relaxed in recent legislation that became effective on February 21, 2001 (the “2001 Amendment”). The 2001 Amendment allows Iowa banks to move towards statewide branching by allowing every Iowa bank, with the approval of its primary regulator, to establish three new bank offices anywhere in Iowa during the next three years. The three offices are in addition to those offices allowed within certain restricted geographic areas under prior Iowa law. Effective July 1, 2004, the 2001 Amendment repeals all limitations on bank office location and effectively allows statewide branching. After that date, banks will be allowed to establish an unlimited number of offices in any location in Iowa subject only to regulatory approval.
Under the Riegle-Neal Act, both state and national banks are allowed to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law. The legislation allowed individual states to “opt-out” of certain provisions of the Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997. Iowa permits interstate bank mergers, subject to certain restrictions, including a prohibition against interstate mergers involving an Iowa bank that has been in existence and continuous operation for fewer than five years.
Miscellaneous. The Bank is subject to certain restrictions on loans to the Company or its non-bank subsidiaries, on investments in the stock or securities thereof, on the taking of such stock or securities as collateral for loans to any borrower, and on the issuance of a guarantee or letter of credit on behalf of the Company or its non-banking subsidiaries. The Bank is also subject to certain restrictions on most types of transactions with the Company or its non-bank subsidiaries, requiring that the terms of such transactions be substantially equivalent to terms of similar transactions with non-affiliated firms.
State Bank Activities. Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the Bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the Bank is a member. These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.
Regulatory Enforcement Authority. The enforcement powers available to federal and state banking regulators are substantial and include, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institutions-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
Page 13 of 92
Item 1. Business (Continued)
CONSOLIDATED STATISTICAL INFORMATION
The following consolidated statistical information reflects selected balances and operations of the Company and the Bank for the periods indicated.
The following tables show (1) average balances of assets, liabilities and stockholders’ equity, (2) interest income and expense on a tax equivalent basis, (3) interest rates and interest differential and (4) changes in interest income and expense.
AVERAGE BALANCES
(Average Daily Basis)
Page 14 of 92
INTEREST INCOME AND EXPENSE
(1) Presented on a tax equivalent basis using a rate of 34% for the three years presented.
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Item 1. Business (Continued)
INTEREST RATES AND INTEREST DIFFERENTIAL
(1)
Non-accruing loans are not significant and have been included in the average loan balances for purposes of this computation.
(2)
Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal and state tax rate of 34% and 5%, respectively, for the three years presented.
(3)
Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets.
Page 16 of 92
Item 1. Business (Continued)
CHANGES IN INTEREST INCOME AND EXPENSE
Rate volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown at tax equivalent amounts.
Page 17 of 92
Item 1. Business (Continued)
LOANS
The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years. The table does not include loans held for sale to the secondary market.
There were no foreign loans outstanding for any of the years presented.
MATURITY DISTRIBUTION OF LOANS
The following table shows the principal payments due on loans as of December 31, 2003:
The types of interest rates applicable to these principal payments are shown below:
(1)
A significant portion of the commercial loans are due in one year or less. A significant percentage of the notes are re-evaluated prior to their maturity and are likely to be extended.
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Item 1. Business (Continued)
NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS
The following table summarizes the Company’s non-accrual, past due, restructured and impaired loans as of December 31 for each of the years presented:
The Company does not have a significant amount of loans that are past due less than 90 days on which there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.
Loans are placed on non-accrual status when management believes the collection of future interest is not reasonably assured. The non-accrual loans for swine production loans were $2.4 million at December 31, 2003 compared to none at December 31, 2002. The non-accrual loans are considered to be impaired loans for purposes of reviewing the adequacy of the loan loss reserve at year-end. Interest income was not materially affected by this classification.
The Company has no individual borrower or borrowers engaged in the same or similar industry exceeding 10% of total loans. The Company has no other interest-bearing assets, other than loans, that meet the non-accrual, past due, restructured or potential problem loan criteria.
Impaired loans increased by $1,916,000 as of December 31, 2003 from December 31, 2002. The increase was primarily related to swine production loans which increased $1.4 million from December 31, 2002 to December 31, 2003.
Specific allowance for losses on non-accrual and impaired loans are established if the loan balances exceed the net present value of the future cash flows or the fair value of the collateral if the loan is collateral dependent.
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Item 1. Business (Continued)
SUMMARY OF LOAN LOSS EXPERIENCE
The following table summarizes the Bank’s loan loss experience for each of the last five years:
(1)
For financial reporting purposes, management regularly reviews the loan portfolio and determines a provision for loan losses based upon the impact of economic conditions on the borrowers’ ability to repay, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio is a significant element in the determination of the provision for loan losses.
Page 20 of 92
Item 1. Business (Continued)
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired. If the loans are impaired, the Bank determines if a specific allowance is appropriate. In addition, the Bank’s management also reviews and, where determined necessary, provides allowances based upon reviews of specific borrowers and provides allowances for areas that management believes are of higher credit risk (agricultural loans and constructed model real estate homes as of December 31, 2003, 2002, 2001, 2000 and 1999). Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed. The percentage begins with historical loss experience factors, which are then adjusted for current economic factors.
The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of December 31, 2003, 2002, 2001, 2000, and 1999:
The allocation of the allowance for loan losses shows an increase of $251,000 to agriculture loans and specifically this was due to loans for swine production. This area of agriculture continues to have overall concerns due to the possible large fluctuations in the hog prices. The prices in 2003 averaged approximately $36.00 per hundred weight compared to $34.20 in 2002. The change in price that can happen is reflected in the average price in 2001 which was $46.30. The average breakeven in the industry is approximately $40.00 per hundred weight, so exposure on these types of loans continues to exist. The other changes in the allocation are primarily related to volume changes of loans outstanding and no material deterioration of credit quality.
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Item 1. Business (Continued)
INVESTMENT SECURITIES
The following tables show the carrying value of the investment securities which are principally held by the Bank as of December 31, 2003, 2002 and 2000 and the maturities and weighted average yield of the investment securities as of December 31, 2003:
Page 22 of 92
Item 1. Business (Continued)
INVESTMENT SECURITIES
As of December 31, 2003, there were no investment securities, exceeding 10% of stockholders’ equity, other than securities of the U. S. Government and U. S. Government agencies and corporations.
The weighted average yield is based on the amortized cost of the investment securities. The yields are computed on a tax-equivalent basis using a federal tax rate of 34% and a state tax rate of 5%.
DEPOSITS
The following tables show the amount of average deposits and rates paid on such deposits for the years ended December 31, 2003, 2002 and 2001 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2003:
There were no deposits in foreign banking offices.
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Item 1. Business (Continued)
RETURN ON STOCKHOLDERS’ EQUITY AND ASSETS
The following table presents the return on average assets, return on average stockholders’ equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2003, 2002 and 2001:
SHORT-TERM BORROWINGS
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of securities sold under agreements to repurchase during 2003, 2002 and 2001:
FEDERAL HOME LOAN BANK BORROWINGS
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates during 2003, 2002 and 2001:
Page 24 of 92
PART I
Item 2.
Item 2. Properties
The Company’s office and the main bank of the Bank are located at 131 Main Street, Hills, Iowa. This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001. With the completion of the 2001 addition, the entire Bank’s processing and administrative systems, including trust, were consolidated in Hills, Iowa. A majority of these operations previously were located in the Bank’s Coralville office. As a result of the consolidation, sixty-five full-time and part-time employees were relocated.
The other offices of Hills Bank and Trust are as follows:
1.
The Iowa City office, located at 1401 South Gilbert Street, is a one-story brick building containing approximately 15,400 square feet. The branch has five drive-up teller lanes and a drive-up, 24-hour automatic teller machine. The Bank’s trust department customer service representatives are located here. This building was constructed in 1982 and has been expanded several times, most recently in 1998.
2.
The Coralville office is a two-story building built in 1972 and expanded in 2001 that contains approximately 23,000 square feet of space. This office is equipped with four drive-up teller lanes and one automatic teller machine and is used primarily for retail banking services.
3.
A 2,800 square foot branch bank in North Liberty, Iowa was opened for business in 1986. This office is a full-service location including three drive-up teller lanes and a drive-up automatic teller machine.
4.
The Bank leases an office at 132 East Washington Street in downtown Iowa City with approximately 2,500 square feet. The office has two 24-hour automatic teller machines and two private offices in addition to a tellers and customer service area. The lease expires in 2006.
5.
In December 2001, the Bank opened a new East Side office location at 2621 Muscatine Avenue, Iowa City. The office is a 5,800 square foot, one-story building, and it has three drive-up lanes and a drive-up ATM. The new office replaced a leased office that had 1,100 square feet.
6.
The Lisbon office is a two-story brick building in Lisbon, Iowa with approximately 3,000 square feet of banking retail space located on the first floor. The building was extensively remodeled in 1996 and has one drive-up lane and a walk-up, 24-hour automatic teller machine.
7.
The Mount Vernon office opened in February 1998 with the completion of a full-service, 4,200 square foot office, with four drive-up lanes and a drive-up automatic teller machine.
8.
In February 2000, the Bank opened a 2,900 square foot branch office in downtown Cedar Rapids that is leased. In April 2001, an additional contiguous 2,100 square feet of space was leased and then remodeled for retail banking purposes. The leases expire in 2007.
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Item 2. Properties (Continued)
9.
The Kalona office is a 6,400 square foot building that contains a walk-up 24-hour automatic teller machine and one drive-up lane. This is an older building that was remodeled in late 1998.
10.
In March of 2002, Hills Bank opened its eleventh office, and the second office location in the Cedar Rapids market. The new 7,200 square foot one-story building has three drive-up lanes and a drive-up ATM. The location of the office is on Williams Boulevard in Southwest Cedar Rapids.
11.
A full service office opened on February 10, 2003 in Marion, Iowa, after extensive remodeling of the property located at 800 11th Street. The office is a two-story building having approximately 8,400 square feet with three drive-up lanes and a drive-up ATM.
All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type.
Item 3.
Item 3. Legal Proceedings
There are no materials pending legal proceedings. Neither the Company nor the Bank holds any properties that are the subject of hazardous waste clean-up investigations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders for the three months ended December 31, 2003.
Page 26 of 92
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There is no established trading market for the Company’s common stock. Its stock is not listed with any exchange or quoted in an automated quotation system of a registered securities association, nor is there any broker/dealer acting as a market maker for its stock. A bid and ask price is quoted in an Iowa City local paper and the quotes are provided by a local broker. The Company’s stock is not actively traded. As of March 15, 2004, the Company had 1,416 stockholders.
Based on the Company’s stock transfer records and information informally provided to the Company, its stock trading transactions have been as follows:
The Company paid aggregate annual cash dividends in 2003, 2002 and 2001 of $2,853,000, $2,622,000 and $2,392,000, respectively, or $1.90 per share in 2003, $1.75 per share in 2002 and $1.60 per share in 2001. In January 2004, the Company declared and paid a dividend of $2.10 per share totaling $3,185,000. The decision to declare any such cash dividends in the future and the amount thereof rests within the discretion of the Board of Directors and will remain subject to, among other things, certain regulatory restrictions imposed on the payment of dividends by the Bank, and the future earnings, capital requirements and financial condition of the Company.
As of December 31, 2003, stock option information is as follows:
Number of shares that would be issued if all options were exercised
19,291
Weighted average price of options outstanding
$
77.27
Number of additional shares that could be granted
45,976
There are no stock option plans that have not been approved by the stockholders.
Page 27 of 92
Item 6.
Item 6. Selected Financial Data
CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY
Page 28 of 92
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition And Results of Operations
Special Note Regarding Forward-Looking Statements
The discussion following contains certain forward-looking statements with respect to the financial condition, the results of operations and business of the Company. These statements involve certain risks and uncertainties, which are often inherent in the ongoing operation of financial institutions such as the Company’s subsidiary bank.
Forward-looking statements discuss matters that are not facts and are typically identified by the words “believe,” “expect,” “anticipate,” “target,” “goal,” “objective,” “intend,” “estimate,” “will,” “can,” “would,” “should,” “could,” “may” and similar expressions. They discuss expectations about the future and are not guarantees. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update them to reflect changes that occur after the date they are made.
There are several factors - many of which are beyond the control of the Company or its subsidiary Bank - that could cause results to differ significantly from expectations. Some of these factors are described below. There are factors other than those described below that could cause results to differ from expectations. Any factor described below could by itself, or together with one or more other factors, adversely affect the business, earnings and/or financial condition of the Company and its subsidiary Bank.
The risks involved in the operations and strategies of the Company and its subsidiary Bank include competition from other financial institutions, changes in interest rates, changes in economic or market conditions as well as events and trends affecting specific assets, the effect of credit quality and market perceptions of value on the fair values of financial instruments and regulatory factors. These risks, which are not inclusive, cannot be accurately estimated.
For example, a financial institution may accept deposits at fixed interest rates, at different times and for different terms, and lend funds at fixed interest rates, at different times and for different terms. In doing so, it accepts the risk that its cost of funds may raise while the use of those funds may be at a fixed rate. Similarly, although market rates of interest may decline, the financial institution may have committed by virtue of the term of a deposit, to pay what essentially becomes an above-market rate.
Loans, and the allowance for loan losses, carry the risk that borrowers will not repay all funds in a timely manner, as well as the risk of total loss. The collateral pledged as security for loans may or may not have the value that has been attributed to it. The loan loss reserve, while believed to be adequate, may prove inadequate if one or more large-balance borrowers, or numerous mid-balance borrowers, or a combination of both, experience financial difficulty for a variety of reasons. These reasons may relate to the financial circumstances of an individual borrower, or may be caused by negative economic circumstances at the local, regional, national or international level that are beyond the control of the borrowers or the lender.
Because the business of banking is of a highly regulated nature, the decisions of governmental entities can have a major effect on operating results. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could have substantial and unpredictable effects including increasing the ability of non-banks to offer competing financial services and products.
Page 29 of 92
Item 7. Management’s Discussion and Analysis of Financial Condition And Results of Operations
The Bank’s success depends, in part, on its ability to attract and retain key people. Competition for the best people - in particular individuals with technology experience - is intense. The Bank may not be able to hire well-qualified people or pay them enough to keep them.
All of these uncertainties, as well as others, are present in the operations and business of the Company, and stockholders are cautioned that the Company’s actual results may differ materially from those included in the forward-looking statements.
Critical Accounting Policies
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policy to be related to the allowance for loan losses. The Company’s allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company’s markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management’s Discussion and Analysis section entitled “Financial Condition - Allowance for Loan Losses”. Although management believes the levels of the allowance as of both December 31, 2003 and 2002 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.
Page 30 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Financial Position
In 2003, total assets grew $84.7 million, compared to an increase of $122.4 million for 2002. The percentage increase in total assets was 7.71% in 2003, compared to 12.54% in 2002. Asset growth for both years was primarily reflected in higher loan balances and investment securities. In the year ended December 31, 2003, although the total asset growth was down compared to the prior year, a review of the balance sheets shows a reduction in federal funds sold of $19.3 million that were used for asset acquisition. As an alternative, the Company could have borrowed from the FHLB and that would have increased the asset growth by $19.3 million. Also, with the use of the federal funds and a good increase in deposits, no additional amount of funding was required from the FHLB. Given the overall interest rates on federal funds and in order to use them more efficiently, it was a business decision to switch to the loan and investment alternatives.
In 2003, net loans increased by $89.3 million. The net loans include loans held for sale to the secondary market, which were $1,960,000 at December 31, 2003, having decreased from the balance of $6,884,000 at December 31, 2002. In the year 2003, as in 2002, the increase in loans was primarily attributable to real estate mortgage loans which increased $75.2 million. The increase for 2002 was $98.2 million with $88.0 in mortgage real estate loans. The increases in both years were driven by the continued low level of interest rates which during 2003 were at fifty year lows. In addition, the overall economy in the Company’s principal place of business, Johnson and Linn Counties, remain in good economic condition with unemployment levels that remain low. Competition for quality loans and deposits will continue to be a challenge. In both counties, new banks and credit unions have been opened in the last few years. Between 2001 and 2003, five new banking locations were added in Johnson County and ten in Linn County. The fifteen new locations include an office of one of the state’s largest credit unions and several large Des Moines based banks. The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.
Deposits increased $66.4 million, or 8.28% in 2003 compared to an increase of 11.43% in 2002. Also, for funding purposes securities sold under agreements to repurchase increased $9.1 million to $29.9 million after having decreased $1.6 million in 2002. Deposits including repurchase agreements increased 9.18% in 2003 compared to 10.87% in 2002. In 2003 and also in 2002, growth continued in deposits due to uncertainties in the stock market from 2001 and 2002, when the stock market had a significant downturn and consumers have elected not to move quickly back to stocks as an investment. Also, in the last two years, the Bank has established new offices in the Cedar Rapids and Marion area and a relocated office on the Eastside of Iowa City, all of which have been helpful in adding new deposit customers for the Bank. In Linn County, as of June 30, 2003, the Company had approximately $119 million in deposits or 3.3% of the total deposit market of $3.6 billion. The Bank has added three offices in the Cedar Rapids-Marion area since 2000, with two of the offices added in 2003 and 2002, respectively to capitalize on the strong Linn County market which in total, is twice the size of the Johnson County market. Johnson County has fourteen banks and Linn County has twenty-seven banks at the end of 2003. In addition, there are two credit unions in Johnson County while Linn County has ten credit unions. In the last two years the Company has increased its market share in both counties. While there is increasing competition in the Linn County market, the Bank’s three newest offices in Linn County grew by $45.7 million in 2002 and 2003, and management anticipates that the Bank’s market share in Linn County will continue to grow in the years ahead.
Page 31 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
In 2002, the Company increased its borrowings from the Federal Home Loan Bank (FHLB) by a net $30 million to increase total advances at December 31, 2002 to $167.6 million. As in prior years, the advances are used to fund asset growth in years where deposit sources are not sufficient. The increase in 2003 in deposits and repurchase agreements coupled with a reduction in federal funds sold of $19.3 million were enough to not require any increase in the borrowings from the FHLB. It is expected that the FHLB funding source will be used in the future when loan growth exceeds deposit increases and the interest rates are favorable compared to other funding alternatives.
Investment securities increased by $21.9 million in 2003 and $24.3 million in 2002. Because the portfolio is marked to market, changes in the value of the portfolio may vary significantly from year to year. The securities portfolio, which includes tax exempt securities and stock of the FHLB that is required for borrowings, is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.
Stockholders’ equity was $96.8 million at December 31, 2003 compared to $88.1 million at December 31, 2002. The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section. Over the last five years, the Company has realized cumulative earnings of $53.7 million and paid shareholders dividends of $13.2 million, or 24.6% of earnings, while still maintaining capital ratios in excess of regulatory requirements.
Net Income Overview
Net income and diluted earnings per share for the last five years are as presented below:
Net income for 2003 reached a record high of $14,269,000, or diluted earnings per share of $9.42. For 2003, diluted earnings per share increased $1.84 per share, while 2002 results had increased $.51 per share. For the year ended December 31, 2002, net income increased by $1,320,000 from the 2001 results. Net income for the year ended December 31, 2003, represents a $2,805,000 increase over the reported income for the same period in 2002. The increase in net income is related to three significant factors. The factors are the continued growth in average earning assets, the decrease in the provision for loan losses and the increase in the gain on sale of loans. Net interest income, including fees increased $3.6 million for the year ended December 31, 2003 compared to 2002. The improvement is due to an increase in average earning assets of $116.4 million. The provision for loan losses and its effect on net income is discussed in a later section of this report. The mortgage refinancing growth continued in 2003 as the number of loans sold on the secondary market and the resulting gain on sale was $4,278,000 which is $2,287,000 more than 2002. The interest rates on secondary market loans that are sold increased in late summer as long-term investment rates rose. As a result of this, coupled with the fact that many consumers had taken advantage of lower rates, the volume of loans sold and the related level of income from this mortgage activity did not continue in the fourth quarter of 2003.
Page 32 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Annual fluctuations in the Company’s net income are driven primarily by three important factors. The first important factor is net interest margin. Net interest income of $40.0 million in 2003 was derived from the Company’s $1.084 billion of average earning assets and its net interest margin of 3.53% for that same year. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of only 10 basis points to 3.43% would result in a $1 million decrease in net income before taxes.
The second significant factor on the Company’s net income is the provision for loan losses. The majority of the Company’s investments are in loans outstanding, which amounted to more than $880 million in 2003. The Company’s allowance for loan losses was $12.6 million in 2003. An increase in problem loans would result in a higher allocation to the loan loss reserve, which in turn would reduce the Company’s net income.
The amount of loans sold on the secondary market is the third significant factor. The gain on the sale of loans on the secondary market has ranged from $316,000 in 1999 to $4,278,000 in 2003. Sales of loans on the secondary market are influenced by the real estate market and interest rates. Interest rates, which also help spur new loan growth and secondary market loans (including refinancing), have been at record lows when compared to interest rate levels over the last fifty years. Effective June 25, 2003, the Federal Reserve Open Market Committee lowered the federal funds target rate to 1.00%, the lowest level since July 1958. Prior to the June 25, 2003 decrease, the target rate was lowered 25 basis points on November 6, 2002. The June 25, 2003 decrease was the thirteenth decrease since May 16, 2000, when the federal funds rate was 6.50%.
Net Interest Income
Net interest income is the excess of the interest and fees received on interest-earning assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The volume of average earning assets has continued to grow over the last few years, primarily due to new loans. The net interest margin has remained steady over the last five years in spite of decreasing interest rates. The net interest margin was 3.53% in 2003, 3.58% in 2002, 3.58% in 2001, 3.62% in 2000 and 3.83% in 1999. The measure is shown on a tax-equivalent basis using a rate of 34% to make the interest earned on taxable and nontaxable assets more comparable.
Page 33 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Net interest income on a tax-equivalent basis changed in 2003 as follows:
Net interest income changes for 2002 were as follows:
Page 34 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
A summary of the net interest spread and margin is as follows:
Provision For Loan Losses
The provision for loan losses totaled $424,000, $2,449,000 and $924,000 for 2003, 2002 and 2001, respectively. Recoveries net of charge-off for 2003 were $36,000 while charge-offs, net of recoveries, were $274,000 for 2002 and $1,402,000 for 2001. The provision for loan losses in 2003 was $424,000 compared to $2,449,000 in 2002 or a decrease of $2,025,000. The provision adjustment computed on a quarterly basis is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the level of impaired loans which are all non-accrual and loans past due ninety days or more. In addition, management considers the credit quality based on their review of problem and watch loans, including loans with historical higher credit risks (primarily agricultural loans).
Other factors that are considered in determining the credit quality of the Company’s loan portfolio are reviewing the vacancy rates for both residential and commercial and retail space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund the loan. The Company also reviews the total economy including unemployment levels, vacancy rates of rental units and demand for commercial and retail space. In most instances the borrowers have used in their rental projections of income at least a 5% vacancy rate. As of December 31, 2003, the unemployment level in Johnson County and Linn County was 3.39% and 4.31%, respectively. These levels compare favorably to the State of Iowa at 4.36% and the national unemployment level at 5.72%. The residential rental vacancy rates in 2003 in Johnson County, the largest trade area for the Company, were 4.06% in Iowa City and 7.19% in Coralville. The State of Iowa vacancy rate is 8.2% and the national is 10.2%. The rates for Iowa City and Coralville for 2001 were both under 2%. Although the vacancy rates have increased in the Company’s trade areas, the Company has not believed it necessary to increase the number of loans in a “problem” or “watch” status based on its current evaluation of the loan portfolio.
The level of problem or watch loans that were included in the reserve computation increased significantly from December 31, 2001 to December 31, 2002 and therefore resulted in the large provision increase in 2002. The increase was due in particular for loans that were in the swine production segment that were of major concern because of the dollar amount of those loans and the severe price fluctuations that swine producers experienced during that time period, management felt it prudent to classify many of those loans as problem or watch loans. The amount of problem or watch loans considered in the estimate for December 31, 2003 was at balances that were similar to December 31, 2002. The allowance for loan losses balance is also affected by the net charge-offs for the periods presented. For the year ended December 31, 2003 and 2002, recoveries were $1,680,000 and $1,514,000, respectively; and charge-offs were $1,644,000 in 2003 and $1,788,000 in 2002.
Page 35 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)
The allowance for loan losses totaled $12,585,000 at December 31, 2003 compared to $12,125,000 at December 31, 2002. The percentage of the allowance to outstanding loans was 1.43% and 1.53% at December 31, 2003 and 2002, respectively. The percentage of the loan loss allowance to gross loans was 1.46%, 1.66% and 1.72% at December 31, 2001, 2000 and 1999, respectively. The decrease was due to loan growth (fueled primarily by an increase in real estate mortgages) and a decrease in the number of “problem” or “watch” loans compared to total loans outstanding. The allowance was based on management’s consideration of a number of factors, including loan concentrations, loans with higher credit risks (primarily agriculture loans and spec real estate construction) and overall increases in net loans outstanding. The methodology used in 2003 is consistent with the prior year. Beginning in 2001, the Bank refined the methodology used to compute the allowance for loan losses, primarily by applying estimated loss rates to several risk categories of loans instead of more general categories of loans.
Agricultural loans totaled $38,153,000 and $37,937,000 at December 31, 2003 and 2002, respectively. The level of agriculture loans the last five years compared to total loans has been between 4.95% down to 4.33% in 2003. Management has assessed the risks for agricultural loans higher than other loans due to unpredictable commodity prices, the effects of weather on crops and uncertainties regarding government support programs. In particular, loans that are in the swine production segment continue to be of major concern as prices for hogs are subject to severe fluctuations.
The University of Iowa, because of its 24,500 employees and because of the money it spends in Johnson County, has a tremendous impact on the economy of the Bank’s primary trade area. In 2002 and 2003, the University of Iowa helped Johnson County’s economy remain strong in spite of a weakened national economy. However, in the last fifteen months the economy of the state of Iowa has weakened and the University continues to suffer from budget cuts. For its fiscal year beginning July 1, 2004 the University expects continued budget constraints. The possible effects on the local economy cannot be predicted, but are likely to weaken the economy in future years.
Other Income
In 2003, the Company’s total other income increased $3,126,000 compared to the prior year. Gain on sale of loans to the secondary market for 2003 increased over the prior year by $2,287,000 due to continued low interest rates that enabled borrowers to re-finance. Loans sold in 2001 were $1,165,000, an increase of $849,000 over 2000. Interest rates on secondary market loans averaged under 6.05% the first half of 2003 compared to 6.69% in 2002 and 7.15% in 2001. Interest rates rose in the last quarter of 2003 and this with the factor that many customers had refinanced in late 2002 and in 2003 reduced the volume of loans sold on the secondary market. In addition, the increase in customer deposit accounts, along with increases in the fees, accounted for a $327,000 increase in deposit account charges and fees. Trust fees in 2003 had a $92,000 increase to $2,444,000 due to more assets under management. The Trust Department has $623 million of assets under management at December 31, 2003 compared to $484 million at December 31, 2002. Trust fees are based on total assets under management. The trust assets that are the most volatile are those that are held in common stock. Approximately 51% of trust assets are held in common stocks and with the major decline in the market in 2002, this effected the growth of the trust assets and trust fees. During the last half of 2003, the major stock indices have all shown much improvement and as a result the asset growth has been in part due to market value increases. An example of the increases is the Dow Jones Industrial Average which was down approximately 16% in 2002 was up over 25% in 2003. Due to the majority of the trust assets growth in terms of new accounts and market value increases coming in the last six months, trust fees did not increase significantly for 2003.
Other fees and charges increased $90,000 from 2002 compared to 2003. In 2003, the credit card processing fee income increased by $507,000 to $698,000. Also, in the other expenses section, the credit card processing expense in 2003 was $957,000 compared to $398,000 in 2002, or an increase of $559,000. Effective on January 1, 2003, the Company began including the gross amount of merchant charges in other income rather than netting it with related processing charges. This change had no effect on the income shown for credit card processing but did decrease the fee income and processing expense by approximately $400,000 for 2002 and 2001. Total other income was also offset by $177,000 due to investment securities losses in the fourth quarter of 2003. In 2002, no securities losses were reported.
Page 36 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)
In 2002, the Company’s total other income increased $973,000 compared to the prior year. Gain on sale of loans revenue for 2002 increased over the prior year by $826,000 due to continued low interest rates that enabled borrowers to re-finance. Interest rates on secondary market loans averaged under 6.50% the last half of 2002 compared to 7.15% in 2001. In addition, the increase in customer deposit accounts, along with changes in the fee structure, accounted for an $189,000 increase in deposit account charges and fees. Trust fees in 2002 were virtually unchanged form 2001, a $47,000 increase. The number of trust accounts under management increased in 2002, but the continued decline in stock values had the effect of reducing trust fees which are based on asset value.
Other Expenses
Total other expenses were $28,641,000 and $24,615,000 for the year ended December 31, 2003 and 2002, respectively. The increase includes $2,212,000 in salaries and benefits, which is the direct result of salary adjustments for 2003 and a net increase in full-time equivalents of fifteen since December 31, 2002. The new employees added included nine in the secondary loan market department and eleven in the Marion office, which opened in February 2003. Medical expenses included with salaries and benefits increased to $1.1 million from $825,000 in 2002. This increase is due to the hiring of new employees and to 20% increases in health and drug claim costs. All other expenses other than salaries and benefits increased a total of $1,814,000 or 16.57%. Credit card processing fees, which composed part of the other expenses, increased $559,000 and was offset by $507,000 of increased fee income of credit card processing included in the other income section. Direct expenses for the secondary market for items such as direct underwriting expense and related expenses were $285,000 higher in 2003 than in 2002. The increase is the result of the higher volume of loans that were sold on the secondary market during 2003. Direct expenses for the secondary market will decrease if the volume of loans sold on the secondary market decreases.
Other expenses increased $1,756,000 in 2002. Of the increase, salaries and benefits accounted for $1,804,000, occupancy and furniture and equipment expense accounted for $76,000 of the increase and all other expenses decreased $124,000. The salaries and employee benefits increased as a direct result of salary adjustments for 2002 and staff additions primarily at the new office locations. Total full-time equivalent employees increased between years by twenty-four. The benefits include a $150,000 increase in medical insurance costs due to increasing medical costs. The increased occupancy and furniture and equipment expense was the result of new locations added and new equipment purchases both in 2001 and 2002. Other expenses decreased $124,000 between 2001 and 2002. The other expenses in 2001 included $261,000 for amortization of intangible assets, which consisted principally of goodwill, equal to the excess of cost over fair value of net assets acquired in business combinations of two banks in 1996 accounted for under the purchase method. As discussed in the section of Impact of Recently Issued Accounting Standards amortization of goodwill ceased effective on January 1, 2002.
Income Taxes
Income tax expense was $6,998,000, $5,122,000 and $4,613,000 for the years ended December 31, 2003, 2002 and 2001, respectively. The corresponding percentage of income taxes compared to income before income taxes is 32.91% in 2003, 30.88% in 2002 and 31.26% in 2001. The percentages are up slightly from 2002 to 2003 due to an increase in pre tax income for the year without a corresponding increase in non-taxable interest income due to lower interest rates in 2003.
Impact of Recently Issued Accounting Standards
The FASB has issued Statement No. 143, “Accounting for Asset Retirement Obligations” which requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. For the Company, the Statement was effective January 1, 2003, and implementation did not have any impact on the financial statements.
Page 37 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)
The FASB has issued Statement No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” This statement is applicable to debt extinguishments and their classification; certain sale-leaseback transactions and intangible assets of motor carriers. Implementation of these provisions of the Statement had no effect and is not expected to have a material impact on the Company’s financial statements.
The FASB has issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The provisions of the Statement are effective for exit or disposal activities that are initiated after December 31, 2002. Implementation of the Statement did not have a material impact on the Company’s financial statements.
The FASB has issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”- an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of the Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Implementation of these provisions of the Interpretation is not expected to have a material impact on the Company’s consolidated financial statements. The disclosure requirements of the Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of Interpretation No. 45’s measurement and recognition provisions did not have a material impact to the Company’s financial position or results of operations.
In October 2002, the FASB issued Statement of Financial Accounting Standards No.147, “Acquisition of Certain Financial Institutions, an Amendment to FASB Statements No.72 and 144 and FASB Interpretation No.9. The statement removes acquisitions of financial institutions from the scope of the previous issued statements and interpretation and requires that those transactions be accounted for in accordance with Statement of Financial Accounting Standards No.141, “Business Combinations” and Statement of Financial Accounting Standards No.142, “Goodwill and Intangible Assets.” Thus, the requirement to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of this statement. The Company adopted FASB No. 147 on October 1, 2002 and the adoption resulted in no reclassification or revisions to prior period financial statements.
In January 2003, the FASB issued Interpretation No.46,”Consolidation of Variable Interest Entities,” which addresses consolidation by business enterprises of variable interest entities which have certain characteristics by requiring that if a business enterprise has a controlling interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity be included in the consolidated financial statements with those of the business enterprise. This statement applies to variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. For variable interest acquired before February 1, 2003, it applies in the first fiscal year or interim period beginning after June 15, 2003. The Company has adopted the various provisions of this statement but presently does not have any variable interest entities that would be required to be included in its consolidated financial statements.
Page 38 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or asset in some circumstances). Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted the statement on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends Statement 133 for decisions made (1) as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133, (2) in connection with other FASB projects dealing with financial instruments, and (3) in connection with the implementation issues raised in relation to the application of the definition of a derivative, in particular, the meaning of “an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors,” the meaning of “underlying,” and the characteristics of a derivative that contains financing components. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The Company adopted SFAS 149 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations.
Page 39 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Interest Rate Sensitivity and Liquidity Analysis
At December 31, 2003, the Company’s interest rate sensitivity report is as follows (amounts in thousands):
The table set forth above includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation. Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on their callable dates because they may be called if interest rates rise over current rates.
Inflation
Inflation has an impact on the growth of total assets and has resulted in the need to increase equity capital to maintain an appropriate equity to asset ratio. The results of operations have been affected by inflation, but the effect has been minimal.
Page 40 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
Liquidity and Capital Resources
On an unconsolidated basis, the Company had cash balances of $2,343,000 as of December 31, 2003. In 2003, the holding company received dividends of $2,856,000 from its subsidiary bank and used those funds to pay dividends to its stockholders of $2,853,000.
As of December 31, 2003 and 2002, stockholders’ equity, before deducting for the maximum cash obligation related to ESOP, was $111,629,000 and $101,035,000 respectively. This measure of equity as a percent of total assets was 9.43% at December 31, 2003 and 9.20% at December 31, 2002. As of December 31, 2003, total equity was 8.18% of assets compared to 8.02% of assets at the prior year end. The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary bank, which affects the Bank’s dividends to the Company. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. In order to maintain acceptable capital ratios in the subsidiary bank, certain of its retained earnings are not available for the payment of dividends. Retained earnings available for the payment of dividends to the Company total approximately $10,820,000, $6,092,000 and $7,015,000 as of December 31, 2003, 2002 and 2001, respectively.
The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991 and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve. These regulations establish minimum capital requirements that member banks must maintain.
As of December 31, 2003, risk-based capital standards require 8% of risk-weighted assets. At least half of that 8% must consist of Tier I core capital (common stockholders’ equity, non-cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries), and the remainder may be Tier II supplementary capital (perpetual debt, intermediate-term preferred stock, cumulative perpetual, long-term and convertible preferred stock, and loan loss reserve up to a maximum of 1.25% of risk-weighted assets). Total risk-weighted assets are determined by weighting the assets according to their risk characteristics. Certain off-balance sheet items (such as standby letters of credit and firm loan commitments) are multiplied by “credit conversion factors” to translate them into balance sheet equivalents before assigning them risk weightings. Any bank having a capital ratio less than the 8% minimum required level must, within 60 days, submit to the Federal Reserve a plan describing the means and schedule by which the Bank shall achieve the applicable minimum capital ratios.
The Bank is an insured state bank, incorporated under the laws of the state of Iowa. As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent of Banking of the State of Iowa (the “Superintendent”). Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, which may be made by state banks, and restrictions relating to investments, opening of bank offices and other activities of state banks. Changes in the capital structure of state banks are also approved by the Superintendent. One of the most significant standards of operation of state banks is the six and one-half percent (6 1/2%) primary capital to total assets ratio generally required by the Superintendent. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank. The Superintendent defines the term “primary capital” to mean the sum of stockholders’ equity and the allowance for loan losses less any intangible assets. In determining the primary capital ratio, the Superintendent uses the total assets as of the date of computation. At December 31, 2003, the primary capital to total assets ratio of the Bank exceeded the ratio required by the Superintendent.
Page 41 of 92
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
The actual amounts and capital ratios as of December 31, 2003 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):
The Bank is classified as “well capitalized” by FDIC capital guidelines.
On a consolidated basis, 2003 cash flows from operations provided $22,145,000 and net increases in deposits provided $66,446,000. These cash flows were invested in net loans of $94,645,000, and net securities of $25,693,000. Also, federal funds sold decreased by $19,281,000 to assist in the funding of the loans and investments growth. In addition, $2,952,000 was used to purchase property and equipment.
At December 31, 2003, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $139,422,000. Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements. It may also obtain additional funds from the Federal Home Loan Bank (FHLB). The Bank as of December 31, 2003 can obtain an additional $139 million from the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged $111 million of credit lines at three banks. The borrowings would be secured by the Bank’s investment securities. As a further source of liquidity, $69 million of additional securities are available to be pledged or liquidated.
While the Bank has off-balance sheet commitments to fund additional borrowings of customers, it does not use other off-balance-sheet financial instruments, including interest rate swaps, as part of its asset and liability management. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings. Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.
Page 42 of 92
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Related Party Transactions
The Bank’s primary transactions with related parties are the loan and deposit relationships it maintains with officers, directors and entities related to these individuals. The Bank makes loans to related parties under substantially the same interest rates, terms and collateral as those prevailing for comparable transactions with unrelated persons. In addition, these parties may maintain deposit account relationships with the Bank that also are on the same terms as with unrelated persons. As of December 31, 2003 and 2002, loan balances to related individuals and businesses totaled $32,454,000 and $27,813,000, respectively. Deposits from related parties totaled $5,800,000 and $6,599,000 as of December 31, 2003 and 2002, respectively.
Commitments and Trends
The Company and the Bank have no material commitments or plans that will materially affect liquidity or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.
Market Risk Exposures
The Company’s primary market risk exposure is to changes in interest rates. The Company’s asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company’s control, such as market interest rates and competition, may also have an impact on the Company’s interest income and interest expense. In the absence of other factors, the Company’s overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market rates increase over an extended period of time. Inversely, the Company’s yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.
The Bank maintains an asset/liability committee, which meets at least quarterly to review the interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.
In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company’s operations, management has implemented an asset/liability program designed to mitigate the Company’s interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of passbook or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company’s interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company’s interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company’s net interest income.
Page 43 of 92
Item 7A. Quantitative and Qualitative Disclosures About Market Risk (Continued)
The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company’s loans, investment securities and deposits that are sensitive to changes in interest rates.
(1)
Includes all available-for-sale investments, held-to-maturity investments, federal funds and Federal Home Loan Bank stock.
(2)
Includes passbook accounts, NOW accounts, Super NOW accounts and money market funds.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary data are included on Pages 45 through 77.
Page 44 of 92
INDEPENDENT AUDITOR’S REPORT
To the Board of Directors
Hills Bancorporation
Hills, Iowa
We have audited the accompanying consolidated balance sheet of Hills Bancorporation and subsidiary as of December 31, 2003, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 2003 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2003, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
January 30,
Page 45 of 92
INDEPENDENT AUDITOR’S REPORT
To the Board of Directors
Hills Bancorporation
Hills, Iowa
We have audited the accompanying consolidated balance sheet of Hills Bancorporation and subsidiary as of December 31, 2002 and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the years ended December 31, 2002 and 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2002, and the results of their operations and their cash flows for the years ended December 31, 2002 and 2001 in conformity with accounting principles generally accepted in the United States of America.
Iowa City, Iowa
February 25, 2003
Page 46 of 92
HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002
(Amounts In Thousands, Except Shares)
See Notes to Consolidated Financial Statements.
Page 47 of 92
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands, Except Per Share Amounts)
See Notes to Consolidated Financial Statements.
Page 48 of 92
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
See Notes to Consolidated Financial Statements.
Page 49 of 92
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands, Except Share Amounts)
See Notes to Consolidated Financial Statements.
Page 50 of 92
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
(Continued)
Page 51 of 92
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
See Notes to Consolidated Financial Statements.
Page 52 of 92
HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies
Nature of activities: Hills Bancorporation (the “Company”) is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Cedar Rapids and Marion, Iowa.
The Bank competes with other financial institutions and nonfinancial institutions providing similar financial products. Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank’s credit is concentrated in real estate loans.
Accounting estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Certain significant estimates: The allowance for loan losses, fair values of securities and other financial instruments, and stock-based compensation expense involves certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2003 may change in the near-term future and that the effect could be material to the consolidated financial statements.
Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany balances and transactions have been eliminated in consolidation.
Revenue recognition: Interest income on loans and investment securities is recognized on the accrual method. Loan origination fees are recognized when the loans are sold. Trust fees, deposit account service charges and other fees are recognized when the services are provided or when customers use the services.
Investment securities: Held-to-maturity securities consist solely of debt securities, which the Company has the positive intent and ability to hold to maturity and are stated at amortized cost.
Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders’ equity. There were no trading securities as of December 31, 2003 and 2002.
Stock of the Federal Home Loan Bank is carried at cost.
Premiums and discounts on debt securities are amortized over the contractual lives of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.
Page 53 of 92
HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Loans: Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses. Interest income is accrued on the unpaid balances as earned.
Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.
The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes the collectability of principal is unlikely. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. The allowance is increased by provisions charged to expense and is reduced by net charge-offs. The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance.
Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due. The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans. The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as bad debt expense in the same manner in which impairment initially was recognized or as a reduction in the amount of bad debt expense that otherwise would be reported. Interest income on impaired loans is recognized on the cash basis.
The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower’s ability to meet payments of interest or principal when they become due.
Loan fees and origination costs are reflected in the consolidated statements of income as collected or incurred. Compared to the net deferral method, this practice had no significant effect on income.
Transfers of financial assets: Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Credit related financial instruments: In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.
Property and equipment: Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings and improvements and 3-10 years for furniture and equipment.
Page 54 of 92
HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Deferred income taxes: Deferred income taxes are provided under the liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Goodwill: Goodwill represents the excess of cost over the fair value of the net assets acquired, and FASB Statement No. 142 provides for the elimination of the amortization of goodwill and other intangibles that are determined to have an indefinite life, and requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life. Effective January 1, 2002, the Company discontinued the amortization of goodwill, but makes an annual assessment for possible impairment. The change in this accounting policy reduced goodwill amortization by $261,000 for the years ended December 31, 2003 and 2002 compared to the year ended December 31, 2001. The carrying amount of goodwill as of December 31, 2003 and 2002 totaled $2,500,000 net of accumulated amortization of $1,398,000 and is included in other assets.
The table below reconciles reported earnings for the year ended December 31, 2001 to “adjusted” earnings, which excludes goodwill amortization.
Stock awards and options: Compensation expense for stock issued through the stock award plan is accounted for using the intrinsic value based method of accounting prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under this method, compensation is measured as the difference between the estimated fair value of the stock at the date of award less the amount required to be paid for the stock. The difference, if any, is amortized straight line to expense over the vesting period of five years of service. No stock-based employee compensation cost is reflected in net income because all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Therefore, the options have no intrinsic value at the date of grant. See Note 8 for a tabular presentation of the reconciliation between net income, basic earnings per share and diluted earnings per share as reported in the financial statements and as the information would have been reported (pro forma) if the Company has chosen to implement the fair value based method for all options.
Common stock held by ESOP: The Company’s maximum cash obligation related to these shares is classified outside stockholders’ equity because the shares are not readily traded and could be put to the Company for cash.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Trust assets: Trust assets, other than cash deposits, held by the Bank in fiduciary or agency capacities for its customers are not included in these statements since they are not assets of the Company.
Earnings per share: Basic per-share amounts are computed by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator). Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce the loss or increase the income per common share from continuing operations.
Following is a reconciliation of the denominator:
There are no potentially dilutive securities that have not been included in the determination of diluted shares.
Statement of cash flows: For purposes of reporting cash flows, cash and due from banks includes cash on hand and amounts due from banks (including cash items in process of clearing). Cash flows from loans originated by the Bank, deposits and federal funds sold and securities sold under agreements to repurchase are reported net.
Fair value of financial instruments: In cases where quoted market prices are not available, fair values of financial instruments are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from fair value disclosure. Accordingly, the aggregate fair value amounts presented in Note 11 do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
Off-balance sheet instruments: Fair values for outstanding letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of the outstanding letters of credit is not believed to be significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding.
Cash and due from banks and federal funds sold: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Investment securities: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.
Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable.
Deposit liabilities: The fair values of demand deposits equal their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short-term borrowings: The carrying amounts of federal funds sold and securities sold under agreements to repurchase approximate their fair values.
Long-term borrowings: The fair values of the Bank’s long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements.
Accrued interest payable: The carrying amount of accrued interest payable approximates its fair value.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 2. Investment Securities
Investment Securities Available For Sale:
Investment securities have been classified in the consolidated balance sheets according to management’s intent. The Company had no securities designated as trading in its portfolio at December 31, 2003 or 2002. The carrying amount of available-for-sale securities and their approximate fair values were as follows December 31 (in thousands):
The amortized cost and fair value of investment securities available for sale are as follows:
The amortized cost and estimated fair market value of available-for-sale securities classified according to their contractual maturities at December 31, 2003, were as follows (in thousands):
As of December 31, 2003, investment securities with a carrying value of $41,932,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as required or permitted by law.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 2. Investment Securities (Continued)
Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows for the years ended December 31 (in thousands):
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2003 (in thousands):
The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. The nature of the investments with gross unrealized losses as of December 31, 2003 was as follows: U.S. government agency backed securities; (5 positions issued and guaranteed by FNMA, FHLB, or FHLMC); and state and municipal bonds (26 A1 or better rated, general obligation bonds). Therefore, none of the impairments in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest. The cause of the impairments is due to changes in interest rates.
Investment Securities Held to Maturity:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 2. Investment Securities (Continued)
The amortization cost and estimated fair market value of securities held to maturity classified according to their contractual maturities at December 31, 2003, were as follows (in thousands):
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2003 (in thousands):
The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. The nature of the investment with a gross unrealized loss as of December 31, 2003 was a local county capital note due June 1, 2004. The impairment in the above table was not due to the deterioration in the credit quality of the issue that might result in the non-collection of contractual principal and interest. The cause of the impairment is due to changes in interest rates.
Note 3. Loans
The composition of loans is as follows:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 3. Loans (continued)
Changes in the allowance for loan losses are as follows:
Information about impaired and nonaccrual loans as of and for the years ended December 31, 2003, 2002 and 2001 are as follows:
Note 4. Property and Equipment
The major classes of property and equipment and the total accumulated depreciation are as follows:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 5. Interest-Bearing Deposits
A summary of these deposits is as follows:
Time deposits have a maturity as follows:
Note 6. Short-Term Borrowings
The following table sets forth selected information for short-term borrowings securities sold under agreements to repurchase with an original maturity of less than one year as of December 31 (in thousands):
(1)
The weighted average interest rate on short-term borrowings outstanding as of December 31, 2003 and 2002 was 1.00% and 1.52%, respectively.
Customer repurchase agreements are used by the Bank to acquire funds from customers where the customer is required or desires to have their funds supported by collateral consisting of government, government agency or other types of securities. The repurchase agreement is a promise to sell these securities to a customer at a certain price and repurchase them at a future date at that same price plus interest accrued at an agreed upon rate. The Bank uses customer repurchase agreements in its liquidity plan as well as an accommodation to customers. At December 31, 2003, $29.9 million of securities sold under repurchase agreements with an interest rate of 1.00%, maturing in 2004, were collateralized by U.S. Government agencies having an estimated fair value of $30.6 million and a amortized cost of $29.7 million.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 7. Federal Home Loan Bank Borrowings
As of December 31, 2003 and 2002, the borrowings were as follows:
$120,000,000 of the borrowings is callable at various dates now through 2005.
The borrowings are collateralized by 1-4 family mortgage loans with an aggregate face amount of $201,089,000. As of December 31, 2003, the Company held Federal Home Loan Bank stock with a cost of $8,774,000.
Note 8. Employee Benefit Plans
The Company has an Employee Stock Ownership Plan (the “ESOP”) to which it makes discretionary cash contributions. The Company’s contribution to the ESOP totaled $108,000, $93,000 and $79,000 for the years ended December 31, 2003, 2002 and 2000, respectively.
In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value. To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders’ equity to liabilities. As of December 31, 2003 and 2002, the shares held by the ESOP, fair value and maximum cash obligation were as follows:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 8. Employee Benefit Plans (Continued)
The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual contributions in amounts to be determined by the Board of Directors. The profit-sharing contribution totaled $862,000, $741,000 and $636,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 66,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Directors may exercise options immediately and officers’ rights under the plan vest over a five-year period from the date of the grant. No compensation expense has been charged to expense using the intrinsic value based method as prescribed by APB No. 25.
The following table illustrates the effect on net income and earnings per share had compensation cost for all of the stock-based compensation plans been determined based on the grant date values of awards (the method described in FASB Statement No. 123, Accounting for Stock-Based Compensation):
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 8. Employee Benefit Plans (Continued)
A summary of the stock options is as follows:
The weighted average fair value of options granted in 2003 and 2002 and 2001 was $16.20 per share, $20.13 per share, and $15.00 per share, respectively.
The fair value of stock options granted was determined utilizing the Black Scholes Valuation model. Significant assumptions include:
Other pertinent information related to the options outstanding at December 31, 2003 is as follows:
As of December 31, 2003, 45,976 shares were available for stock options and awards. The committee is also authorized to grant awards of restricted common stock, and it authorized the issuance of 900, 891 and 1,550 shares of common stock to a group of employees in 2003, 2002 and 2001, respectively. The vesting period for these awards is five years and the Bank amortizes the expense on a straight line basis during the vesting period. The expense relating to these awards for the years ended December 31, 2003, 2002 and 2001 was $61,000, $50,000 and $44,000, respectively.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 9. Income Taxes
Income taxes for the years ended December 31, 2003, 2002 and 2001 are summarized as follows:
Deferred income tax liabilities and assets arose from the following temporary differences:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 9. Income Taxes (Continued)
The net change in the deferred income taxes for the years ended December 31, 2003, 2002 and 2001 is reflected in the financial statements as follows:
The income tax provisions for the years ended December 31, 2003, 2002 and 2001 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 10.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions
The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results. Under capital adequacy guidelines and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications of the Company and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the tables that follow) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes that, as of December 31, 2003 and 2002, the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2003, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table that follows. There are no conditions or events since that notification that management believes have changes the institution’s category.
The actual amounts and capital ratios as of December 31, 2003 and 2002, with the minimum regulatory requirements for the Company and Bank are presented below (amounts in thousands):
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 10.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions (continued)
The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends. To maintain a ratio of capital to assets of 8%, retained earnings of $10,820,000 as of December 31, 2003 are available for the payment of dividends to the Company.
The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank. Reserve balances totaled $2,092,000 and $1,405,000 as of December 31, 2003 and 2002, respectively.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 11. Related Party Transactions
Certain directors of the Company and the Bank and companies with which the directors are affiliated and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business. Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.
The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2003 and 2002:
Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 12. Fair Value of Financial Instruments
The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2003 and 2002 are as follows:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13. Parent Company Only Financial Information
Following is condensed financial information of the Company (parent company only):
CONDENSED BALANCE SHEETS
December 31, 2003 and 2002
(Amounts In Thousands)
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13. Parent Company Only Financial Information (Continued)
CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13. Parent Company Only Financial Information (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 14. Commitments and Contingencies
Concentrations of credit risk: The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank’s market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $21,801,000. The concentrations of credit by type of loan are set forth in Note 3. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon the economic conditions in Johnson County, Iowa.
Contingencies: In the normal course of business, the Company and Bank are involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying financial statements.
Financial instruments with off-balance sheet risk: The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, credit card participations and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.
The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at December 31, 2003 and 2002 is as follows:
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 14. Commitments and Contingencies (Continued)
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties. Credit card participations are the unused portion of the holders’ credit limits. Such amounts represent the maximum amount of additional unsecured borrowings.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year, or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment. The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above. If the commitment is funded the Bank would be entitled to seek recovery from the customer. At December 31, 2003 and 2002 no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees.
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HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 15. Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)
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PART II
Item 9.
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
On May 13, 2003, upon the recommendation and approval of its Audit Committee, the Company terminated its relationship with McGladrey & Pullen LLP (“McGladrey & Pullen”) as its independent auditor and appointed the firm of KPMG LLP (“KPMG”) to be the Company’s Auditor for the 2003 fiscal year. There were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure. KPMG has not audited any of the Company’s financial statements for year-ends prior to December 31, 2002 and therefore is unable to express an opinion on any prior years’ financial information.
McGladrey & Pullen’s audit reports on the Company’s consolidated financial statements for each of the fiscal years ended December 31, 2002 and 2001 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.
During the two fiscal years ended December 31, 2002 and 2001 and the subsequent interim preceding the decision to change independent auditors, there were no disagreements with McGladrey & Pullen on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure which, if not resolved to McGladrey & Pullen’s satisfaction would have caused them to make reference to the subject matter of the disagreement in connection with the audit reports on the Company’s consolidated financial statements for such year, and there were no reportable events as defined in Item 304 (a)(1)(v) of Regulation S-K.
In the years ended December 31, 2002 and 2001 and up to May 13, 2003, the date of KPMG’s engagement, the Company did not consult KPMG with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company’s consolidated financial statements, or any other matters or reportable events as set forth in Items 304 (a)(2)(i) and (ii) of Regulation S-K.
Item 9A.
Item 9A. Controls and Procedures
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operations of the Company’s disclosure controls and procedures, and as defined in Exchange Act Rule 15d-15(e). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in enabling the Company’s periodic SEC filings within the required time period. There have been no changes in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by Item 10 of Part III is presented under the items entitled “Certain Information Regarding Directors and Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Definitive Proxy Statement dated March 22, 2004 for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.
No current member of the Audit Committee is a financial expert. The Company hopes to add a financial expert as a member of the Board of Directors and the Audit Committee in the near future.
The Company has a Code of Ethics in place for the Chief Executive Officer and Chief Financial Officer. A copy of the Company’s Code of Ethics will be provided free of charge, upon written request to:
James G. Pratt
Treasurer
Hills Bancorporation
131 Main Street
Hills, Iowa 52235
Item 11.
Item 11. Executive Compensation
The information required by Item 11 of the Part III is presented under the item entitled “Executive Compensation and Benefits” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholders Matters
The information required by Item 12 of Part III is presented under the item entitled “Security Ownership of Principal Stockholders and Management” and “Report on Executive Compensation,” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 of Part III is presented under the item entitled “Loans to and Certain Other Transactions with Executive Officers and Directors” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
Information required by this item is contained in the Registrant’s Proxy Statement dated March 22, 2004, under the heading “Independent Auditors - Change of Auditors in 2003,” which section is incorporated herein by this reference.
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PART IV
Item 15.
Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K
Page 80 of 92
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2003
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