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

FORM 10-Q

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

For the Quarterly Period ended March 31, 2007

Commission File Number: 0-19972

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

 

(605)  333-7556
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES x    NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

LARGE ACCELERATED FILER o     ACCELERATED FILER o     NON-ACCELERATED FILER x

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

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

As of May 9, 2007 there were 4,002,383 issued and outstanding shares of the Registrant’s Common Stock, with $.01 par value per share.

HF FINANCIAL CORP.

Form 10-Q

Table of Contents

PART I – FINANCIAL INFORMATION
Item 1.		Financial Statements (Unaudited):
		Consolidated Statements of Financial Condition As of March 31, 2007 and June 30, 2006
		Consolidated Statements of Income for the Three Months and Nine Months Ended March 31, 2007 and 2006
		Consolidated Statements of Cash Flows for the Nine Months Ended March 31, 2007 and 2006
		Notes to Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures about Market Risk
Item 4.		Controls and Procedures
PART II – OTHER INFORMATION
Item 1.		Legal Proceedings
Item 1A.		Risk Factors
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.		Exhibits
Form 10-Q		Signature Page

 

PART I  - FINANCIAL INFORMATION

Item 1.             Financial Statements

HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in Thousands)

		March 31, 2007			June 30, 2006
		(Unaudited)			(Audited)
ASSETS
Cash and cash equivalents		$	30,465		$	27,037
Securities available for sale		138,675			145,518
Federal Home Loan Bank stock		6,381			5,647
Loans held for sale		9,210			7,623
Loans and leases receivable		756,024			727,260
Allowance for loan and lease losses		(5,778		)	(5,657		)
Net loans and leases receivable		750,246			721,603
Accrued interest receivable		8,319			6,880
Office properties and equipment, net of accumulated depreciation		15,810			14,459
Foreclosed real estate and other properties		1,780			1,889
Cash value of life insurance		13,391			13,013
Servicing rights		10,855			5,648
Goodwill, net		4,951			4,951
Other assets		6,041			7,026
Total assets		$	996,124		$	961,294
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits		$	787,114		$	769,002
Advances from Federal Home Loan Bank and other borrowings		90,500			91,620
Subordinated debentures payable to trusts		27,837			27,837
Advances by borrowers for taxes and insurance		14,134			6,969
Accrued expenses and other liabilities		14,776			9,808
Total liabilities		934,361			905,236
STOCKHOLDERS’ EQUITY
Preferred stock, $.01 par value, 500,000 shares authorized, none outstanding		—			—
Series A Junior Participating Preferred Stock, $1.00 stated value, 50,000 shares authorized, none outstanding		—			—
Common stock, $.01 par value, 10,000,000 shares authorized, 5,965,632 and 5,926,496 shares issued at March 31, 2007 and June 30, 2006, respectively		60			59
Common stock subscribed for but not issued, 4,078 shares at June 30, 2006		—			65
Additional paid-in capital		20,501			19,384
Retained earnings, substantially restricted		71,181			68,179
Accumulated other comprehensive income (loss), net of related deferred tax effect		(812		)	(2,462		)
Less cost of treasury stock, 1,977,836 and 1,977,836 shares at March 31, 2007 and June 30, 2006, respectively		(29,167		)	(29,167		)
Total stockholders’ equity		61,763			56,058
Total liabilities and stockholders’ equity		$	996,124		$	961,294

 

See accompanying notes to unaudited consolidated financial statements.

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HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except Per Share Data)

(Unaudited)

		Three Months Ended						Nine Months Ended
		March 31,						March 31,
		2007			2006			2007			2006
Interest, dividend and loan fee income:
Loans and leases receivable		$	13,435		$	11,829		$	40,403		$	34,543
Investment securities and interest-earning deposits		1,925			1,637			5,698			4,538
		15,360			13,466			46,101			39,081
Interest expense:
Deposits		7,268			5,239			21,168			14,328
Advances from Federal Home Loan Bank and other borrowings		1,689			1,845			6,052			5,643
		8,957			7,084			27,220			19,971
Net interest income		6,403			6,382			18,881			19,110
Provision for losses on loans and leases		34			418			786			4,510
Net interest income after provision for losses on loans and leases		6,369			5,964			18,095			14,600
Noninterest income:
Gain on sale of branches, net		—			—			2,763			—
Fees on deposits		1,232			1,029			3,740			3,375
Loan servicing income		525			118			1,295			805
Gain on sale of loans, net		223			280			679			688
Trust income		238			214			684			609
Gain on sale of land, net		—			—			—			3,557
Gain on sale of securities, net		—			2			—			2
Other		395			434			1,218			1,415
		2,613			2,077			10,379			10,451
Noninterest expense:
Compensation and employee benefits		4,768			4,044			13,402			12,559
Occupancy and equipment		962			861			2,858			2,470
Advertising		217			173			1,364			604
Check and data processing expense		578			543			1,697			1,602
Other		946			804			2,750			2,556
		7,471			6,425			22,071			19,791
Income before income taxes		1,511			1,616			6,403			5,260
Income tax expense		477			366			2,161			1,688
Net income		$	1,034		$	1,250		$	4,242		$	3,572
Comprehensive income		$	1,306		$	799		$	5,892		$	2,375
Cash dividends declared per share (1)		$	0.1050		$	0.1023		$	0.3125		$	0.3045
Earnings per share:(1)
Basic		$	0.26		$	0.32		$	1.07		$	0.91
Diluted		$	0.25		$	0.31		$	1.05		$	0.89

 

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

See accompanying notes to unaudited consolidated financial statements.

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HF FINANCIAL CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)

		Nine Months Ended March 31,
		2007			2006
Cash flows from operating activities
Net income		$	4,242		$	3,572
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for losses on loans and leases		786			4,510
Depreciation		1,221			1,127
Amortization of discounts and premiums on securities and other		1,406			1,446
Stock based compensation		715			409
Deferred income taxes (credits)		(534		)	(544		)
Loans originated for resale		(60,900		)	(71,516		)
Proceeds from the sale of loans		55,736			73,199
(Gain) on sale of loans, net		(679		)	(688		)
Realized (gain) on sale of securities, net		—			(2		)
(Gain) on sale of land		—			(3,557		)
(Gain) on sale of branches		(2,763		)	—
Losses and provision for losses on sales of foreclosed real estate and other properties, net		48			33
(Gain) loss on disposal of office properties and equipment, net		(9		)	20
Change in other assets and liabilities		6,072			(2,541		)
Net cash provided by operating activities		5,341			5,468
Cash flows from investing activities
Loan participations purchased		(19,329		)	(2		)
Loan participations sold		—			6,123
Loans and leases originated and held		(301,097		)	(291,782		)
Principal collected on loans and leases		290,238			258,009
Proceeds from sale of land		—			4,863
Proceeds from sale of loans associated with branch sales		4,256			—
Securities available for sale:
Sales and maturities and repayments		27,781			35,816
Purchases		(18,564		)	(39,362		)
Purchase of Federal Home Loan Bank stock		(3,844		)	(3,031		)
Redemption of Federal Home Loan Bank stock		3,110			4,241
Proceeds from sale of office properties and equipment		9			2
Proceeds from sale of office properties and equipment associated with branch sales		341			—
Purchase of office properties and equipment		(2,913		)	(2,118		)
Purchase of servicing rights		(5,858		)	(840		)
Proceeds from sale of foreclosed real estate and other properties, net		703			580
Net cash (used in) investing activities		(25,167		)	(27,501		)

 

See accompanying notes to unaudited consolidated financial statements.

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		Nine Months Ended March 31,
		2007			2006
Cash flows from financing activities
Net increase in deposit accounts		$	51,675		$	24,049
Proceeds of advances from Federal Home Loan Bank and other borrowings		529,615			366,973
Payments on advances from Federal Home Loan Bank and other borrowings		(530,735		)	(372,122		)
Proceeds from issuance of subordinated debentures		10,000			—
Deposit account disbursements associated with branch sales		(33,563		)	—
Redemption of subordinated debentures		(10,000		)	—
Increase in advances by borrowers		7,165			3,040
Proceeds from issuance of common stock		337			460
Cash dividends paid		(1,240		)	(1,189		)
Net cash provided by financing activities		23,254			21,211
Increase (decrease) in cash and cash equivalents		3,428			(822		)
Cash and cash equivalents
Beginning		27,037			18,248
Ending		$	30,465		$	17,426
Supplemental Disclosures of Cash Flows Information
Cash payments for interest		$	26,085		$	18,777
Cash payments for income and franchise taxes, net		647			3,513

 

See accompanying notes to unaudited consolidated financial statements.

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HF FINANCIAL CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For The Three and Nine Months Ended March 31, 2007 and 2006

(Unaudited)

NOTE 1.          SELECTED ACCOUNTING POLICIES

Basis of presentation:

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

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

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

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

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NOTE 2.          REGULATORY CAPITAL

The following table sets forth the Bank’s compliance with its minimum capital requirements for a well-capitalized institution at March 31, 2007:

		Amount			Percent
		(Dollars in Thousands)
Tier I (core) capital (to adjusted total assets):
Required		$	49,548		5.00	%
Actual		81,960			8.27
Excess over required		32,412			3.27
Risk-based capital (to risk-weighted assets):
Required		$	80,194		10.00	%
Actual		87,738			10.94
Excess over required		7,544			0.94

 

NOTE 3.          EARNINGS PER SHARE

Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding  (the denominator) during the period.  Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. The weighted average number of basic common shares outstanding for the three months ended March 31, 2007 and 2006 was 3,982,096 and 3,937,219, respectively.  The weighted average number of basic common shares outstanding for the nine months ended March 31, 2007 and 2006 was 3,970,119 and 3,905,120, respectively.

Dilutive earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive options outstanding had been exercised. The weighted average number of common and dilutive potential common shares outstanding for the three months ended March 31, 2007 and 2006 was 4,065,310 and 4,025,351, respectively.  The weighted average number of common and dilutive potential common shares outstanding for the nine months ended March 31, 2007 and 2006 was 4,048,119 and 3,992,671, respectively.

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

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NOTE 4.          INVESTMENTS IN SECURITIES

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

		March 31, 2007
					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			(Losses)			Value
		(Dollars in Thousands)
Debt securities:
U.S. government agencies		$	12,079		$	40		$	(57	)	$	12,062
Federal Home Loan Bank		13,474			34			(46		)	13,462
Municipal bonds		7,671			30			(72		)	7,629
Preferred Term Securities		11,018			28			(76		)	10,970
Other Investments		5,072			70			—			5,142
		49,314			202			(251		)	49,265
Common Stock:
FNMA		8			14			—			22
Federal Ag Mortgage		7			3			—			10
Other Investments		134			—			—			134
		149			17			—			166
Mortgage-backed securities		90,522			154			(1,432		)	89,244
		$	139,985		$	373		$	(1,683	)	$	138,675

 

		March 31, 2006
					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			(Losses)			Value
		(Dollars in Thousands)
Debt securities:
U.S. government agencies		$	9,513		—			$	(129	)	$	9,384
Federal Home Loan Bank		8,977			—			(139		)	$	8,838
Municipal bonds		3,510			—			(75		)	$	3,435
Preferred Term Securities		11,019			73			(123		)	$	10,969
		33,019			73			(466		)	32,626
Equity securities:
FNMA		8			12			—			20
Federal Ag Mortgage		7			4			—			11
Other Investments		38			—			—			38
		53			16			—			69
Mortgage-backed securities		113,433			1			(2,903		)	110,531
		$	146,505		$	90		$	(3,369	)	$	143,226

 

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The following table presents the fair value and age of gross unrealized losses by investment category at March 31, 2007 in accordance with FASB Staff Position (“FSP”) No. FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which supersedes Emerging Issues Task Force Issue No. 03-1:

		Less than 12 Months						12 Months or More						Total
					Gross						Gross						Gross
		Fair			Unrealized			Fair			Unrealized			Fair			Unrealized
		Value			(Losses)			Value			(Losses)			Value			(Losses)
		(Dollars in Thousands)
Debt securities:
U.S. government agencies		$	—		$	—		$	7,967		$	(57	)	$	7,967		$	(57	)
Federal Home Loan Bank		—			—			7,518			(46		)	7,518			(46		)
Municipal bonds		3,076			(37		)	1,753			(35		)	4,829			(72		)
Preferred term securities		—			—			1,943			(76		)	1,943			(76		)
Mortgage-backed securities		5,875			(16		)	65,239			(1,416		)	71,114			(1,432		)
		$	8,951		$	(53	)	$	84,420		$	(1,630	)	$	93,371		$	(1,683	)

 

Management does not believe any individual unrealized losses as of March 31, 2007 represent an other-than-temporary impairment.  The unrealized losses reported for mortgage-backed securities relate to securities issued by the Federal National Mortgage Association (“FNMA”), the Government National Mortgage Association and the Federal Home Loan Mortgage Corporation (“FHLMC”).  These unrealized losses in total are primarily attributable to changes in interest rates and the contractual cashflows of those investments are guaranteed by an agency of the U.S. government.  As a group, the unrealized losses were less than 1.8% of their respective amortized cost basis at March 31, 2007.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be at maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2007.

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NOTE 5.          SEGMENT REPORTING

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

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

Three Months Ended March 31, 2007		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	7,140		$	(737	)	$	6,403
Intersegment interest income		(211		)	211			—
Provision for losses on loans and leases		(34		)	—			(34		)
Noninterest income		2,665			(52		)	2,613
Intersegment noninterest income		(108		)	108			—
Noninterest expense		—			(7,471		)	(7,471		)
Intersegment noninterest expense		3			(3		)	—
Income (loss) before income taxes		$	9,455		$	(7,944	)	$	1,511
Total assets at March 31, 2007		$	994,613		$	1,511		$	996,124

 

Three Months Ended March 31, 2006		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	7,171		$	(789	)	$	6,382
Intersegment interest income		(279		)	279			—
Provision for losses on loans and leases		(418		)	—			(418		)
Noninterest income		2,262			(185		)	2,077
Intersegment noninterest income		(45		)	45			—
Noninterest expense		(6,347		)	(78		)	(6,425		)
Intersegment noninterest expense		1			(1		)	—
Income (loss) before income taxes		$	2,345		$	(729	)	$	1,616
Total assets at March 31, 2006		$	919,427		$	1,822		$	921,249

 

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Nine Months Ended March 31, 2007		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	21,593		$	(2,712	)	$	18,881
Intersegment interest income		(688		)	688			—
Provision for losses on loans and leases		(786		)	—			(786		)
Noninterest income		10,566			(187		)	10,379
Intersegment noninterest income		(316		)	316			—
Noninterest expense		(14,179		)	(7,892		)	(22,071		)
Intersegment noninterest expense		7			(7		)	—
Income (loss) before income taxes		$	16,197		$	(9,794	)	$	6,403
Total assets at March 31, 2007		$	994,613		$	1,511		$	996,124

 

Nine Months Ended March 31, 2006		Banking			Other			Total
		(Dollars in Thousands)
Net interest income		$	21,535		$	(2,425	)	$	19,110
Intersegment interest income		(878		)	878			—
Provision for losses on loans and leases		(4,510		)	—			(4,510		)
Noninterest income		7,098			3,353			10,451
Intersegment noninterest income		(141		)	141			—
Noninterest expense		(19,324		)	(467		)	(19,791		)
Intersegment noninterest expense		4			(4		)	—
Income before income taxes		$	3,784		$	1,476		$	5,260
Total assets at March 31, 2006		$	919,427		$	1,822		$	921,249

 

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NOTE 6.                             DEFINED BENEFIT PLAN

The Company has a noncontributory (cash balance) defined benefit pension plan covering all employees of the Company and its wholly-owned subsidiaries who have attained the age of 21 and have completed 1,000 hours of service in a plan year.  The benefits are based on 6% of each eligible participant’s annual compensation, plus income earned in the accounts at a rate determined annually based on 30-year treasury note rates.  The Company’s funding policy is to make the minimum annual required contribution plus such amounts as the Company may determine to be appropriate from time to time.  Participants are 100% vested after five years of service with a normal retirement age of 65.  Information relative to the components of net periodic benefit cost for the Company’s defined benefit plan is presented below:

		Three Months Ended						Nine Months Ended
		March 31,						March 31,
		2007			2006			2007			2006
Service cost		$	116,521		$	116,367		$	349,563		$	349,101
Interest cost		97,748			91,239			293,244			273,715
Expected return on plan assets		(109,101		)	(93,185		)	(327,303		)	(279,555		)
Amortization of transition asset		—			2,907			—			8,722
Total costs recognized in expense		$	105,168		$	117,328		$	315,504		$	351,983

 

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

NOTE 7.                             SELF-INSURED HEALTHCARE PLAN

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

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

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

 

NOTE 8.                             FASB STATEMENT NO. 140

During the third quarter of Fiscal 2006, the Company completed a line item change of its income recorded on originated mortgage servicing rights for loans sold to South Dakota Housing Development Authority.  This process was done upon a fuller interpretation of Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” as issued by the FASB.   All periods presented have been revised in presentation to reflect this line item and there was no change to net income, earnings per share, or recorded value of servicing rights as a result of this line item change.  The following table reflects the effects of the line item change on the Company’s consolidated statements of income for the three and nine months ended March 31, 2007 and 2006.

		Three Months Ended						Nine Months Ended
		March 31,						March 31,
		2007			2006			2007			2006
		(Dollars in Thousands)
Loan servicing income		$	—		(66		)	$	—		(159		)
Gain on sale of loans, net		—			66			—			159
Net income change		$	—		$	—		$	—		$	—

 

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NOTE 9.                             STOCK-BASED COMPENSATION PLANS

The fair value of each incentive stock option grant and stock appreciation right is estimated at the grant date using the Black-Scholes option-pricing model.  The following weighted average assumptions were used for grants in the nine months ended March 31, 2007 and 2006:

		For the Nine Months Ended
		March 31,
		2007		2006
Expected volatility		23.00	%	24.00	%
Expected dividend yield		2.56	%	2.75	%
Risk-free interest rate		4.61	%	4.09	%
Expected term (in years)		4		7

 

Stock option and stock appreciation right activity for the nine months ended March 31 follows:

		2007
							Weighted
							Average
				Weighted			Remaining		Aggregate
				Average			Contractual		Intrinsic
				Exercise			Term		Value
		Shares		Price			(in years)		(In thousands)
Balance, beginning July 1		318,977		$	12.77
Granted		20,953		16.00
Forfeited		(13,796	)	16.54
Exercised		(32,968	)	12.90
Balance, ending March 31		293,166		$	12.81		5.46		$	1,595
Exercisable at March 31		232,428		$	12.02		4.70		$	1,447

 

		2006
							Weighted
							Average
				Weighted			Remaining		Aggregate
				Average			Contractual		Intrinsic
				Exercise			Term		Value
		Shares		Price			(in years)		(In thousands)
Balance, beginning July 1		325,422		$	12.22
Granted		30,769		17.27
Forfeited		(3,278	)	14.85
Exercised		(25,635	)	11.41
Balance, ending March 31		327,278		$	12.73		6.01		$	1,437
Exercisable at March 31		233,202		$	11.55		4.92		$	1,295

 

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The weighted-average grant date fair value of options and appreciation rights granted during the nine months ended March 31, 2007 and 2006 was $3.11 and $3.83, respectively.  The total intrinsic value of options exercised during the nine months ended March 31, 2007 and 2006 was $176,000 and $146,000, respectively.  As of March 31, 2007, there was $28,000 of total unrecognized compensation cost related to nonvested stock option awards.  The cost is expected to be recognized over a period of two years.  Cash received from the exercise of options for the nine months ended March 31, 2007 and 2006 was $425,000 and $293,000, respectively.  The tax benefit realized for the tax deductions from cashless option exercises totaled $42,000 and $28,000 for the nine months ended March 31, 2007 and 2006, respectively.

Restricted share activity for the nine months ended March 31 follows:

		2007					2006
				Weighted					Weighted
				Average					Average
				Grant					Grant
				Date					Date
				Fair					Fair
		Shares		Value			Shares		Value
Nonvested Balance, beginning		158,159		$	15.85		91,888		$	13.62
Granted		11,603		16.75			85,572		17.42
Vested		(17,467	)	13.63			(15,533	)	11.41
Forfeited		(5,417	)	15.32			(3,346	)	15.85
Nonvested Balance, ending		146,878		$	16.08		158,581		$	15.73

 

Pretax compensation expense recognized for restricted shares for the nine months ended March 31, 2007 and 2006 was $344,000 and $313,000, respectively.  The tax benefit for the nine months ended March 31, 2007 and 2006 was $117,000 and $107,000, respectively.  As of March 31, 2007, there was $1.5 million of total unrecognized compensation cost related to restricted shares granted under the Company’s 2002 Stock Option and Incentive Plan, as amended (“the Plan”).  That cost is expected to be recognized over a weighted-average period of five years.  The total fair value of shares vested during the nine months ended March 31, 2007 and 2006 was $238,000 and $179,000, respectively.

The Company has a Director Restricted Stock Plan which provides that awards of restricted shares of the Company’s common stock be made to outside directors of the Company.  The plan is designed to allow for payment of the annual retainer fee in shares of the Company’s common stock, with the inclusion of an annual cost of living adjustment based on the Consumer Price Index.  Each outside director is entitled to all voting, dividend and distribution rights during the restriction period.  The effective date of the plan was July 1, 1997.  The plan has 90,750 shares allocated to it and is in effect for a period of ten years.  During the nine months ended March 31, 2007 and 2006, 5,760 and 4,824 shares were awarded and $74,000 and $72,000 of expense was incurred under the plan, respectively, as the annual retainer for the Company’s Board of Directors.

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

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NOTE 10.                       SUBORDINATED DEBENTURES PAYABLE TO TRUSTS

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

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

NOTE 11.                  SALE OF BRANCHES

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

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

Forward-Looking Statements

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

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

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

·                  Forecasts of future economic performance.

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

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

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

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

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Executive Summary

The Company’s net income for the third quarter of Fiscal 2007 was $1.0 million, or $0.25 per diluted share, compared to $1.3 million, or $0.31 per diluted share, for the third quarter of Fiscal 2006.  For the first nine months of Fiscal 2007, net income was $4.2 million, or $1.05 per diluted share, compared to $3.6 million, or $0.89 per diluted share, for the first nine months of Fiscal 2006.    Return on average equity was 9.59% at March 31, 2007 compared to 8.74% at March 31, 2006.

The net interest margin on a fully taxable equivalent basis for the nine months ended March 31, 2007 was 2.80%, compared to 3.04% for the same period a year ago, a decline of 24 basis points.  The decrease over the same period last year is primarily attributable to an increase in interest rates for the Company’s variable priced trust preferred securities, which are tied to LIBOR.  In addition, there was a $290,000 expense of unamortized debt issuance costs related to the early redemption of the Trust I trust preferred securities in the second quarter of Fiscal 2007, causing a decrease of four basis points.  During the nine months ended March 31, 2007, $1.9 million in loans were placed into nonaccrual for the first time, resulting in a reversal of $154,000 in interest income.  Comparatively, for the same period a year ago, $2.3 million in loans were placed into nonaccrual for the first time, with a reversal of $103,000 in interest income.

Net interest income for the first nine months of Fiscal 2007 was $18.9 million, a decrease of  $229,000, or 1.2%, over the same period a year ago.  Net interest income increased $21,000, or 0.3%, to $6.4 million for the three months ended March 31, 2007 from $6.4 million for same period in the prior fiscal year.  For the nine months ended March 31, 2007, average interest-earning assets and average interest-bearing liabilities increased 8.2% and 7.7%, respectively, compared to the same period a year ago.  Yields on earning assets increased to 6.70% in the first nine months of Fiscal 2007, compared to 6.15% a year ago, an increase of 55 basis points.  For the same time period, cost of funds increased to 4.40%, compared to 3.47%, an increase of 93 basis points.

Net interest margin ratio may vary due to many factors, including Federal Reserve policies for short-term interest rates, competitive and economic factors and customer preferences for various products and services.  From July 1, 2005 to March 31, 2006, the Federal Reserve increased short-term interest rates six times at 25 basis points each, for a total increase of 150 basis points.  There has been no change since June 30, 2006.  The flattening and subsequent inversion of the treasury yield curve caused by increasing short-term rates and lagging and declining long-term rates continued to affect the Company’s net interest margin ratio during the quarter.  This inverted yield curve is evidenced by the interest rate spread of 23 basis points between the 3-month Treasury Bill and the 10-year Treasury Note at March 31, 2006, decreasing to a negative 39 basis points at March 31, 2007.

The Company had previously issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings.  Interest expense on the $27.8 million of trust preferred securities outstanding increased to $2.4 million for the nine months ended March 31, 2007, compared to $1.6 million for the same period a year ago, an increase of $778,000 or 47.8%.  The average rate paid on these securities increased 234 basis points, from 7.78% at March 31, 2006 to 10.12% at March 31, 2007.  In December 2006, the Company refinanced $10.0 million of trust preferred securities, originally issued in November 2001.  This new funding was calculated at a rate based on three-month LIBOR plus 1.83%, fixed for five years, and adjusted quarterly thereafter.  This compares to the original issuance which is based on six-month LIBOR plus 3.75%.  As a result of this refinancing, the Company expensed $290,000 of unamortized debt issuance costs.  Excluding this expense, the overall cost on the trust preferred securities was 8.99%, compared to 10.12%, a 113 basis point decrease.  The Company expects to refinance additional trust preferred securities outstanding over the next year depending upon the yield curve spreads, which exist at the time of refinancing.

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The allowance for loan and lease losses increased to $5.8 million at March 31, 2007, compared to $5.4 million at March 31, 2006, an increase of $409,000 or 7.6%.  The ratio of allowance for loan and lease losses to total loans and leases was 0.76% as of March 31, 2007 compared to 0.76% at March 31, 2006.  Total nonperforming assets at March 31, 2007 were $4.1 million as compared to $4.7 million a year ago, a decrease of $627,000 or 13.2%.  The ratio of nonperforming assets to total assets decreased to 0.41% at March 31, 2007, compared to 0.51% at March 31, 2006.  The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience.  This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time.

Total deposits at March 31, 2007 were $787.1 million, an increase of $81.8 million, or 11.6%, from March 31, 2006.  Interest expense on these deposits was $21.2 million for the nine months ended March 31, 2007, an increase of $6.8 million, or 47.7%, over the same period a year ago.  In-market deposits increased from $661.6 million at March 31, 2006 to $699.3 million at March 31, 2007, an increase of $37.7 million, or 5.7%.  For the same period, out-of-market deposits increased from $43.7 million to $87.8 million, respectively.  Public funds have increased, from $92.2 million at March 31, 2006 to $107.9 million at March 31, 2007.  The primary factor affecting interest expense on deposits was the increase in average fiscal year-to-date volume of certificates of deposits by $68.3 million, or 23.3%, from March 2006 to March 2007.  Average out-of-market certificates of deposits accounted for $42.2 million or nearly 62% of this increase.  Interest expense for certificates of deposits increased by $4.8 million or 62.6% in the first nine months of Fiscal 2007, compared to the same period in the prior fiscal year, driving its average cost of funds to 4.57% from 3.46%.

The total risk-based capital ratio of 10.94% at March 31, 2007 is above the 10.81% at March 31, 2006, an increase of 13 basis points.  This continues to place the Bank in the “well capitalized” category within OTS regulation at March 31, 2007 and is consistent within the “well capitalized” OTS category in which the Company plans to operate.  The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages and student loans and a loan securitization.

Noninterest income was $2.6 million for the quarter ended March 31, 2007 compared to $2.1 million at March 31, 2006, an increase of $536,000 or 25.8%.  The primary factor affecting noninterest income was an increase of $407,000 in loan servicing income due to the purchase of mortgage servicing rights at September 30, 2006 and an increase of $203,000 in fees on deposits, due to higher activity and increased service pricing.

Noninterest expense was $7.5 million for the quarter ended March 31, 2007 compared to $6.4 million at March 31, 2006, an increase of $1.0 million or 16.3%.  The primary factors affecting noninterest expense include increases of $724,000 in employee compensation and benefits.  Specific increases in employee compensation and benefits include $378,000 in net healthcare costs and $257,000 in variable pay related to performance incentives.  In addition, occupancy and equipment costs increased $101,000, primarily attributable to several new branches opened over the last year.

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General

The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income.  Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk.  The Company’s net income is derived by managing net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses.  The primary source of revenues comes from the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding).  The net interest margin is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows.  Fees earned include charges for deposit services, trust services and loan services.  Personnel costs are the primary expenses required to deliver the services to customers.  Other costs include occupancy and equipment and general and administrative expenses.

Financial Condition Data

At March 31, 2007, the Company had total assets of $996.1 million, an increase of $34.8 million from the level at June 30, 2006.  The increase in assets was due primarily to increases in net loans and leases receivable of $28.6 million, loan servicing rights of $5.2 million and cash and cash equivalents of $3.4 million.  The increase in liabilities of $29.1 million from June 30, 2006 to March 31, 2007 was primarily due to increases in deposits of $18.1 million, advances by borrowers for taxes and insurance of $7.2 million and accrued expenses and other liabilities of $5.0 million.  In addition, stockholders’ equity increased $5.7 million to $61.8 million at March 31, 2007 from $56.1 million at June 30, 2006, primarily due to net income of $4.2 million.

The increase in net loans and leases receivable of $28.6 million was due primarily to an increase in purchases and originations over sales, amortization and repayments of principal.  In addition, net deferred (fees), costs and discounts decreased $110,000 from the levels at June 30, 2006 to $773,000 at March 31, 2007.

The decrease in securities available for sale of $6.8 million was primarily the result of sales, maturities and repayments of $27.8 million exceeding purchases of $18.6 million.  The purchases of $18.6 million included fixed-rate, mortgage-backed securities of $12.2 million.

Loan servicing rights increased $5.2 million primarily due to the purchase of $4.9 million in mortgage servicing rights from Great Western Bank at the end of the first quarter of Fiscal 2007.

Cash and cash equivalents increased $3.4 million due primarily to an increase in deposits of $18.1 million resulting primarily from out-of-market certificates of deposits.

The $18.1 million increase in deposits was due to increases in out-of-market certificates of deposit of $30.4  million, interest-bearing checking accounts of $13.0 million and in-market certificates of deposit of $9.5 million, offset by decreases in savings accounts of $27.1 million, noninterest-bearing checking accounts of $5.7 million and money market accounts of $2.0 million.  The $27.1 million decrease in savings accounts was primarily due to temporary fluctuations experienced with one public fund entity, while the increase in out-of-market certificates of deposits was primarily driven by wholesale funding sources.

Advances by borrowers for taxes and insurance increased $7.2 million primarily due to the purchase of $4.9 million in mortgage servicing rights during the first quarter of fiscal 2007 which resulted in an increase in escrow accounts for taxes and insurance of $3.7 million.

Accrued expenses and other liabilities increased $5.0 million from the level at June 30, 2006 in part due to an increase in accrued income taxes payable of $1.8 million resulting primarily from the Company’s net income of $4.2 million for the nine months ended March 31, 2007 and an increase in accrued interest payable of $1.1 million.

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

 

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