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HFFC > SEC Filings for HFFC > Form 10-Q on 3-May-2013All Recent SEC Filings

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Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q ("Form 10-Q"), as well as other reports issued by HF Financial Corp. (the "Company") include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, the Company's management may make forward-looking statements orally to the media, securities analysts, investors and others from time to time. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Words such as "optimism," "look-forward," "bright," "believe," "expect," "anticipate," "intend," "hope," "plan," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may," are intended to identify these forward-looking statements.
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 are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
adverse economic and market conditions of the financial services industry in general, including, without limitation, the credit markets;

the effect of recent legislation to help stabilize the financial markets;

increase of non-performing loans and additional provisions for loan losses;

the failure of assumptions underlying the establishment of reserves for loan losses and other estimates;

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the failure to maintain our reputation in our market area;

prevailing economic, political and business conditions in South Dakota and Minnesota;

the effects of competition from a wide variety of local, regional, national and other providers of financial services;

compliance with existing and future banking laws and regulations, including, without limitation, regulatory capital requirements and FDIC insurance coverages and costs;

changes in the availability and cost of credit and capital in the financial markets;

the effects of FDIC deposit insurance premiums and assessments;

the risks of changes in market interest rates on the composition and costs of deposits, loan demand, net interest income, and the values and liquidity of loan collateral, and our ability or inability to manage interest rate and other risks;

changes in the prices, values and sales volumes of residential and commercial real estate;

an extended period of low commodity prices, significantly reduced yields on crops, reduced levels of governmental assistance to the agricultural industry, and reduced farmland values;

soundness of other financial institutions;

the risks of future acquisitions and other expansion opportunities, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and expense savings from such transactions;

security and operations risks associated with the use of technology;

the loss of one or more of our key personnel, or the failure to attract, assimilate and retain other highly qualified personnel in the future;

changes in or interpretations of accounting standards, rules or principles; and

other factors and risks described under Part I, Item 2-"Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 3-Quantitative and Qualitative Disclosures About Market Risk" in this Form 10-Q.

Forward-looking statements speak only as of the date they are made. Forward-looking statements are based upon management's then-current beliefs and assumptions, but management does not give any assurance that such beliefs and assumptions will prove to be correct. We undertake no obligation to publicly update or revise any forward-looking statements included or incorporated by reference in this Form 10-Q or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise, except to the extent required by federal securities laws. Based upon changing conditions, should any one or more of the above risks or uncertainties materialize, or should any of our underlying beliefs or assumptions prove incorrect, actual results may vary materially from those described in any forward-looking statement.
References in this Form 10-Q to "we," "our," "us" and other similar references are to the Company, unless otherwise expressly stated or the context requires otherwise.
Executive Summary
The Company's net income for the first nine months of fiscal 2013 was $4.5 million, or $0.64 in diluted earnings per common share, compared to $3.4 million, or $0.48 in diluted earnings per common share, for the same period of fiscal 2012. This resulted in a return on average equity (i.e., net income divided by average equity) of 6.11% for the first nine months of fiscal 2013, compared to 4.72% for the same period of the prior fiscal year. For the same respective periods, the return on average assets (i.e., net income divided by average assets) was 0.51% compared to 0.37%.
Net interest income for the first nine months of fiscal 2013 was $21.6 million, a decrease of $4.0 million, or 15.5%, compared to the same period a year ago. For the comparative time-frames, average interest-earning assets and average interest-bearing liabilities decreased 2.1% and 4.0%, respectively. The average yield on interest-earning assets decreased to 3.63% for the first nine months of fiscal 2013, compared to 4.31% a year ago, a decrease of 68 basis points, due primarily to the repricing of adjustable rate loans and competitive pricing pressures in a low interest rate environment. In addition, this economic environment impacts the yields on investment securities and other short-term investments and prepayment speeds of mortgage-

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backed securities purchased at a premium. For the same period, cost of deposits, which include all interest-bearing and noninterest-bearing deposits, decreased by 29 basis points to 0.56%, compared to 0.85% in the previous year. The net interest margin expressed on a fully taxable equivalent basis ("Net Interest Margin, TE") for the nine months ended March 31, 2013 was 2.68%, which is a decrease of 41 basis points from the same period of the prior fiscal year. The margin declined primarily due to the decreases in yields associated with loans and the declining average balances of loans, when compared to the same period of the prior fiscal year. Conversely, investment securities average balances increased, but at lower rates of earnings when compared to loan interest rates. Deposit rates and resulting interest expense also declined to partially offset the decline in interest income. A sustained overall decline in the interest rate yield curve has affected both the yield for the interest-earning assets and the interest-bearing liabilities, and the average balances for these categories decreased when compared to the same period of the prior year. Net Interest Margin, TE is a non-GAAP financial measure. See "Analysis of Net Interest Income" for a calculation of this non-GAAP financial measure and for further discussion as to the reasons we believe this non-GAAP financial measure is useful.
Total loans increased by $5.0 million during the most recent quarter to $682.6 million at March 31, 2013, which is similar to the balance at June 30, 2012 of $683.7 million. Commercial real estate and agricultural lending opportunities have increased during the last three months, while strong underwriting standards remain in place. Residential mortgage loan originations continued year-over-year increased production with the majority of these loans sold into the secondary market. Refinancing of single family loans has contributed to a decline in the consumer home equity portfolio. We remain cautiously optimistic that the overall strength of the local economic recovery is reflected in increased lending activity, while also acknowledging that we continue to operate in uncertain national conditions. We believe that the operating environment has resulted in increased competition among financial institutions for loan demand from credit-worthy borrowers.
The allowance for loan and lease losses increased by $98,000 to $10.7 million at March 31, 2013, compared to June 30, 2012. This resulted in a ratio of allowance for loan and lease losses to total loans and leases of 1.56% compared to 1.55% at June 30, 2012. The overall loan balances decreased by less than 1% during the first nine months of fiscal 2013, but the amount of loan balances from which the general reserve is calculated decreased by approximately 1.5%. The general reserve decreased due in part to the effects of the decrease in applicable loan balances, historical charge-off activity and management's assessment of environmental factors. During this time, recoveries exceeded charge-offs resulting in a net recovery of $270,000. The net recoveries exceeded the amounts added to the allowance for loan and lease losses and contributed to a net benefit for the provision for loan and lease losses of $172,000 for the first nine months of fiscal 2013. Total nonperforming assets at March 31, 2013 were $23.6 million as compared to $17.8 million at June 30, 2012. The ratio of nonperforming assets to total assets increased to 1.97% at March 31, 2013, compared to 1.49% at June 30, 2012. The overall increase in nonperforming assets from June 30, 2012 was primarily related to some continued difficulty in the dairy sector. Despite the increase in nonperforming assets, the Bank has $3.2 million less classified assets at March 31, 2013 when compared to June 30, 2012. The Company continues to pro-actively manage its problem assets which have been enhanced by improving conditions in the regional commercial and agricultural markets. The valuation allowance recorded in accordance with ASC 310 on identified impaired loans increased to $2.7 million at March 31, 2013, compared to $2.1 million at June 30, 2012, while the valuation allowance recorded in accordance with ASC 450 decreased by $490,000 due to the factors mentioned earlier. Approximately 58% of the valuation allowance on impaired loans relate to agricultural loans and, more specifically, 54% are within the dairy sector. All identified impaired loans are reviewed to assess the borrower's ability to make payments under the terms of the loan and/or a shortfall in collateral value that would result in charging off the loan or the portion of the loan that was impaired.
Foreclosed real estate and other properties totaled $901,000 at March 31, 2013, compared to $1.6 million at June 30, 2012, or a decrease of $726,000. The balance at March 31, 2013 consists primarily of residential loans that were foreclosed and remained unsold at quarter end.
The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history over 12, 36, and 60 month time periods, 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. Management intends to continue its disciplined credit administration and loan underwriting processes and to remain focused on the creditworthiness of new loan originations. Management believes that it has identified the most significant nonperforming assets in the loan portfolio and is working to clarify and resolve the credit, credit administration, and environmental factor issues related to these assets to obtain the most favorable outcome for the Company.
Total deposits at March 31, 2013, were $897.2 million, an increase of $3.4 million from June 30, 2012. This increase was primarily due to the $50.6 million increase in core deposits and partially offset by a $46.6 million decrease of seasonal public fund balances. Public funds have seasonal fluctuations due to semiannual tax collection and subsequent disbursement to entities. Interest rates on deposits, which are one of the primary factors affecting the amount of interest expense paid,

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decreased to the average rate paid of 0.66% on interest-bearing deposits for the nine month period ended March 31, 2013, compared to 0.98% for the same period of the prior year.
On April 29, 2013, the Company announced it will pay a quarterly cash dividend of 11.25 cents per common share for the third quarter of fiscal 2013. The dividend will be paid on May 17, 2013, to stockholders of record on May 10, 2013.
The total risk-based capital ratio of 16.42% at March 31, 2013, increased by 55 basis points from 15.87% at June 30, 2012. Tier I capital increased 14 basis points to 9.80% at March 31, 2013 when compared to 9.66% at June 30, 2012. This continues to place the Bank in the "well-capitalized" category within financial institution regulation at March 31, 2013 and is consistent with the "well-capitalized" regulatory 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.
Noninterest income was $10.8 million for the nine months ended March 31, 2013, compared to $9.8 million for the same period in the prior fiscal year, an increase of $1.0 million. This increase was due to increases in gain on sale of loans and fees on deposits, but was partially offset by a decrease in net loan servicing income. The gain on sale of loans increased by $1.7 million due to increased volume of originated single-family loans. Deposit fees increased $393,000 to $4.9 million for the first nine months of fiscal 2013, as compared to the same period of the prior year. In the first quarter of fiscal 2013, $600,000 of nonrecurring vendor incentive fees were received related to a debit card brand change for customer accounts. Security gains totaled $2.0 million for the first nine months of fiscal 2013, which is an increase of $1.1 million compared to the same period of the prior year. The increases in security gains were offset by a decrease in other noninterest income of $1.6 million, primarily due to a first quarter nonrecurring charge related to the termination of hedging activity on deposit balances, for the nine months ended March 31, 2013. Net loan servicing income decreased $1.0 million to a net loss of $84,000 for the nine months ended March 31, 2013, due primarily to an increase in net impairment provisions and amortization expenses of $420,000 and $374,000, respectively, when compared to the same period of the prior year. These reductions in servicing income were primarily the result of higher prepayment speeds calculated within the servicing portfolio which have resulted from the low interest rate environment. During the most recent quarter, prepayment speeds declined, which contributed to an impairment provision benefit and a reduction in amortization when compared to December 31, 2012.
Noninterest expense was $25.8 million for the nine months ended March 31, 2013, as compared to $27.5 million for the same period of the prior fiscal year, a decrease of $1.7 million, or 6.2%. The decrease was attributed primarily to decreases in compensation and employee benefits of $559,000 and professional fees of $801,000. In addition, FDIC insurance and occupancy and equipment expenses decreased a total of $292,000. Compensation costs decreased due to a reduced number of average full-time equivalents ("FTE's") for the first nine months of fiscal 2013 compared to the same period in the prior fiscal year, while employee benefits decreased due to reduced levels of utilization of the self-insurance health care plan. Professional fees have declined on a year-over-year basis due to the resolution of certain employment, regulatory and governance matters the Company faced in the first and second quarter of fiscal 2012. FDIC insurance decreased due to lower modified rates assessed, which may fluctuate based on asset quality, financial performance and other factors. Occupancy and equipment decreased when compared to the same period of the prior year because of the efficiency initiatives taken in the second through fourth quarters of fiscal 2012 which reduced the number of branches by consolidating six branches with other nearby branches to improve operating efficiencies. During the prior fiscal year, the Company was informed by the South Dakota Housing Development Authority ("SDHDA") that a change in business model was necessary for SDHDA to continue to meet the financing needs of its single family mortgage program in South Dakota. This change would include the development of a new bond resolution, to support a mortgage-backed securities program. As such, a request for proposal for a master servicer with a two year commitment period was provided to interested parties, and the Company was informed that a new master servicer would begin effective April 1, 2012. This change in business model terminated the new flow of servicing assets from SDHDA to the Company beginning in the fourth quarter of fiscal 2012. The Company does not expect this event to have a material impact on the fiscal 2013 income statement. The single family mortgage segment of the Company's SDHDA servicing portfolio is expected to decrease in value over time, as principal is reduced, which may be offset by increases to the Fannie Mae servicing portfolio balances through new origination activity. The Company continues to evaluate potential acquisition of servicing assets dependent upon market conditions and characteristics desirable by the Company, which may include bidding as the master servicer for SDHDA after the initial two year commitment is complete.
On November 12, 2009, the FDIC Board approved a rule requiring prepayment of the quarterly assessments for the fourth quarter of calendar year 2009 and the entire calendar years of 2010, 2011, and 2012. On December 30, 2009, the Company paid $4.9 million, which was recorded as a prepaid asset and is being proportionally expensed as each quarter elapses. At March 31, 2013, the remaining balance recorded as a prepaid asset was $855,000. The prepaid assessment credit program ended with the 13th and final credit application on the March 29, 2013 quarterly deposit insurance invoice. Refunds of any unused prepaid assessment credits will be issued on the June 28, 2013 invoice. Effective for each of the first three quarters of fiscal 2013, the FDIC insurance assessment rate was modified and reduced due to the Bank's asset quality ratios and earnings as

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compared to risk weighted assets. As a result, FDIC insurance decreased by $190,000, to $606,000 for the nine months ended March 31, 2013 compared to the same period in the prior fiscal year.
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 management of the 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 is 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 and debit card 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, 2013, the Company had total assets of $1.20 billion, an increase of $4.6 million from the level at June 30, 2012. Total investment securities available for sale and cash and cash equivalents increased a combined $18.6 million, while loans held for sale and net loans and leases receivable decreased $7.7 million and $1.2 million, respectively. Total liabilities increased by $2.0 million primarily due to an increase in deposits of $3.4 million and advances to borrowers for taxes and insurance of $5.6 million, but were partially offset by a decrease in advances from the FHLB and other borrowings of $7.3 million. Stockholders' equity increased by $2.6 million since June 30, 2012, primarily due to net income and a decrease in accumulated other comprehensive loss, which were partially offset by the payment of dividends.
The securities available for sale increased by $45.9 million due primarily to the purchase of securities during the second and third quarters. Total proceeds on the sale of securities during the fiscal year were $91.4 million for a net gain of $2.0 million. The decrease in net loans and leases receivable, which excludes loans in process and deferred fees, was $1.2 million due to the decrease in loan balances of $1.1 million and the increase in the allowance for loan and lease losses of $98,000. Commercial real estate and agricultural loans increased a total of $25.3 million since June 30, 2012, while residential, commercial and consumer loans decreased a total of $26.4 million.
Loans held for sale decreased $7.7 million, primarily due to timing of mortgage financing activity sold to secondary market investors and the resulting amount of one-to four-family loans held at March 31, 2013.
See the Consolidated Statement of Cash Flows for a detailed analysis of the change in cash and cash equivalents.
Deposits increased $3.4 million, to $897.2 million at March 31, 2013, due primarily to the increase in core deposit accounts, exclusive of public funds and out-of-market certificates of deposits, and partially offset by a decrease in seasonal public fund balances. Core deposits increased $50.6 million, or 7.2% since June 30, 2012, while public fund deposit balances decreased $46.6 million. Advances from the FHLB and other borrowings decreased $7.3 million, to $135.1 million at March 31, 2013 as compared to June 30, 2012, due to reduced funding needs.
Stockholders' equity increased $2.6 million at March 31, 2013 when compared to June 30, 2012. Increases in stockholders' equity were derived from net income of $4.5 million, and a net decrease in accumulated other comprehensive loss of $113,000. These increases to equity were partially offset by the payment of cash dividends of $2.4 million.
Analysis of Net Interest Income
Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
Average Balances, Interest Rates and Yields. The following tables present for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The tables do not reflect any effect of income taxes. Average balances consist of daily average balances for the Bank with simple average balances for all other subsidiaries of the Company. The average balances include nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.

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                                                             Three Months Ended March 31,
                                                    2013                                      2012
                                      Average         Interest                  Average        Interest
                                    Outstanding       Earned/      Yield/     Outstanding       Earned/     Yield/
                                      Balance           Paid        Rate        Balance          Paid        Rate
                                                                (Dollars in Thousands)
Interest-earning assets:
Loans and leases receivable(1)(3)  $    687,223     $    8,082      4.77 %   $    743,977     $   9,833      5.32 %
Investment securities(2)(3)             415,936          1,508      1.47          356,436         1,124      1.27
Correspondent bank stock                  7,417             53      2.90            8,068            60      2.99
Total interest-earning assets         1,110,576     $    9,643      3.52 %      1,108,481     $  11,017      4.00 %
Noninterest-earning assets               79,912                                    84,723
Total assets                       $  1,190,488                              $  1,193,204
Interest-bearing liabilities:
Checking and money market          $    380,004     $      241      0.26 %   $    334,647     $     469      0.56 %
Savings                                 118,408             70      0.24          133,518            90      0.27
Certificates of deposit                 268,814            800      1.21          297,306         1,105      1.49
Total interest-bearing deposits         767,226          1,111      0.59          765,471         1,664      0.87
FHLB advances and other borrowings      132,781          1,029      3.14          147,401         1,108      3.02
Subordinated debentures payable to
trusts                                   27,837            403      5.87           27,837           500      7.22
Total interest-bearing liabilities $    927,844     $    2,543      1.11 %   $    940,709     $   3,272      1.40 %
Noninterest-bearing deposits            130,687                                   125,909
Other liabilities                        32,987                                    31,057
Total liabilities                     1,091,518                                 1,097,675
Equity                                   98,970                                    95,529
Total liabilities and equity       $  1,190,488                              $  1,193,204
Net interest income; interest rate
spread(4)                                           $    7,100      2.41 %                    $   7,745      2.60 %
Net interest margin(4)(5)                                           2.59 %                                   2.81 %
Net interest margin, TE(6)                                          2.64 %                                   2.84 %
. . .
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