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HFFC > SEC Filings for HFFC > Form 10-K on 13-Sep-2013All Recent SEC Filings

Show all filings for HF FINANCIAL CORP

Form 10-K for HF FINANCIAL CORP


13-Sep-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This section should be read in conjunction with the following parts of this Form 10-K: Forward-Looking Statements, Part II, Item 8 "Financial Statements and Supplementary Data," Part II, Item 7A "Quantitative and Qualitative Disclosures About Market Risk," and Part I, Item 1 "Business." Executive Summary
The Company's net income for fiscal 2013 was $5.9 million, or $0.83 in diluted earnings per common share, compared to $5.2 million, or $0.74 in diluted earnings per common share, for fiscal 2012. Return on average equity was 5.96% at June 30, 2013, compared to 5.41% at June 30, 2012. The return on average assets was 0.50% and 0.43%, respectively, for fiscal 2013 and fiscal 2012. Earnings reflected a more efficient branch network and a robust mortgage lending operation in fiscal 2013. As discussed in more detail below, the increase in earnings was due to a variety of key factors, including a decrease in the provision for losses on loans and leases of $1.5 million, a decrease in noninterest expense of $2.8 million and an increase in noninterest income of $2.2 million, partially offset by a decrease in net interest income of $5.3 million and an increase in income taxes of $541,000.
During fiscal 2013, the Company benefited from continued proactive management of problem assets leading to a $1.5 million reduction in provision for loan and lease losses as compared to fiscal 2012. Total past due loans 30 days or greater were $2.6 million at June 30, 2013, compared to $9.1 million one year earlier. While a majority of problem asset stress in recent years related to the agricultural portfolio, and in particular dairy operations, signs of stabilization did occur and commodity prices remained favorable for most agricultural production in 2012 and continuing into 2013.
Agricultural and commercial real estate accounted for the majority of the increase in loan balances between fiscal 2013 and 2012. Agricultural business and commercial real estate loans were the primary contributors to this overall increase since the prior fiscal year end with growth of $16.1 million and $13.7 million, respectively. Consumer loans partially offset the increase to gross loans with a net decrease of $21.9 million since June 30, 2012, to $139.7 million at June 30, 2013. Consumer home equity loans decreased by $15.2 million since the prior year end, which was the primary factor in the consumer loan overall decrease and reflective of consumer refinance activity. The portfolio segments of commercial real estate and agricultural are the largest segments of the loan portfolio and comprise 43.3% and 25.5%, respectively, which is an increase from 41.7% and 22.7% at June 30, 2012. The increased activity during fiscal 2013 reinforces our belief that the overall local economy has shown continued signs of recovery and that local businesses are stabilized and looking for additional opportunities. The agricultural loans include a diverse range of agricultural enterprises, including grain production, dairy and livestock operations. The credit risk related to agricultural loans is largely influenced by general economic conditions and the


resulting impact on a borrower's operations or on the value of underlying collateral, if any. Credit risk is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing each borrower's financial soundness and relationship on an ongoing basis.
The provision for loan losses is the charge to net income that management determines to be necessary to maintain the allowance for loan and lease losses at a sufficient level reflecting management's estimate of probable incurred losses in the loan portfolio. Management performs periodic and systematic detailed reviews of the loan portfolio to identify trends and to assess the overall collectability of the loan portfolio. The allowance for loan and lease losses remained relatively stable during fiscal 2013 and totaled $10.7 million at June 30, 2013. The ratio of allowance for loan and lease losses to total loans and leases was 1.54% at June 30, 2013, compared to 1.55% at June 30, 2012. The specific valuation allowance of $2.5 million, is comprised primarily of $1.5 million allowance attributed to agricultural loans and $665,000 allowance attributed to commercial business loans. The remainder of the allowance for loan and lease losses is the general valuation allowance which is evaluated based primarily upon a review of historical loss and environmental factors. During fiscal 2013, the general valuation allowance decreased by $167,000, compared to June 30, 2012. At June 30, 2013, classified assets declined to $40.2 million as compared to $42.9 million at June 30, 2012. Total nonperforming assets at June 30, 2013 were $23.2 million as compared to $17.8 million at June 30, 2012. The ratio of nonperforming assets to total assets was 1.90% for June 30, 2013, compared to 1.49% at June 30, 2012.
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. See "Asset Quality" for more information.
Total deposits at June 30, 2013, were $898.8 million, an increase of $4.9 million, or 0.5%, from June 30, 2012. Due to the continued low interest rate environment, the Company experienced a preference by customers of non-maturity deposits. Noninterest-bearing checking accounts increased $9.9 million to $156.9 million at June 30, 2013, while interest-bearing checking accounts and money market accounts increased $13.3 million and $2.5 million, respectively, to $151.4 million and $212.8 million. Savings and certificates of deposits decreased $5.5 million and $15.3 million, respectively, from the prior year end to $115.6 million and $262.1 million, at June 30, 2013. Public funds, which are included in the various types of deposits account balances, decreased $33.4 million, or 19.0%, from June 30, 2012, to $142.4 million. Interest expense on deposits was $4.8 million for fiscal 2013, a decrease of $2.5 million, or 34.1%, over fiscal 2012.
Management's objectives are to provide capital sufficient to cover the risks inherent in the Company's businesses, to maintain excess capital to well-capitalized standards, and to assure ready access to the capital markets. The total risk-based capital ratio was 15.83% at June 30, 2013, compared to 15.87% at June 30, 2012. Tier I capital decreased 10 basis points to 9.56% at June 30, 2013 when compared to 9.66% at June 30, 2012. These capital ratios continued to allow the Bank to meet the regulatory criteria to be considered a "well-capitalized" institution at June 30, 2013. The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages. The Company continued to return capital to investors through a quarterly dividend, or $0.45 per diluted common share on an annual basis.
The current interest rate environment has been directly affected by the intervention of the Federal Reserve as it assisted in the economic recovery. The target federal funds rate remained at 25 basis points during fiscal 2013. The impact of this historically low interest rate environment on the Company has been mixed. While the low interest rates negatively affected yields of loans and the securities portfolio, the impact to our cost of funds was favorable. Net interest income for fiscal 2013 was $28.4 million, a decrease of $5.3 million, or 15.6%, compared to fiscal 2012. The net interest margin was 2.58%, compared to 3.03% for the prior year, a decrease of 45 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2013 was 2.63%, compared to 3.07% in fiscal 2012. 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. The yield on earning assets decreased from 4.25% to 3.55%, a decrease of 70 basis points. For the same period, the cost of funds rate on interest-bearing liabilities decreased from 1.44% in fiscal 2012 to 1.15% in fiscal 2013, a change of 29 basis points. Decreases in average balances from fiscal 2012 to fiscal 2013 for average interest-earning assets and interest-bearing liabilities were 1.0% and 2.6%, respectively. The average yield on interest-earning assets decreased primarily due to the repricing of adjustable rate loans, refinancing activity 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-backed securities purchased at a premium.


Variability of the net interest margin ratio may be affected by many factors, including Federal Reserve policies for short-term interest rates, competitive and global economic conditions and customer preferences for various products and services. At June 30, 2013, management believes that it has positioned the institution for a neutral interest rate risk profile, whereas an asset sensitive institution will generally realize an increase in income if interest rates rise due to the fact that more assets will be reinvested at higher market rates than liabilities. However, within a 12 to 24 month time horizon, there may be a slight lag effect where liabilities may initially reprice faster than assets for a portion of the time period.
Noninterest income was $15.1 million for fiscal 2013, compared to $12.9 million for the prior fiscal year, an increase of $2.2 million, or 17.3%. 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 $1.9 million due to a record year of increased volume of originated single-family loans. Deposit fees increased $485,000 to $6.5 million for fiscal 2013, as compared to fiscal 2012, but included a one-time nonrecurring vendor incentive fee related to a debit card brand change of $600,000 which was received in the first quarter of fiscal 2013. Investment security gains totaled $2.1 million for fiscal 2013, which is an increase of $620,000 compared to the prior fiscal year. The increases in security gains were partially offset by a decrease in other noninterest income of $1.4 million, which includes the loss on terminations of certain interest rate swap contracts of $2.2 million and a gain on the extinguishment of a subordinated debenture of $870,000.
Net loan servicing income decreased $127,000 to $476,000 for fiscal 2013 due to an increase in amortization expense and a decrease in service fee income of $401,000 and $253,000, respectively, and partially offset by a decrease in net valuation provisions of $527,000 when compared to the prior fiscal year. The valuation of mortgage servicing rights ("MSRs"), as well as the periodic amortization of MSRs, is significantly influenced by the level of market interest rates and loan prepayments. If market interest rates for one- to four-family loans increase and/or actual or expected loan prepayment expectations decrease in future periods, the Company could recover all or a portion of its previously established allowance on MSRs, as well as record reduced levels of MSR amortization expense. Alternatively, if interest rates decrease and/or prepayment expectations increase, the Company could potentially record additional charges to earnings related to increases in the valuation allowance on its MSRs. Lower interest rates also typically cause an increase in actual mortgage loan prepayment activity, which generally results in an increase in the amortization of MSRs.
Noninterest expense for fiscal 2013 was $34.3 million, a decrease of $2.8 million, or 7.5% as compared to fiscal 2012. Compensation and employee benefits, occupancy and equipment, and professional fees decreased by $434,000, $716,000, and $1.1 million, respectively.
Compensation and employee benefits decreased by 2.1% for fiscal 2013 as compared to fiscal 2012 due to a net reduction in base compensation expense in excess of variable compensation increases primarily related to mortgage commissions, a decrease in overall health claims, and partially offset by an increase in employee incentive pay programs. Management continues to assess staff efficiency and reported full-time equivalent ("FTE") employees of 306 at June 30, 2013, compared to 292 at June 30, 2012. This increase is primarily due to adding sales staff for mortgage origination and agricultural and business lending efforts. Occupancy and equipment and professional fees decreased 14.6% and 34.8%, respectively, from fiscal 2012 primarily resulting from the expense savings related to the branch reductions previously mentioned and a reduction of certain employment, regulatory and governance matters that required additional resources in fiscal 2012.
The ability to successfully manage expenses is important to our long-term prosperity. During fiscal 2012, the Company executed on a strategic initiative to improve efficiency and completed six branch closures within the South Dakota market area as it merged branches into other nearby branches, without any noticeable impact to customer retention. During fiscal 2013, one additional branch closure was completed in the fourth fiscal quarter. Costs related to the recent closure included $22,000 for the disposition of closed-branch fixed assets and additional one-time expenses of $32,000 for severance and lease terminations. Management expects to recognize noninterest expense savings of $275,000 annually related to the fiscal 2013 branch closure.
The Company focuses on balancing operating costs with operating revenue levels in order to provide better efficiency ratios over time and continues to review its operations for ways to reduce its cost structure while continuing to support long-term revenue enhancements. The operating efficiency ratio (i.e., noninterest expense divided by total revenue adjusted for interest expense of trust preferred securities and the loss on disposal of closed-branch fixed assets) for fiscal 2013 was 77.52%, compared to 77.17% for the prior fiscal year, an increase of 35 basis points. The operating efficiency ratio excludes both the impact of net interest expense on the variable priced trust preferred securities and losses due to non-operating activities. The operating efficiency ratio is a non-GAAP financial measure. See Item 6, "Selected Financial Data-Non-GAAP Reconciliation of the Operating Efficiency Ratio" of this Form 10-K for further analysis. The Company had issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings. Net interest expense on the average balance totaling $27.6 million of trust preferred securities outstanding was $1.7 million for fiscal 2013, a $195,000 decrease from the prior fiscal year. The average rate paid for fiscal 2013 and fiscal 2012 was 6.03% and 6.69%, respectively. The total efficiency


ratio (i.e., noninterest expense divided by total revenue) was 78.91% for the year ended June 30, 2013, compared to 79.74% for the prior year, a decrease of 83 basis points. Primary changes which affected the efficiency ratio from the prior year were the increase in revenue due to the $1.9 million increase in net gain on sale of loans and the decrease of $5.3 million in net interest income. As a result, the overall total revenues decreased by $3.0 million, while noninterest expenses decreased by $2.8 million. Management believes that improvement to the operating efficiency ratio can be accomplished through steady growth of the balance sheet and the containment of incremental operating expenses.
The enactment of the Dodd-Frank Act in July 2010 significantly impacted how financial services companies are regulated and authorizes expansive new regulation by various federal agencies. Many of the most sweeping changes in the Dodd-Frank Act are currently still in the process of being implemented through the agency rulemaking process and thus uncertainty exists as to the full impact of the Dodd-Frank Act and its implementing regulations. The Company and Bank continue to closely monitor and evaluate developments under the Dodd-Frank Act with respect to our business, financial condition, results of operations and prospects.
In July 2013, the Federal Reserve and the OCC, the primary federal regulators for the Company and the Bank, respectively, published final rules (the "Basel III Capital Rules") establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee's December 2010 framework known as "Basel III" for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to all U.S. banks that are subject to minimum capital requirements, as well as to bank and savings and loan holding companies, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions' regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions' regulatory capital ratios and replace the existing risk-weighting approach with a more risk-sensitive approach. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies' rules.
The Basel III Capital Rules are effective for the Company and the Bank on January 1, 2015 (subject to a phase-in period). Management believes that, as of June 30, 2013, the Company and the Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis if such requirements were currently effective.
The Basel III Capital Rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income, which currently does not affect regulatory capital. Management anticipates adopting the one-time election to retain existing treatment for accumulated other comprehensive income at the appropriate reporting period. For additional information on the laws and regulations governing the activities of the Company and Bank, including the Basel III Capital Rules, see "Item 1: Business-Regulation".
Recent events in the financial markets continue to produce uncertainties for management about future operating results and the future financial condition of the Company. The interdependencies of the national economy and financial markets do affect the macro economics reviewed by management and may produce outcomes in the future that have not impacted the Company previously. 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 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 June 30, 2013, the Company had total assets of $1.22 billion, an increase of $24.9 million from the level at June 30, 2012. Total investment securities available for sale and net loans and leases receivable increased by $51.2 million and $11.9 million, respectively, while cash and cash equivalents and loans held for sale decreased $29.0 million and $7.0 million, respectively. Total liabilities increased by $24.5 million primarily due to increases in advances from FHLB and other borrowings and deposits of $24.8 million and $4.9 million, respectively, while subordinated debentures payable to trusts and


Table of Contents

accrued expenses and other liabilities decreased $3.0 million and $2.1 million, respectively. Stockholders' equity increased by $455,000 since June 30, 2012, primarily due to net income and reduced by dividends paid and an increase in accumulated other comprehensive loss.
The securities available for sale increased by $51.2 million due primarily to the purchase of securities in excess of investment security sales, maturities and repayments of $61.0 million during fiscal 2013. Total proceeds on the sale of securities during the fiscal year were $116.6 million for a net gain of $2.1 million. The increase in net loans and leases receivable, which excludes loans in process and deferred fees, was $11.9 million due to the increase in loan balances of $12.1 million and reduced by the increase in the allowance for loan and lease losses of $177,000. Commercial business, real estate and agricultural loans collectively increased by $34.0 million, while consumer loans decreased by $21.9 million.
Loans held for sale decreased $7.0 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 June 30, 2013.
See the Consolidated Statement of Cash Flows for a detailed analysis of the change in cash and cash equivalents.
Deposits increased $4.9 million, to $898.8 million at June 30, 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 $28.1 million, or 4.0% since June 30, 2012, while public fund deposit balances decreased $33.4 million. Advances from the FHLB and other borrowings increased $24.8 million, to $167.2 million at June 30, 2013 as compared to June 30, 2012, due to increased funding needs.
Stockholders' equity increased $455,000 at June 30, 2013 when compared to June 30, 2012. Increases in stockholders' equity were derived from net income of $5.9 million, and reduced by the payment of cash dividends of $3.2 million and a net increase in accumulated other comprehensive loss of $2.7 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.


                                                                       Years Ended June 30,
                                     2013                                      2012                                      2011
                       Average        Interest                   Average        Interest                   Average        Interest
                     Outstanding       Earned/      Yield/     Outstanding       Earned/      Yield/     Outstanding       Earned/      Yield/
                       Balance          Paid         Rate        Balance          Paid         Rate        Balance          Paid         Rate
                                                                      (Dollars in Thousands)
Interest-earning
assets:
Loans and leases
receivable(1)(3)    $    696,075     $  33,923       4.87 %   $    772,344     $  42,283       5.47 %   $    867,346     $  48,557       5.60 %
Investment
securities(2)(3)         395,082         4,844       1.23          329,387         4,671       1.42          263,964         5,526       2.09
Correspondent bank
stock                      7,943           224       2.82            8,101           257       3.17           10,047           328       3.26
Total
interest-earning
assets                 1,099,100     $  38,991       3.55 %      1,109,832     $  47,211       4.25 %      1,141,357     $  54,411       4.77 %
Noninterest-earning
assets                    79,967                                    86,266                                    83,181
Total assets        $  1,179,067                              $  1,196,098                              $  1,224,538
Interest-bearing
liabilities:
Deposits:
Checking and money
market              $    360,833     $   1,118       0.31 %   $    335,455     $   1,999       0.60 %   $    283,368     $   1,578       0.56 %
Savings                  115,331           282       0.24          120,285           346       0.29           85,053           282       0.33
Certificates of
deposit                  271,132         3,362       1.24          313,174         4,883       1.56          411,918         7,712       1.87
Total
interest-bearing
deposits                 747,296         4,762       0.64          768,914         7,228       0.94          780,339         9,572       1.23
FHLB advances and
other borrowings         144,339         4,179       2.90          147,038         4,474       3.04          182,672         5,682       3.11
Subordinated
debentures payable
to trusts                 27,606         1,666       6.03           27,837         1,861       6.69           27,837         1,823       6.55
Total
interest-bearing
liabilities              919,241        10,607       1.15          943,789        13,563       1.44          990,848        17,077       1.72
Noninterest-bearing
deposits                 130,291                                   122,759                                   104,368
Other liabilities         31,045                                    34,141                                    34,761
Total liabilities      1,080,577                                 1,100,689                                 1,129,977
Equity                    98,490                                    95,409                                    94,561
. . .
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