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HFFC > SEC Filings for HFFC > Form 10-Q on 9-Nov-2012All 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 three months of fiscal 2013 was $2.1 million, or $0.29 in diluted earnings per common share, compared to $1.4 million, or $0.21 in diluted earnings per common share, for the same period of fiscal 2012. The first quarter of fiscal 2013 resulted in a return on average equity (i.e., net income divided by average equity) of 8.42%, compared to 6.08% in the same quarter of the prior year. For the quarter ended September 30, 2012, the return on average assets (i.e., net income divided by average assets) was 0.71% compared to 0.48% in the prior year's quarter.
Net interest income for the first three months of fiscal 2013 was $7.3 million, a decrease of $1.8 million, or 19.2%, compared to the same period a year ago. For the three months ended September 30, 2012, average interest-earning assets and average interest-bearing liabilities decreased 4.1% and 5.2%, respectively, compared to the same period a year ago. Yields on interest-earning assets decreased to 3.75% for the first three months of fiscal 2013, compared to 4.53% a year ago, a decrease of 78 basis points, due primarily to the repricing of adjustable rate loans and competitive pricing pressures in a low interest rate environment. The yields on investment securities and other short-term investments are also impacted by the low interest rate

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environment and prepayment speeds of mortgage-backed securities purchased at a premium. For the same period, cost of deposits, which include all interest-bearing and noninterest-bearing deposits, decreased to 0.65%, compared to 0.96%, a decrease of 31 basis points.
The net interest margin expressed on a fully taxable equivalent basis ("Net Interest Margin, TE") for the three months ended September 30, 2012 was 2.72%, which is a decrease of 52 basis points from the same period of the prior fiscal year. The margin declined primarily due to the decreases in yield associated with the loan and investment rates in excess of the decrease in the deposit rates paid. 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 to $695.6 million from $683.7 million at June 30, 2012. Commercial real estate lending opportunities have increased, 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. 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. The operating environment has resulted in increased competition among financial institutions for loan demand from creditworthy borrowers.
The allowance for loan and lease losses increased $243,000 to $10.8 million at September 30, 2012, compared to June 30, 2012. The ratio of allowance for loan and lease losses to total loans and leases was 1.55% as of September 30, 2012 compared to 1.55% at June 30, 2012. The overall loan balances have increased during the fiscal year, while the general reserve increased in part due to the effects of the change in loan balances, historical charge-off activity and management's assessment of environmental factors. During the quarter, recoveries exceeded charge-offs resulting in a net recovery of $543,000. The recoveries combined with the overall analysis of the allowance for loan and lease losses contributed to a net benefit for the provision for loan and lease losses of $300,000 for the first three months of fiscal 2013. Total nonperforming assets at September 30, 2012 were $15.6 million as compared to $16.2 million at June 30, 2012. The ratio of nonperforming assets to total assets decreased to 1.45% at September 30, 2012, compared to 1.49% at June 30, 2012. The overall decrease in nonperforming assets from the previous quarter was primarily attributed to improving conditions in the regional commercial and agricultural markets and our continued proactive management of problem assets. The valuation allowance recorded in accordance with ASC 310 on identified impaired loans remained steady at $2.1 million at September 30, 2012, the same as June 30, 2012. Approximately 91% of the valuation allowance on impaired loans are agricultural loans and, more specifically, 85% 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 decreased by $572,000 to $1.1 million at September 30, 2012 from $1.6 million at June 30, 2012, with remaining assets primarily consisting of residential loans that were foreclosed and 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 September 30, 2012, were $861.6 million, a decrease of $32.3 million from June 30, 2012. The decrease in overall deposits was primarily due to the $45.0 million decrease in public funds, offset by a $13.0 million increase of in-market deposits, exclusive of public funds. 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, decreased to the average rate paid of 0.77% on interest-bearing deposits for the three month period ended September 30, 2012, compared to 0.82% for the three month period ended June 30, 2012.
On October 29, 2012, the Company announced it will pay a quarterly cash dividend of 11.25 cents per common share for the first quarter of fiscal 2013. The dividend will be paid on November 16, 2012, to stockholders of record on November 9, 2012.

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The total risk-based capital ratio of 16.32% at September 30, 2012, increased by 45 basis points from 15.87% at June 30, 2012. Tier I capital increased 39 basis points to 10.05% at September 30, 2012 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 September 30, 2012 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 $4.1 million for the three months ended September 30, 2012, compared to $3.4 million for the same period in the prior fiscal year, an increase of $761,000. This increase was due to increases in gain on sale of loans and fees on deposits, and partially offset by the decrease in net loan servicing income. The gain on sale of loans increased by $646,000 due to increased levels of originated single-family loans. Deposit fees for the first fiscal quarter included approximately $600,000 of nonrecurring vendor incentive fees related to a debit card brand change for customer accounts. Security gains totaled $1.8 million for the quarter ended September 30, 2012, which is an increase of $1.5 million compared to the same quarter of the prior year. The increases in security gains were offset by a decrease in other noninterest income of $1.5 million due to a nonrecurring charge related to the termination of hedging activity on deposit balances for the quarter ended September 30, 2012. Net loan servicing income decreased $511,000 to a net loss of $40,000 for the three months ended September 30, 2012, due primarily to a provision recorded of $263,000 and increased amortization expenses recorded of $162,000, when compared to the prior year's quarter. These reductions in servicing income were the result of higher prepayment speeds calculated within the servicing portfolio which have resulted from the low interest rate environment.
Noninterest expense was $8.8 million for the three months ended September 30, 2012, as compared to $9.8 million for the same period of the prior fiscal year, a decrease of $968,000, or 9.9%. The decrease was attributed primarily to decreases in compensation and employee benefits of $787,000, along with decreases in the cost of FDIC insurance, occupancy and equipment, and professional fees for a total of $310,000. Compensation costs decreased due to a reduced number of average full-time equivalents ("FTE's") for the first three months 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. FDIC insurance decreased due to a modified rate which was lower because of improved asset quality and net income to risk weighted asset ratios. Occupancy and equipment decreased when compared to the same quarter 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 them with other nearby branches to improve operating efficiencies. 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 quarter of fiscal 2012.
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 fiscal 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 September 30, 2012, the remaining balance recorded as a prepaid asset was $1.2 million. Effective in the first quarter of fiscal 2013, the FDIC insurance assessment rate was modified and reduced due to the Bank's asset quality ratios and earnings as compared to risk weighted assets. As a result, FDIC insurance decreased by $62,000, to $210,000 for the three months ended September 30, 2012 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

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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 September 30, 2012, the Company had total assets of $1.15 billion, a decrease of $39.2 million from the level at June 30, 2012. Securities available for sale decreased $58.2 million and were partially offset by an increase in net loans and leases receivable of $11.6 million. Total liabilities decreased by $41.3 million primarily due to decreases in deposits and advances from the FHLB and other borrowings of $32.3 million and $11.0 million, respectively. Stockholders' equity increased by $2.1 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 decreased by $58.2 million due primarily to the sale of securities during the first fiscal quarter of $73.0 million for a net gain of $1.8 million. The increase in net loans and leases receivable, which excludes loans in process and deferred fees, was $11.6 million due to the increase in loan balances of $11.9 million and slightly offset by the increase in the allowance for loan and lease losses of $243,000. Commercial real estate was the primary contributor to the change with an increase of $10.0 million during the three months ended September 30, 2012.
In addition, loans held for sale increased $1.7 million, primarily due to increased mortgage financing activity and the amount of one-to four-family loans held at September 30, 2012.
See the Consolidated Statement of Cash Flows for a detailed analysis of the change in cash and cash equivalents.
Deposits decreased $32.3 million, to $861.6 million at September 30, 2012, due primarily to the decrease in deposits held for public funds of $45.0 million. Deposit accounts, exclusive of public funds and out-of-market certificates of deposits, increased $13.0 million, or 1.8% since June 30, 2012, which offset some of the decrease related to the public funds. Advances from the FHLB and other borrowings decreased $11.0 million, to $131.4 million at September 30, 2012 as compared to June 30, 2012, due to reduced funding needs.
Stockholders' equity increased $2.1 million at September 30, 2012 when compared to June 30, 2012. Increases in stockholders' equity was derived from net income of $2.1 million, and a net decrease in accumulated other comprehensive loss of $683,000. These increases were partially offset by the payment of a cash dividend of $794,000.
Analysis of Net Interest Income
Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
Average Balances, Interest Rates and Yields. The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes. Average balances consist of daily average balances for the Bank with simple average balances for all other 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 September 30,
                                                      2012                                     2011
                                        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)    $    703,470     $   9,006      5.08 %   $    832,298     $  11,566      5.53 %
Investment securities(2)(3)               371,721         1,186      1.27          289,492         1,241      1.71
FHLB stock                                  7,977            51      2.54            8,232            62      3.00
Total interest-earning assets           1,083,168     $  10,243      3.75 %      1,130,022     $  12,869      4.53 %
Noninterest-earning assets                 83,133                                   69,100
Total assets                         $  1,166,301                             $  1,199,122
Interest-bearing liabilities:
Checking and money market            $    336,643     $     397      0.47 %   $    311,203     $     532      0.68 %
Savings                                   112,365            74      0.26          113,693            81      0.28
Certificates of deposit                   278,278           935      1.33          350,521         1,544      1.75
Total interest-bearing deposits           727,286         1,406      0.77          775,417         2,157      1.11
FHLB advances and other borrowings        147,241         1,061      2.86          148,936         1,159      3.10
Subordinated debentures payable to
trusts                                     27,837           428      6.10           27,837           455      6.50
Total interest-bearing liabilities   $    902,364     $   2,895      1.27 %   $    952,190     $   3,771      1.58 %
Noninterest-bearing deposits              131,901                                  119,758
Other liabilities                          34,163                                   32,834
Total liabilities                       1,068,428                                1,104,782
Equity                                     97,873                                   94,340
Total liabilities and equity         $  1,166,301                             $  1,199,122
Net interest income; interest rate
spread(4)                                             $   7,348      2.48 %                    $   9,098      2.95 %
Net interest margin(4)(5)                                            2.69 %                                   3.20 %
Net interest margin, TE(6)                                           2.72 %                                   3.24 %


(1) Includes loan fees and interest on accruing loans and leases past due 90 days or more.

(2) Includes federal funds sold and interest earning reserve balances at the Federal Reserve Bank.

(3) Yields do not reflect the tax-exempt nature of loans, equipment leases and municipal securities.

(4) Percentages for the three months ended September 30, 2012 and 2011 have been annualized.

(5) Net interest income divided by average interest-earning assets.

(6) Net interest margin expressed on a fully taxable equivalent basis ("Net Interest Margin, TE") is a non-GAAP financial measure. See the following Non-GAAP Disclosure Reconciliation of Net Interest Income (GAAP) to Net Interest Margin, TE (Non-GAAP). The tax-equivalent adjustment to net interest income recognizes the income tax savings when comparing taxable and tax-exempt assets and adjusting for federal and state exemption of interest income and certain other permanent income tax differences. We believe that it is a standard practice in the banking industry to present net interest margin expressed on a fully taxable equivalent basis, and accordingly believe the presentation of this non-GAAP financial measure may be useful for peer comparison purposes. As a non-GAAP financial measure, Net Interest Margin, TE should be considered supplemental to and not a substitute for or superior to, financial measures calculated in accordance with GAAP. As other companies may use different calculations for Net Interest Margin, TE, this presentation may not be comparable to similarly titled measures reported by other companies.

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