Heartland Financial USA 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended September 30, 2007
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For transition period __________ to __________
Commission File Number: 0-24724
HEARTLAND FINANCIAL USA, INC.
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of incorporation or organization)
(I.R.S. employer identification number)
1398 Central Avenue, Dubuque, Iowa 52001
(Address of principal executive offices)(Zip Code)
(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
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 Accelerated filer x Non-accelerated filer
Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Securities Exchange Act of 1934). Yes No x
Indicate the number of shares outstanding of each of the classes of Registrant's common stock as of the latest practicable date: As of November 8, 2007, the Registrant had outstanding 16,447,779 shares of common stock, $1.00 par value per share.
HEARTLAND FINANCIAL USA, INC.
Form 10-Q Quarterly Report
ITEM 1. FINANCIAL STATEMENTS
See accompanying notes to consolidated financial statements.
HEARTLAND FINANCIAL USA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: BASIS OF PRESENTATION
The interim unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and accompanying notes to the consolidated financial statements for the fiscal year ended December 31, 2006, included in Heartland Financial USA, Inc.’s ("Heartland") Form 10-K filed with the Securities and Exchange Commission on March 16, 2007. Accordingly, footnote disclosures, which would substantially duplicate the disclosure contained in the audited consolidated financial statements, have been omitted.
The financial information of Heartland included herein has been prepared in accordance with U.S. generally accepted accounting principles for interim financial reporting and has been prepared pursuant to the rules and regulations for reporting on Form 10-Q and Rule 10-01 of Regulation S-X. Such information reflects all adjustments (consisting of normal recurring adjustments), that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods presented. The results of the interim periods ended September 30, 2007, are not necessarily indicative of the results expected for the year ending December 31, 2007.
Earnings Per Share
Basic earnings per share is determined using net income and weighted average common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average common shares and assumed incremental common shares issued. Amounts used in the determination of basic and diluted earnings per share for the three-month and nine-month periods ended September 30, 2007 and 2006, are shown in the tables below:
Options are typically granted annually with an expiration date ten years after the date of grant. Vesting is generally over a five-year service period with portions of a grant becoming exercisable at three years, four years and five years after the date of grant. The standard stock option agreement provides that the options become fully exercisable and expire if not exercised within 6 months of the date of retirement, including early retirement at age 55, provided the officer has provided 10 years of service to Heartland. A summary of the status of the stock options as of September 30, 2007 and 2006, and changes during the nine months ended September 30, 2007 and 2006, follows:
At September 30, 2007, the vested options totaled 300,554 shares with a weighted average exercise price of $11.60 per share and a weighted average remaining contractual life of 3.44 years. The intrinsic value for the vested options as of September 30, 2007, was $2.7 million. The intrinsic value for the total of all options exercised during the nine months ended September 30, 2007, was $2.1 million, and the total fair value of shares vested during the nine months ended September 30, 2007, was $1.2 million. At September 30, 2007, shares available for issuance under the 2005 Long-Term Incentive Plan totaled 613,860.
The fair value of the 2007 stock options granted was estimated utilizing the Black Scholes valuation model. The fair value of a share of common stock on the grant date of the 2007 options was $27.85. The fair value of a share of common stock on the grant date of the 2006 options was $21.60. Significant assumptions include:
The option term of each award granted was based upon Heartland’s historical experience of employees’ exercise behavior. Expected volatility was based upon historical volatility levels and future expected volatility of Heartland’s common stock. Expected dividend yield was based on a set dividend rate. Risk free interest rate reflects the yield on the 7 year zero coupon U.S. Treasury bond. Cash received from options exercised for the nine months ended September 30, 2007, was $1.9 million, with a related tax benefit of $845 thousand. Cash received from options exercised for the nine months ended September 30, 2006, was $533 thousand, with a related tax benefit of $388 thousand.
Total compensation costs recorded were $1.2 million and $630 thousand for the nine months ended September 30, 2007 and September 30, 2006, respectively, for stock options, restricted stock awards and shares to be issued under the 2006 Employee Stock Purchase Plan. As of September 30, 2007, there was $3.1 million of total unrecognized compensation costs related to the 2005 Long-Term Incentive Plan for stock options and restricted stock awards which is expected to be recognized through 2011.
Effect of New Financial Accounting Standards
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which is an interpretation of FASB Statement No. 109, Accounting for Income Taxes. This interpretation prescribes the minimum recognition threshold a tax position must meet before being recognized in the financial statements. FIN 48 also provides guidance on the derecognition, measurement, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. FIN 48 is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2006. Differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption should be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The cumulative effect adjustment would not apply to those items that would not have been recognized in earnings, such as the effect of adopting FIN 48 on tax positions related to business combinations. Heartland adopted FIN 48 on January 1, 2007. See Note 6 for a discussion of the effect of the adoption on Heartland’s consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 (“FAS 157”), Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of FAS 157 apply to other accounting pronouncements that require or permit fair value measurements. FAS 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Heartland plans to adopt FAS 157 on January 1, 2008, and is evaluating the impact of the adoption of this statement on its consolidated financial statements.
In September 2006, the Emerging Issues Task Force Issue 06-4 (“EITF 06-4”), Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements, was ratified. EITF 06-4 addresses accounting for separate agreements which split life insurance policy benefits between an employer and employee and requires the employer to recognize a liability for future benefits payable to the employee under these agreements. The effects of applying EITF 06-4 must be recognized through either a change in accounting principle through an adjustment to equity or through the retrospective application to all prior periods. For calendar year companies, EITF 06-4 is effective beginning January 1, 2008. Heartland is assessing the impact of the adoption of this issue on its consolidated financial statements.
In September 2006, the Emerging Issues Task Force Issue 06-5 (“EITF 06-5”), Accounting for Purchases of Life Insurance – Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulleting No. 85-4, was ratified. EITF 06-5 requires that a policyholder should consider any additional amounts included in the contractual terms of the policy in determining the amount that could be realized under the insurance contract on a policy by policy basis. EITF 06-5 is effective for fiscal years beginning after December 15, 2006, and requires that recognition of the effects of adoption should be by a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption or a change in accounting principle through retrospective application to all prior periods. Heartland’s adoption of EITF 06-5 on January 1, 2007, did not have an impact on its consolidated financial statements.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159 (“FAS 159”), The Fair Value Option for Financial Assets and Financial Liabilities, which allows entities to voluntarily choose, at specified election dates, to measure many financial assets and financial liabilities at fair value. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, FAS 159 specifies that all subsequent changes in fair value for that instrument shall be reported in earnings. FAS 159 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. Heartland plans to adopt FAS 159 on January 1, 2008, and is evaluating the impact of the adoption of this statement on its consolidated financial statements.
NOTE 2: CORE DEPOSIT PREMIUM AND OTHER INTANGIBLE ASSETS
The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2007, and December 31, 2006, are presented in the table below, in thousands:
Projections of amortization expense for mortgage servicing rights are based on existing asset balances and the existing interest rate environment as of September 30, 2007. Heartland’s actual experience may be significantly different depending upon changes in mortgage interest rates and market conditions. There was no valuation allowance on mortgage servicing rights at September 30, 2007, and at December 31, 2006. The fair value of Heartland’s mortgage servicing rights was estimated at $6.7 million and $6.0 million at September 30, 2007, and December 31, 2006, respectively.
The following table shows the estimated future amortization expense for amortized intangible assets, in thousands:
NOTE 3: DERIVATIVE FINANCIAL INSTRUMENTS
On occasion, Heartland uses derivative financial instruments as part of its interest rate risk management, including interest rate swaps, caps, floors and collars. Heartland’s objectives in using derivatives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.
To reduce the potentially negative impact a downward movement in interest rates would have on its interest income, Heartland entered into the following two transactions during 2006 and 2005, respectively. On April 4, 2006, Heartland entered into a three-year interest rate collar transaction with a notional amount of $50.0 million. The collar was effective on April 4, 2006, and matures on April 4, 2009. Heartland is the payer on prime at a cap strike rate of 8.95% and the counterparty is the payer on prime at a floor strike rate of 7.00%. As of September 30, 2007, and December 31, 2006, the fair market value of this collar transaction was recorded as an asset of $202 thousand and $59 thousand, respectively.
On September 19, 2005, Heartland entered into a five-year interest rate collar transaction on a notional amount of $50.0 million. The collar has an effective date of September 21, 2005, and a maturity date of September 21, 2010. Heartland is the payer on prime at a cap strike rate of 9.00% and the counterparty is the payer on prime at a floor strike rate of 6.00%. As of September 30, 2007, the fair market value of this collar transaction was recorded as an asset of $112 thousand. As of December 31, 2006, the fair market value of this collar transaction was recorded as a liability of $43 thousand.
For accounting purposes, the two collar transactions above are designated as cash flow hedges of the overall changes in the cash flows above and below the collar strike rates associated with interest payments on certain of Heartland’s prime-based loans that reset whenever prime changes. The hedged transactions for the two hedging relationships are designated as the first prime-based interest payments received by Heartland each calendar month during the term of the collar that, in aggregate for each period, are interest payments on principal from specified portfolios equal to the notional amount of the collar.
Prepayments in the hedged loan portfolios are treated in a manner consistent with the guidance in SFAS 133 Implementation Issue No. G25, Cash Flow Hedges: Using the First-Payments-Received Technique in Hedging the Variable Interest Payments on a Group of Non-Benchmark-Rate-Based Loans, which allows the designated forecasted transactions to be the variable, prime-rate-based interest payments on a rolling portfolio of prepayable interest-bearing loans using the first-payments-received technique, thereby allowing interest payments from loans that prepay to be replaced with interest payments from new loan originations. Based on Heartland’s assessments, both at inception and throughout the life of the hedging relationship, it is probable that sufficient prime-based interest receipts will exist through the maturity dates of the collars.
To reduce the potentially negative impact an upward movement in interest rates would have on its net interest income, Heartland entered into the following two transactions on February 1, 2007. For accounting purposes, these two cap transactions are designated as cash flow hedges of the changes in cash flows attributable to changes in LIBOR, the benchmark interest rate being hedged, above the cap strike rate associated with the interest payments made on $45.0 million of Heartland’s subordinated debentures (issued in connection with the trust preferred securities of Heartland Financial Statutory Trust IV and V) that reset quarterly on a specified reset date. At inception, Heartland asserted that the underlying principal balance will remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments will exist through the maturity date of the caps.
The first transaction executed was a twenty-three month interest rate cap transaction on a notional amount of $20.0 million. The cap has an effective date of February 1, 2007, and a maturity date of January 7, 2009. Should 3-month LIBOR exceed 5.5% on a reset date, the counterparty will pay Heartland the amount of interest that exceeds the amount owed on the debt at the cap LIBOR rate of 5.5%. The floating-rate subordinated debentures contain an interest deferral feature that is mirrored in the cap transaction. As of September 30, 2007, the fair market value of this cap transaction was recorded as an asset of $5 thousand.
The second transaction executed on February 1, 2007, was a twenty-five month interest rate cap transaction on a notional amount of $25.0 million to reduce the potentially negative impact an upward movement in interest rates would have on its net interest income. The cap has an effective date of February 1, 2007, and a maturity date of March 17, 2009. Should 3-month LIBOR exceed 5.5% on a reset date, the counterparty will pay Heartland the amount of interest that exceeds the amount owed on the debt at the cap LIBOR rate of 5.5%. The floating-rate subordinated debentures contain an interest rate deferral feature that is mirrored in the cap transaction. As of September 30, 2007, the fair market value of this cap transaction was recorded as an asset of $22 thousand.
For both the collar and cap transactions described above, the effective portion of changes in the fair values of the derivatives is initially reported in other comprehensive income (outside of earnings) and subsequently reclassified to earnings (interest income on loans or interest expense on borrowings) when the hedged transactions affect earnings. Ineffectiveness resulting from the hedging relationship, if any, is recorded as a gain or loss in earnings as part of noninterest income. Heartland uses the “Hypothetical Derivative Method” described in SFAS 133 Implementation Issue No. G20, Cash Flow Hedges: Assessing and Measuring the Effectiveness of a Purchased Option Used in a Cash Flow Hedge, for its quarterly prospective and retrospective assessments of hedge effectiveness, as well as for measurements of hedge ineffectiveness. No component of the change in the fair value of the hedging instrument is excluded from the assessment of hedge effectiveness. No significant ineffectiveness was realized on the derivatives qualifying for cash flow hedge accounting for the three and nine months ended September 30, 2007 and 2006.
A portion of the September 19, 2005, collar transaction did not meet the retrospective hedge effectiveness test at June 30, 2007. The failure was on a portion of the $50.0 million notional amount. That portion, $14.3 million, was designated as a cash flow hedge of the overall changes in the cash flows above and below the collar strike rates associated with interest payments on certain of Rocky Mountain Bank’s prime-based loans. The failure of this hedge relationship was caused by the sale of the Broadus branch (see Note 5), which reduced the designated loan pool from $14.3 million to $7.5 million. This hedge failure resulted in the recognition of a loss of $51 thousand during the quarter ended June 30, 2007, which consists of the mark to market loss on the collar transaction of $36 thousand and a reclass of unrealized losses out of other comprehensive income to earnings of $15 thousand. On August 17, 2007, the $14.3 million portion of the September 19, 2005, collar transaction was redesignated and met the requirements for hedge accounting treatment. Since the fair value of the collar transaction was zero on the redesignation date, a mark to market gain of $36 thousand was recorded as other noninterest income during the period from June 30, 2007, to August 17, 2007. As was the case at origination, the redesignation remains as a cash flow hedge of the overall changes in the cash flows above and below the collar strike rates associated with interest payments on certain of Rocky Mountain Bank’s prime-based loans. On September 30, 2007, this portion of the collar transaction demonstrated retrospective hedge effectiveness.
For the nine months ended September 30, 2007, the change in net unrealized gains of $235 thousand for derivatives designated as cash flow hedges is separately disclosed in the statement of changes in stockholders’ equity, before income taxes of $87 thousand. For the nine months ended September 30, 2006, the change in net unrealized gains of $136 thousand for derivatives designated as cash flow hedges is separately disclosed in the statement of changes in shareholders’ equity, before income taxes of $51 thousand.
Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received or made on Heartland’s variable-rate assets and liabilities. For the nine months ended September 30, 2007, the change in net unrealized losses on cash flow hedges reflects a reclassification of $45 thousand of net unrealized losses from accumulated other comprehensive income to interest income or interest expense. For the next twelve months, Heartland estimates that an additional $9 thousand will be reclassified from accumulated other comprehensive income to interest income.
On July 8, 2005, Heartland entered into a two-year interest rate floor transaction on prime at a strike level of 5.50% on a notional amount of $100.0 million. This floor transaction matured on July 8, 2007, and was not replaced upon maturity. Changes in the fair market value of this hedge transaction were recorded through Heartland’s income statement under the other noninterest income category as it was not designated in a formal hedging relationship. The floor contract had no fair market value as of December 31, 2006.
By using derivatives, Heartland is exposed to credit risk if counterparties to derivative instruments do not perform as expected. Heartland minimizes this risk by entering into derivative contracts with large, stable financial institutions and Heartland has not experienced any losses from counterparty nonperformance on derivative instruments. Furthermore, Heartland also periodically monitors counterparty credit risk in accordance with the provisions of SFAS 133.
NOTE 4: ACQUISITIONS
On March 9, 2007, Heartland completed its acquisition of a book of business from Independent Financial Marketing Group, Inc. (“IFMG”), a subsidiary of Sun Life. The brokers and support staff at the Denver office of IFMG served 8,800 investment clients. Immediately upon the acquisition, the staff relocated to Summit Bank & Trust’s Broomfield, Colorado office. The purchase price of $650 thousand will be paid in installments. The initial payment of $50 thousand was paid at closing. The remaining payments are scheduled for payment as follows: $100 thousand on December 31, 2007, and $125 thousand on December 31, 2008, 2009, 2010 and 2011. The resultant acquired customer relationship intangible of $260 thousand is being amortized over a period of 5 years. The remaining excess purchase price of $390 thousand was recorded as goodwill.
NOTE 5: DISCONTINUED OPERATIONS
On June 22, 2007, Rocky Mountain Bank, Heartland’s Montana bank subsidiary, completed the sale of its branch banking office in Broadus, Montana. Included in the sale were $20.9 million of loans and $30.2 million of deposits. Heartland recorded a pre-tax gain of $2.4 million as a result of the sale. The branch sale represents a strategic decision on the part of Heartland and Rocky Mountain Bank to identify branch offices of relatively smaller size and greater distance from its primary banking markets for possible divestiture. Neither Rocky Mountain Bank nor Heartland anticipates the divestiture of other Montana banking offices. The results of operations of the branch, including the gain on sale, have been reflected on the income statement as discontinued operations for both the current and prior periods reported. Also included with the results of operations of the Broadus branch on the income statement as discontinued operations for the prior periods are the results of the operations of ULTEA, Inc., Heartland’s fleet leasing subsidiary, which was sold on December 22, 2006.
NOTE 6: INCOME TAXES
Heartland adopted the provisions of FIN 48 on January 1, 2007. The evaluation was performed for those tax years which remain open to audit. Heartland files a consolidated tax return for federal purposes and a separate or consolidated tax return for state purposes dependent upon the state tax regulations. The tax years ended December 31, 2006, 2005, 2004 and 2003, remain subject to examination by the Internal Revenue Service. For state purposes, the tax years ended December 31, 2006, 2005, 2004, 2003 and 2002 remain open for examination. As a result of the implementation of FIN 48, Heartland did not recognize any increase or decrease for unrecognized tax benefits. The amount of unrecognized tax benefits on January 1, 2007, and September 30, 2007, was $1.3 million and accrued interest and penalties of $250 thousand for a total of $1.5 million. If recognized, the entire amount of the unrecognized tax benefits would affect the effective tax rate. At September 30, 2007, Heartland does not anticipate any significant increase or decrease in unrecognized tax benefits during the next twelve months. Wisconsin Community Bank, one of Heartland’s bank subsidiaries, has undergone a franchise tax review for the years ended December 31, 2002 and 2003, and is currently in the process of appealing the field audit report. In dispute is $1.1 million of deducted expenditures, or $126 thousand in taxes, interest and penalties, which have been fully accrued for.
NOTE 7: OTHER BORROWINGS
On March 19, 2007, Heartland Financial Statutory Trust II, a trust subsidiary of Heartland, redeemed all of its $8.0 million variable rate trust preferred securities and its variable rate common securities at a redemption price equal to the $8.00 liquidation amount of each security plus all accrued and unpaid interest per security. The redeemed trust preferred securities were originally issued in 2002. Remaining unamortized issuance costs associated with these securities of $202 thousand were expensed under the noninterest expenses category upon redemption.
On June 21, 2007, Heartland completed an offering of $20.0 million of fixed/variable rate cumulative trust preferred securities representing undivided beneficial interests in Heartland Financial Statutory Trust VI. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. Interest is payable quarterly on March 15, June 15, September 15 and December 15 of each year. The debentures will mature and the trust preferred securities must be redeemed on September 15, 2037. Heartland has the option to shorten the maturity date to a date not earlier than June 15, 2012. If the debentures are redeemed between June 15, 2012, and June 15, 2017, Heartland may be required to pay a “make-whole” premium. On or after June 15, 2017, the debentures are redeemable at par. No underwriting commissions or placement fees were paid in connection with this issuance. For regulatory purposes, all $20.0 million qualified as Tier 2 capital.
On June 26, 2007, Heartland completed an offering of $20.0 million of variable rate cumulative trust preferred securities representing undivided beneficial interests in Heartland Financial Statutory Trust VII. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. Interest is payable quarterly on March 1, June 1, September 1 and December 1 of each year. The debentures will mature and the trust preferred securities must be redeemed on September 1, 2037. On or after September 1, 2012, the debentures are redeemable at par. No underwriting commissions or placement fees were paid in connection with this issuance. For regulatory purposes, all $20.0 million qualified as Tier 2 capital. The proceeds on both of these new trust preferred securities issuances has been used as a permanent source of funding for general corporate purposes, including replacement for the redemption of $8.0 million of higher priced trust preferred securities in March 2007 and the redemption of another $5.0 million of trust preferred securities on October 1, 2007, future acquisitions and as a source of funding for the operations of Citizens Finance Co., Heartland’s finance company subsidiary.
Heartland currently has seven wholly-owned trust subsidiaries that were formed to issue trust preferred securities. The proceeds from the offerings were used to purchase junior subordinated debentures from Heartland. The proceeds are being used for general corporate purposes. Heartland has the option to shorten the maturity date to a date not earlier than the callable dates listed in the schedule below. Heartland may not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. In connection with these offerings, the balance of deferred issuance costs included in other assets was $306 thousand as of September 30, 2007. These deferred costs are amortized on a straight-line basis over the life of the debentures. The majority of the interest payments are due quarterly.
A schedule of Heartland’s trust preferred offerings outstanding as of September 30, 2007, is as follows:
For regulatory purposes, $73.3 million of the capital securities qualified as Tier 1 capital for regulatory purposes as of September 30, 2007.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SAFE HARBOR STATEMENT
This document (including information incorporated by reference) contains, and future oral and written statements of Heartland and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of Heartland. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of Heartland’s management and on information currently available to management, are generally identifiable by the use of words such as "believe", "expect", "anticipate", "plan", "intend", "estimate", "may", "will", "would", "could", "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and Heartland undertakes no obligation to update any statement in light of new information or future events.
Heartland’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. The factors which could have a material adverse effect on the operations and future prospects of Heartland and its subsidiaries are detailed in the “Risk Factors” section included under Item 1A. of Part I of Heartland’s 2006 Form 10-K filed with the Securities and Exchange Commission on March 16, 2007. In addition to the risk factors described in that section, there are other factors that may impact any public company, including Heartland, which could have a material adverse effect on the operations and future prospects of Heartland and its subsidiaries. These additional factors include, but are not limited to, the following:
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
Heartland’s results of operations depend primarily on net interest income, which is the difference between interest income from interest earning assets and interest expense on interest bearing liabilities. Noninterest income, which includes service charges and fees, trust income, brokerage and insurance commissions and gains on sale of loans, also affects Heartland’s results of operations. Heartland’s principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy and equipment costs and provision for loan and lease losses.
Net income of $6.9 million, or $0.42 per diluted share, for the quarter ended September 30, 2007, was consistent with net income of $6.9 million, or $0.41 per diluted share, earned during the third quarter of 2006. Return on average equity was 12.72% and return on average assets was 0.86% for the third quarter of 2007, compared to 13.93% and 0.91%, respectively, for the same quarter in 2006.
The sale of Rocky Mountain Bank’s branch banking office in Broadus, Montana, was completed on June 22, 2007. Included in the sale were $20.9 million of loans and $30.2 million of deposits. The results of operations of the branch have been reflected on the income statement as discontinued operations for the prior periods reported. Also included on the income statement as discontinued operations for the prior periods are the results of operations of ULTEA, Inc., Heartland’s fleet leasing subsidiary, which was sold to ALD Automotive on December 22, 2006.
Income from continuing operations was $6.9 million, or $0.42 per diluted share, during the third quarter of 2007 compared to $6.6 million, or $0.39 per diluted share, during the third quarter of 2006. This increase in earnings from continuing operations was primarily a result of a lower provision for loan losses, which was $575 thousand during the third quarter of 2007 compared to $1.4 million during the third quarter of 2006. Noninterest income increased by $415 thousand or 6% during the third quarter of 2007 compared to the same quarter in 2006. The categories experiencing the largest increases were trust fees, brokerage and insurance commissions and income on bank owned life insurance. For the third quarter of 2007, noninterest expense increased $1.6 million or 7% in comparison with the same period in 2006. The largest component of noninterest expense, salaries and employee benefits, increased $1.3 million or 10% during the third quarter of 2007 in comparison to the third quarter of 2006. This growth in salaries and employee benefits expense was primarily due to additional staffing at Heartland’s operations center to provide support services to the growing number of bank subsidiaries and the formation and expansion of Summit Bank & Trust.
Net income recorded for the first nine months of 2007 was $18.9 million, or $1.14 per diluted share, an increase of $1.3 million or 7% over net income of $17.6 million, or $1.05 per diluted share, recorded during the first nine months of 2006. Return on average equity was 11.89% and return on average assets was 0.80% for the first nine months of 2007, compared to 12.23% and 0.81%, respectively, for the same period in 2006. During the first quarter of 2006, a pre-tax judgment of $2.4 million against Heartland and Wisconsin Community Bank was recorded as noninterest expense, while a $286 thousand award under a counterclaim was recorded as a loan loss recovery. The net after-tax effect to net income for this one-time event was $1.3 million. Exclusive of this expense, Heartland’s net income for the first nine months of 2006 was $18.9 million, or $1.13 per diluted share. Because of the non-recurring nature of this expense, management believes that this pro-forma presentation can help investors better understand Heartland’s financial performance for the first nine months of 2006.
During the nine-month period ended September 30, 2007, income from discontinued operations included a $2.4 million pre-tax gain recorded as a result of the sale of the Broadus branch. For the nine months ended September 30, 2007, income from continuing operations was $17.2 million, or $1.04 per diluted share, compared to $16.8 million, or $1.00 per diluted share, during the same period in 2006. This increase in earnings resulted from an improvement in net interest income and noninterest income that outweighed additional provision for loan losses and noninterest expenses recorded during the nine-month comparative periods. For the first nine months of 2007, noninterest income increased $2.1 million or 10% over the same period in 2006, primarily from trust fees, brokerage and insurance commissions, gains on sale of loans and income on bank owned life insurance. For the nine-month period ended September 30, 2007, noninterest expense increased $3.1 million or 4% when compared to the same nine-month period in 2006. Exclusive of the $2.4 million judgment recorded during the first quarter of 2006, noninterest expense increased $5.5 million or 8% in comparison to the first nine months of 2006. Again, the largest contributor to this increase was salaries and employee benefits which grew by $4.2 million or 11% during this nine-month comparative period, primarily due to the expansion efforts. Total full-time equivalent employees increased to 975 at September 30, 2007, from 953 at September 30, 2006.
At September 30, 2007, total assets had increased $144.2 million or 6% annualized since year-end 2006, primarily because of loan growth. Total loans and leases were $2.27 billion at September 30, 2007, an increase of $126.3 million or 8% annualized since year-end 2006. The sale of the Broadus branch of Rocky Mountain Bank included loans of $20.9 million. The growth in loans was balanced between Heartland’s Midwestern and Western markets. The commercial and commercial real estate loan category grew by $127.5 million or 11% annualized. In order to provide the investing community with a perspective on how the growth in both loans and deposits during the first nine months of the year equates to performance on an annualized basis, the growth rates on these two categories as an annualized percentage. These annualized numbers were calculated by multiplying the growth percentage for the first nine months of the year by 1.33.
Total deposits at September 30, 2007, were $2.42 billion, an increase of $109.6 million or 6% annualized since year-end 2006. The sale of the Broadus branch of Rocky Mountain Bank included deposits of $30.2 million. Growth in deposits was greater in Heartland’s Western markets. Demand deposits experienced a decline while savings and time deposit balances experienced an increase. Savings deposits increased largely as a result of the promotion of a new money market product, as well as additional temporary deposits by a municipality. Over half of the growth in time deposits occurred at the Midwestern banks where depositors tend to be more desirous of the term deposit product.
CRITICAL ACCOUNTING POLICIES
The process utilized by Heartland to estimate the adequacy of the allowance for loan and lease losses is considered a critical accounting policy for Heartland. The allowance for loan and lease losses represents management’s estimate of identified and unidentified probable losses in the existing loan portfolio. Thus, the accuracy of this estimate could have a material impact on Heartland’s earnings. The adequacy of the allowance for loan and lease losses is determined using factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, loan collateral values, past loss experience, loan delinquencies, and potential losses from identified substandard and doubtful credits. Nonperforming loans and large non-homogeneous loans are specifically reviewed for impairment and the allowance is allocated on a loan by loan basis as deemed necessary. Homogeneous loans and loans not specifically evaluated are grouped into pools to which a loss percentage, based on historical experience, is allocated. The adequacy of the allowance for loan and lease losses is monitored on an ongoing basis by the loan review staff, senior management and the banks’ boards of directors. Specific factors considered by management in establishing the allowance included the following:
There can be no assurances that the allowance for loan and lease losses will be adequate to cover all loan losses, but management believes that the allowance for loan and lease losses was adequate at September 30, 2007. While management uses available information to provide for loan and lease losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions. Even though there have been various signs of emerging strength in the economy, it is not certain that this strength will be sustainable. Should the economic climate deteriorate, borrowers may experience difficulty, and the level of nonperforming loans, charge-offs, and delinquencies could rise and require further increases in the provision for loan and lease losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan and lease losses carried by the Heartland subsidiaries. Such agencies may require Heartland to make additional provisions to the allowance based upon their judgment about information available to them at the time of their examinations.
NET INTEREST INCOME
Net interest margin, expressed as a percentage of average earning assets, was 3.87% during the third quarter of 2007 compared to 4.16% for the third quarter of 2006. For the first nine months of 2007, net interest margin, expressed as a percentage of average earning assets, was 3.98% compared to 4.22% for the same nine months of 2006. Contributing to the decline in net interest margin during the third quarter of 2007 was a shift in Heartland’s asset mix as a larger percentage of earning assets was held in fed funds sold or investments. Also affecting the net interest margin was the impact of foregone interest on Heartland’s nonperforming loans which have increased during the second and third quarters of 2007. Additionally, early in the third quarter of 2007, a $20.5 million investment was made in bank owned life insurance upon which interest expense associated with the funding of this investment affects net interest margin while the corresponding earnings on this investment is recorded as noninterest income. Given the asset sensitive posture of Heartland’s balance sheet, the 50 basis point rate cut by the Fed in August 2007 and the most recent 25 basis point rate cut by the Fed in October 2007, Heartland will be challenged to maintain its net interest margin at the current level. Management continues to support a pricing discipline in which the focus is less on price and more on the unique value provided to business and retail clients.
Net interest income on a tax-equivalent basis totaled $28.2 million during the third quarter of 2007, an increase of $424 thousand or 2% from the $27.8 million recorded during the third quarter of 2006. For the nine-month period during 2007, net interest income on a tax-equivalent basis was $84.6 million, an increase of $4.0 million or 5% from the $80.6 million recorded during the first nine months of 2006. Contributing to these increases was the $246.6 million or 9% growth in average earning assets during the comparable quarterly periods and the $289.3 million or 11% growth in average earning assets during the first nine months of 2007 compared to 2006. Also contributing to the improvement was the decline in the percentage of nonearning assets to total average assets from 12% during the first nine months of 2006 to 9% during the first nine months of 2007, due primarily to the assets of discontinued operations which, in addition to the Broadus branch, included ULTEA, Inc. during the first nine months of 2006.
On a tax-equivalent basis, interest income in the third quarter of 2007 totaled $55.6 million compared to $50.7 million in the third quarter of 2006, an increase of $4.9 million or 10%. For the first nine months of 2007, interest income on a tax-equivalent basis increased $22.7 million or 16% over the same period in 2006. More than half of the loans in Heartland’s commercial and agricultural loan portfolios are floating rate loans, thus changes in the national prime rate impact interest income more quickly than if there were more fixed rate loans. In a downward rate environment, like the present, continued increases in interest income will be partially dependent upon the amount of loan growth experienced.
Interest expense for the third quarter of 2007 was $27.4 million compared to $22.9 million in the third quarter of 2006, an increase of $4.5 million or 20%. On a nine-month comparative basis, interest expense increased $18.8 million or 31%. Approximately 77% of Heartland’s certificate of deposit accounts will mature within the next twelve months at a weighted average rate of 4.87%.
Heartland manages its balance sheet to minimize the effect a change in interest rates has on its net interest margin. During the remainder of 2007, Heartland will continue to work toward improving both its earning asset and funding mix through targeted organic growth strategies, which management believes will result in additional net interest income. Heartland’s net interest income simulations reflect an asset sensitive posture leading to stronger earnings performance in a rising interest rate environment. The expected benefits associated with an inherently asset sensitive balance sheet will be delayed if rates rise as a highly competitive environment is expected to place pressure on deposit costs. Eventually, in a rapidly rising interest rate environment, funding costs should stabilize while asset yields continue to improve. Alternatively, Heartland’s net interest income would likely decline in a falling rate environment. Item three of this Form 10-Q contains additional information about the results of Heartland’s most recent net interest income simulations.
In order to reduce the potentially negative impact a downward movement in interest rates would have on net interest income on the loan portfolio, Heartland has two derivative transactions currently open: a five-year collar transaction on a notional $50.0 million entered into in September 2005 and a three-year collar transaction on a notional $50.0 million entered into in April 2006. Additionally, in August 2006, Heartland entered into a leverage structured wholesale repurchase agreement transaction. This wholesale repurchase agreement in the amount of $50.0 million bears a variable interest rate that resets quarterly to the 3-month LIBOR rate plus 29.375 basis points. Embedded within this contract is an interest floor option that results when the 3-month LIBOR rate falls to 4.40% or lower. If that situation occurs, the rate paid will be decreased by two times the difference between the 3-month LIBOR rate and 4.40%. In order to effectuate this wholesale repurchase agreement, a $55.0 million government agency bond was acquired. On the date of the contract, the interest rate on the securities was nearly equivalent to the interest rate being paid on the repurchase agreement contract.
On February 1, 2007, Heartland entered into two interest rate cap transactions on a total notional amount of $45.0 million to reduce the potentially negative impact an upward rate environment would have on net interest income. These two-year contracts were acquired with the counterparty as the payer on 3-month LIBOR at a cap strike rate of 5.50% and were designated as a cash flow hedge against the LIBOR based variable-rate interest payments on Heartland’s subordinated debentures associated with two of its trust preferred capital securities. The cost of these derivative transactions was $90 thousand.
The table below sets forth certain information relating to Heartland’s average consolidated balance sheets and reflects the yield on average earnings assets and the cost of average interest bearing liabilities for the periods indicated. Dividing income or expense by the average balance of assets or liabilities derives such yield and costs. Average balances are derived from daily balances. Nonaccrual loans and loans held for sale are included in each respective loan category.