**UNITED STATES            SECURITIES AND EXCHANGE COMMISSION            Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended June 30, 2007**

 

Commission file number: **0-12668**

 

**Hills Bancorporation**

 

 

| Incorporated in Iowa | I.R.S. Employer Identification |
|----------------------|--------------------------------|

|   | No. 42-1208067 |
|--------|----------------|

 

|   | 131 MAIN STREET, HILLS, IOWA 52235 |
|--------|------------------------------------|

 

|   | Telephone number: (319) 679-2291 |
|--------|----------------------------------|

 

 

Indicate by checkmark 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.

x Yes              o No

 

Indicate by checkmark 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. (Check one):

| Large accelerated filer o                                          Accelerated                            Filer x |  | Non-accelerated filer                            o |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--|----------------------------------------------------|

 

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

 

**APPLICABLE ONLY TO CORPORATE ISSUERS:**

 

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

 

|   | **SHARES OUTSTANDING** |
|--------|------------------------|

|   | **CLASS** | **At July 31, 2007**  |
|--------|-----------|----------------------------|

 

| **Common Stock, no par value** | **4,497,121** |
|--------------------------------|---------------|

 

 

 

Page            1 of 35

 

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**HILLS BANCORPORATION**

**Index to Form 10-Q**

 

**Part I****FINANCIAL INFORMATION**

 

|                              |   |                                                                                                                                                                                                                 | PageNumber |
|-----------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
||
| Item                    1.        |   | Financial                    Statements                                                                                                                                                                              |       |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
|                              |   | Consolidated balance                    sheets, June 30, 2007 (unaudited)                           and December 31, 2006                                                         | 3          |   |
|                              |   | Consolidated statements                    of income (unaudited) for three and six                           months ended June 30, 2007 and                    2006               | 4          |   |
|                              |   | Consolidated statements                    of comprehensive income (unaudited) for                           three and six months ended June 30,                    2007 and 2006 | 5          |   |
|                              |   | Consolidated statements                    of stockholders’ equity (unaudited)                           for six months ended June 30, 2007                    and 2006     | 6          |   |
|                              |   | Consolidated statements                    of cash flows (unaudited) for six                           months ended June 30, 2007 and                    2006                     | 7          |  -                    8 |
|                              |   | Notes to                    consolidated financial statements                                                                                                                                                        | 9          |  -12 |
|                              |   |                                                                                                                                                                                                                 |
|  Item                    2.  |   | Management’s                    Discussion and Analysis of Financial Condition                          and Results of Operations                                                     | 13         |  -                    25 |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    3.        |   | Quantitative and                    Qualitative Disclosures About Market Risk                                                                                                                                        | 26         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    4.        |   | Controls                    and Procedures                                                                                                                                                                           | 27         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
|                              |   | **Part II                    OTHER INFORMATION**                                                                                                                                                                     |       |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    1.        |   | Legal                    proceedings                                                                                                                                                                                 | 28         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    1A.       |   | Risk                    factors                                                                                                                                                                                      | 28         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    2.        |   | Unregistered sales of                    equity securities and use of proceeds                                                                                                                                       | 28         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    3.        |   | Defaults                    upon senior securities                                                                                                                                                                   | 28         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    4.        |   | Submission of matters to                    a vote of security holders                                                                                                                                               | 28         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    5.        |   | Other                    information                                                                                                                                                                                 | 29         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Item                    6.        |   | Exhibits                                                                                                                                                                                                             | 29         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Signatures                        |   |                                                                                                                                                                                                                 | 30         |   |
|                              |   |                                                                                                                                                                                                                 |       |   |
| Exhibits                    Index |   |                                                                                                                                                                                                                 | 31         |   |

 

 

Page            2 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED BALANCE SHEETS            (Amounts In Thousands, Except Shares)

| **ASSETS**                                                                                                                                                                                                                                           | **June 30,                            2007                            (Unaudited)** |          | December 31, 2006 |        |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------|---------------|-------------------|--------|
|                                                                                                                                                                                                                                                      |                                                                                |
|                                                                                                                                                                                                                                                 |                                                                                |          |              |   |   |   |
| Cash and due from banks                                                                                                                                                                                                                              | **$**                                                                               | **26,560**    | ** **        | $      | 23,397 |   |
| Federal funds                    sold                                                                                                                                                                                                                | ** **                                                                          | **8,052**     | ** **        |   | — |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|    Total cash and cash                    equivalents                                                                                                                                                                                 | **$**                                                                               | **34,612**    | ** **        | $      | 23,397 |   |
| Investment                    securities:                                                                                                                                                                                                            |
|    Available for sale at                    fair value (amortized cost June 30, 2007 $190,065;                          December 31, 2006 $180,106)                                                     | ** **                                                                          | **186,857**   | ** **        |   | 178,057 |   |
|    Held to maturity at                    amortized cost (fair value June 30, 2007 $130;                          December 31, 2006 $177)                                                                    | ** **                                                                          | **125**       | ** **        |   | 170 |   |
| Stock                    of Federal Home Loan Bank                                                                                                                                                                                                   | ** **                                                                          | **13,280**    | ** **        |   | 12,757 |   |
| Loans held for                    sale                                                                                                                                                                                                               | ** **                                                                          | **5,388**     | ** **        |   | 3,808 |   |
| Loans,                    net                                                                                                                                                                                                                        | ** **                                                                          | **1,293,005** | ** **        |   | 1,279,227 |   |
| Property and equipment,                    net                                                                                                                                                                                                       | ** **                                                                          | **21,601**    | ** **        |   | 22,061 |   |
| Tax                    credit real estate                                                                                                                                                                                                            | ** **                                                                          | **6,940**     | ** **        |   | 7,111 |   |
| Accrued interest                    receivable                                                                                                                                                                                                       | ** **                                                                          | **11,541**    | ** **        |   | 10,292 |   |
| Deferred income taxes                                                                                                                                                                                                                                | ** **                                                                          | **8,490**     | ** **        |   | 7,613 |   |
| Goodwill                                                                                                                                                                                                                                             | ** **                                                                          | **2,500**     | ** **        |   | 2,500 |   |
| Other                    assets                                                                                                                                                                                                                      | ** **                                                                          | **4,582**     | ** **        |   | 4,240 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 | **$**                                                                               | **1,588,921** | ** **        | $      | 1,551,233 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 |
| **LIABILITIES AND                    STOCKHOLDERS’ EQUITY**                                                                                                                                                                                    |                                                                                |          |              |   |   |   |
|                                                                                                                                                                                                                                                      |                                                                                |
|                                                                                                                                                                                                                                                 |                                                                                |          |              |   |   |   |
| Liabilities                                                                                                                                                                                                                                          |                                                                                |          |              |   |   |   |
|    Noninterest-bearing                    deposits                                                                                                                                                                                    | **$**                                                                               | **139,704**   | ** **        | $      | 143,274 |   |
|    Interest-bearing                    deposits                                                                                                                                                                                       | ** **                                                                          | **989,056**   | ** **        |   | 964,135 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|          Total                    deposits                                                                                                                                                              | **$**                                                                               | **1,128,760** | ** **        | $      | 1,107,409 |   |
|    Short-term                    borrowings                                                                                                                                                                                           | ** **                                                                          | **53,015**    | ** **        |   | 59,063 |   |
|    Federal Home Loan Bank                    borrowings                                                                                                                                                                               | ** **                                                                          | **245,379**   | ** **        |   | 235,379 |   |
|    Federal Reserve Bank                    borrowings                                                                                                                                                                                 | ** **                                                                          | **8,000**     | ** **        |   | — |   |
|    Accrued interest                    payable                                                                                                                                                                                        | ** **                                                                          | **3,533**     | ** **        |   | 3,500 |   |
|    Other                    liabilities                                                                                                                                                                                               | ** **                                                                          | **7,644**     | ** **        |   | 6,303 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 | **$**                                                                               | **1,446,331** | ** **        | $      | 1,411,654 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 |
| Redeemable Common Stock                    Held by Employee Stock                                                                                                                                                                                    |                                                                                |          |              |   |   |   |
|    Ownership Plan                    (ESOP)                                                                                                                                                                                           | **$**                                                                               | **21,766**    | ** **        | $      | 20,940 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
| **STOCKHOLDERS’                    EQUITY**                                                                                                                                                                                                    |
|    Capital stock, no par                    value; authorized 10,000,000 shares; issued                           June 30, 2007 4,579,670 shares; December                    31, 2006 4,571,659 shares | **$**                                                                               | **—**   | ** **        | $      | — |   |
|    Paid                    in capital                                                                                                                                                                                                 | ** **                                                                          | **12,643**    | ** **        |   | 12,364 |   |
|    Retained                    earnings                                                                                                                                                                                               | ** **                                                                          | **136,051**   | ** **        |   | 131,852 |   |
|    Accumulated other                    comprehensive loss                                                                                                                                                                            | ** **                                                                          | **(1,981**    | **)**             |   | (1,265 | ) |
|    Treasury stock at cost                    (June 30, 2007 82,549 shares;                          December 31, 2006 67,921                    shares)                                                 | ** **                                                                          | **(4,123**    | **)**             |   | (3,372 | ) |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 | **$**                                                                               | **142,590**   | ** **        | $      | 139,579 |   |
|    Less                    maximum cash obligation related to ESOP shares                                                                                                                                                             | ** **                                                                          | **21,766**    | ** **        |   | 20,940 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 | **$**                                                                               | **120,824**   | ** **        | $      | 118,639 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |
|                                                                                                                                                                                                                                                 | **$**                                                                               | **1,588,921** | ** **        | $      | 1,551,233 |   |
|                                                                                                                                                                                                                                                      |                                                                                     |

See Notes to Consolidated            Financial Statements.

 

 

Page            3 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED STATEMENTS OF INCOME (Unaudited)            (Amounts In Thousands, Except Per Share Amounts)

|                                                                                                                                                                                                |        |        |            | Three Months Ended                    June 30, |        | Six Months Ended                    June 30, |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|------------|------------------------------------------------|--------|----------------------------------------------|
|                                                                                                                                                                                                |        |   |            |
||
|                                                                                                                                                                                                |
| Interest                    income:                                                                                                                                                            |   |   |       |                                           |   |                                         |   |   |   |   |   |   |   |
|   Loans,                    including fees                                                                                                                                           |   |   | **$**      | **21,888**                                     |   | $                                            | 19,709 |   | **$** | **43,262** |   | $ | 38,080 |
|   Investment                    securities:                                                                                                                                          |   |   |       |                                           |   |                                         |   |   |   |   |   |   |   |
|     Taxable                                                                                                                                                                |   |   | ** ** | **1,202**                                      |   |                                         | 1,150 |   | ** ** | **2,241** |   |   | 2,290 |
|     Nontaxable                                                                                                                                                             |   |   | ** ** | **776**                                        |   |                                         | 715 |   | ** ** | **1,539** |   |   | 1,422 |
|   Federal                    funds sold                                                                                                                                              |   |   | ** ** | **142**                                        |   |                                         | 20 |   | ** ** | **250** |   |   | 31 |
|                                                                                                                                                                                                |        |
|                                    ** Total interest income**                                                  |   |   | **$**      | **24,008**                                     |   | $                                            | 21,594 |   | **$** | **47,292** |   | $ | 41,823 |
|                                                                                                                                                                                                |        |
| Interest                    expense:                                                                                                                                                           |   |   |       |                                           |   |                                         |   |   |   |   |   |   |   |
|   Deposits                                                                                                                                                                           |   |   | **$**      | **8,925**                                      |   | $                                            | 6,580 |   | **$** | **17,443** |   | $ | 12,538 |
|   Short-term                    borrowings                                                                                                                                           |   |   | ** ** | **484**                                        |   |                                         | 783 |   | ** ** | **989** |   |   | 1,200 |
|   FHLB                    borrowings                                                                                                                                                 |   |   | ** ** | **2,987**                                      |   |                                         | 2,814 |   | ** ** | **5,930** |   |   | 5,603 |
|                                                                                                                                                                                                |        |
|                                     **Total interest expense**                                                 |   |   | **$**      | **12,396**                                     |   | $                                            | 10,177 |   | **$** | **24,362** |   | $ | 19,341 |
|                                                                                                                                                                                                |        |
|                                    ** Net interest income**                                                    |   |   | **$**      | **11,612**                                     |   | $                                            | 11,417 |   | **$** | **22,930** |   | $ | 22,482 |
| Provision for loan                    losses                                                                                                                                                   |   |   | ** ** | **954**                                        |   |                                         | 1,054 |   | ** ** | **1,486** |   |   | 1,709 |
|                                                                                                                                                                                                |        |
|                                    ** Net interest income after provision for loan                    losses** |   |   | **$**      | **10,658**                                     |   | $                                            | 10,363 |   | **$** | **21,444** |   | $ | 20,773 |
|                                                                                                                                                                                                |        |
| Other                    income:                                                                                                                                                               |   |   |
|   Net gain on                    sale of loans                                                                                                                                       |   |   | **$**      | **326**                                        |   | $                                            | 227 |   | **$** | **527** |   | $ | 381 |
|   Trust                    fees                                                                                                                                                      |   |   | ** ** | **960**                                        |   |                                         | 870 |   | ** ** | **1,888** |   |   | 1,713 |
|   Service                    charges and fees                                                                                                                                        |   |   | ** ** | **2,020**                                      |   |                                         | 1,761 |   | ** ** | **3,731** |   |   | 3,333 |
|   Rental                    revenue on tax credit real estate                                                                                                                        |   |   | ** ** | **190**                                        |   |                                         | 190 |   | ** ** | **306** |   |   | 402 |
|   Other noninterest                    income                                                                                                                                        |   |   | ** ** | **640**                                        |   |                                         | 724 |   | ** ** | **1,313** |   |   | 1,398 |
|                                                                                                                                                                                                |        |
|                                                                                                                                                                                           |   |   | **$**      | **4,136**                                      |   | $                                            | 3,772 |   | **$** | **7,765** |   | $ | 7,227 |
|                                                                                                                                                                                                |        |
|                                                                                                                                                                                           |   |   |
| Other                    expenses:                                                                                                                                                             |   |   |       |                                           |   |                                         |   |   |   |   |   |   |   |
|   Salaries and                    employee benefits                                                                                                                                  |   |   | **$**      | **4,832**                                      |   | $                                            | 4,625 |   | **$** | **9,648** |   | $ | 9,102 |
|   Occupancy                                                                                                                                                                          |   |   | ** ** | **585**                                        |   |                                         | 543 |   | ** ** | **1,163** |   |   | 1,096 |
|   Furniture                    and equipment                                                                                                                                         |   |   | ** ** | **891**                                        |   |                                         | 824 |   | ** ** | **1,723** |   |   | 1,613 |
|   Office                    supplies and postage                                                                                                                                     |   |   | ** ** | **321**                                        |   |                                         | 359 |   | ** ** | **639** |   |   | 648 |
|   Advertising                    and business development                                                                                                                            |   |   | ** ** | **454**                                        |   |                                         | 520 |   | ** ** | **815** |   |   | 859 |
|   Outside                    services                                                                                                                                                |   |   | ** ** | **1,272**                                      |   |                                         | 1,249 |   | ** ** | **2,428** |   |   | 2,412 |
|   Rental                    expenses on tax credit real estate                                                                                                                       |   |   | ** ** | **240**                                        |   |                                         | 224 |   | ** ** | **491** |   |   | 465 |
|   Other                    noninterest expense                                                                                                                                       |   |   | ** ** | **326**                                        |   |                                         | 330 |   | ** ** | **626** |   |   | 601 |
|                                                                                                                                                                                                |        |
|                                                                                                                                                                                           |   |   | **$**      | **8,921**                                      |   | $                                            | 8,674 |   | **$** | **17,533** |   | $ | 16,796 |
|                                                                                                                                                                                                |        |
|                                    ** Income before income taxes**                                             |   |   | **$**      | **5,873**                                      |   | $                                            | 5,461 |   | **$** | **11,676** |   | $ | 11,204 |
| Income taxes                                                                                                                                                                                   |   |   | ** ** | **1,806**                                      |   |                                         | 1,671 |   | ** ** | **3,604** |   |   | 3,465 |
|                                                                                                                                                                                                |        |
|                                    ** Net income**                                                             |   |   | **$**      | **4,067**                                      |   | $                                            | 3,790 |   | **$** | **8,072** |   | $ | 7,739 |
|                                                                                                                                                                                                |        |
|                                                                                                                                                                                           |   |   |
| Earnings per                    share:                                                                                                                                                         |   |   |
|   Basic                                                                                                                                                                              |   |   | **$**      | **0.90**                                       |   | $                                            | 0.83 |   | **$** | **1.79** |   | $ | 1.70 |
|   Diluted                                                                                                                                                                            |   |   | ** ** | **0.90**                                       |   |                                         | 0.83 |   | ** ** | **1.78** |   |   | 1.69 |

 

See            Notes to Consolidated Financial Statements.

 

 

Page            4 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)            (Amounts In Thousands)

|                                                                                                             |        |        |            | Three Months Ended                    June 30, |            |        | Six Months Ended                    June 30, |        |
|-------------------------------------------------------------------------------------------------------------|--------|--------|------------|------------------------------------------------|------------|--------|----------------------------------------------|--------|
|                                                                                                             |        |        |            |                                                |            |   |
||
|                                                                                                             |   |
|                                                                                                        |   |   |       |                                           |       |   |                                         |   |   |   |   |   |   |   |
| Net                    income                                                                               |   |   | **$**      | **4,067**                                      |       | $      | 3,790                                        |   | **$** | **8,072** | ** ** | $ | 7,739 |   |
|                                                                                                             |        |        |            |                                                |            |   |
| **Other                    comprehensive loss:**                                                            |   |   |
|       Unrealized                    holding losses arising during the period, |   |   | **$**      | **(1,491**                                     | **)**      | $      | (1,347                                       | )      | **$** | **(1,159** | **)** | $ | (2,037 | ) |
|       Income                    tax effect of unrealized losses               |   |   | ** ** | **570**                                        | ** ** |   | 515                                          |   | ** ** | **443** | ** ** |   | 779 |   |
|                                                                                                             |        |        |            |                                                |            |   |
| **Other                    comprehensive loss**                                                             |   |   | **$**      | **(921**                                       | **)**      | $      | (832                                         | )      | **$** | **(716** | **)** | $ | (1,258 | ) |
|                                                                                                             |        |        |            |                                                |            |   |
| **Comprehensive                    income**                                                                 |   |   | **$**      | **3,146**                                      |       | $      | 2,958                                        |   | **$** | **7,356** | ** ** | $ | 6,481 |   |
|                                                                                                             |        |        |            |                                                |            |   |

See Notes to Consolidated            Financial Statements.

 

 

Page            5 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)            (Amounts In Thousands, Except Share Amounts)

|                                                                                                                                              |        |        | Paid In                    Capital |             | Retained                    Earnings |            | Accumulated                    Other                    Comprehensive                    Loss |            | Maximum                    Cash                    Obligation                    Related                    To ESOP                    Shares |             | Treasury                    Stock |            | Total       |            |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|------------------------------------|-------------|--------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------|------------|-------------|------------|
|                                                                                                                                              |
|                                                                                                                                         |   |   |                               |        |                                 |       |                                                                                          |       |                                                                                                                                          |        |                              |       |        |       |   |   |   |   |   |   |
| Balance, December 31, 2006                                                                                                                   |   |   | **$**                              | **12,364**  | ** **                           | **$**      | **131,852**                                                                                   | ** ** | **$**                                                                                                                                         | **(1,265**  | **)**                             | **$**      | **(20,940** | **)**      | **$** | **(3,372** | **)** | **$** | **118,639** | ** ** |
|    Issuance of 8,487                    shares of                         common stock               |   |   | ** **                         | **188**     | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **188** | ** ** |
|    Forfeiture of 476                    shares of                         common stock               |   |   | ** **                         | **(20**     | **)**                                | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **(20** | **)** |
|    Share-based                    compensation                                                                                |   |   | ** **                         | **18**      | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **18** | ** ** |
|    Income                    tax benefit related to                         share-based compensation |   |   | ** **                         | **93**      | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **93** | ** ** |
|    Change                    related to ESOP shares                                                                           |   |   | ** **                         | **—** | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **(826**    | **)**      | ** ** | **—** | ** ** | ** ** | **(826** | **)** |
|    Net                    income                                                                                              |   |   | ** **                         | **—** | ** **                           | ** ** | **8,072**                                                                                     | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **8,072** | ** ** |
|    Cash                    dividends ($.86 per share)                                                                         |   |   | ** **                         | **—** | ** **                           | ** ** | **(3,873**                                                                                    | **)**      | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **(3,873** | **)** |
|    Purchase of 14,628                    shares of                         common stock              |   |   | ** **                         | **—** | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **—** | ** **                        | ** ** | **—** | ** ** | ** ** | **(751** | **)** | ** ** | **(751** | **)** |
|    Other                    comprehensive loss                                                                                |   |   | ** **                         | **—** | ** **                           | ** ** | **—**                                                                                   | ** ** | ** **                                                                                                                                    | **(716**    | **)**                             | ** ** | **—** | ** ** | ** ** | **—** | ** ** | ** ** | **(716** | **)** |
|                                                                                                                                              |        |
| **Balance, June                    30, 2007**                                                                                                |   |   | **$**                              | **12,643**  | ** **                           | **$**      | **136,051**                                                                                   | ** ** | **$**                                                                                                                                         | **(1,981**  | **)**                             | **$**      | **(21,766** | **)**      | **$** | **(4,123** | **)** | **$** | **120,824** | ** ** |
|                                                                                                                                              |        |
|                                                                                                                                         |   |   |                               |        |                                 |       |                                                                                          |       |                                                                                                                                          |        |                              |       |        |       |   |   |   |   |   |   |
| Balance, December 31,                    2005                                                                                                |   |   | $                                  | 11,970      |                                 | $          | 119,989                                                                                       |       | $                                                                                                                                             | (1,783      | )                                 | $          | (20,634     | )          | $ | (63 | ) | $ | 109,479 |   |
|    Issuance of 2,803                    shares of                         common stock               |   |   |                               | 134         |                                 |       | —                                                                                       |       |                                                                                                                                          | —     |                              |       | —     |       |   | — |   |   | 134 |   |
|    Forfeiture of 1,180                    shares of                         common stock             |   |   |                               | (42         | )                                    |       | —                                                                                       |       |                                                                                                                                          | —     |                              |       | —     |       |   | — |   |   | (42 | ) |
|    Share-based                    compensation                                                                                |   |   |                               | 28          |                                 |       | —                                                                                       |       |                                                                                                                                          | —     |                              |       | —     |       |   | — |   |   | 28 |   |
|    Change                    related to ESOP shares                                                                           |   |   |                               | —     |                                 |       | —                                                                                       |       |                                                                                                                                          | —     |                              |       | 576         |       |   | — |   |   | 576 |   |
|    Net                    income                                                                                              |   |   |                               | —     |                                 |       | 7,739                                                                                         |       |                                                                                                                                          | —     |                              |       | —     |       |   | — |   |   | 7,739 |   |
|    Cash                    dividends ($.81 per share)                                                                         |   |   |                               | —     |                                 |       | (3,695                                                                                        | )          |                                                                                                                                          | —     |                              |       | —     |       |   | — |   |   | (3,695 | ) |
|    Purchase of 3,977                    shares of                         common stock               |   |   |                               | —     |                                 |       | —                                                                                       |       |                                                                                                                                          | —     |                              |       | —     |       |   | (188 | ) |   | (188 | ) |
|    Other                    comprehensive loss                                                                                |   |   |                               | —     |                                 |       | —                                                                                       |       |                                                                                                                                          | (1,258      | )                                 |       | —     |       |   | — |   |   | (1,258 | ) |
|                                                                                                                                              |        |
| Balance, June 30,                    2006                                                                                                    |   |   | $                                  | 12,090      |                                 | $          | 124,033                                                                                       |       | $                                                                                                                                             | (3,041      | )                                 | $          | (20,058     | )          | $ | (251 | ) | $ | 112,773 |   |
|                                                                                                                                              |        |

See Notes to Consolidated            Financial Statements.

 

 

Page            6 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)            (Amounts In Thousands)

|                                                                                                                                                                                                                                   |        |        |            | Six Months Ended                    June 30, |            |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|------------|----------------------------------------------|------------|
|                                                                                                                                                                                                                                   |        |   |
||
|                                                                                                                                                                                                                                   |   |
| Cash Flows                    from Operating Activities                                                                                                                                                                           |   |   |       |                                         |       |   |   |   |
|    Net                    income                                                                                                                                                                                   |   |   | **$**      | **8,072**                                    | ** ** | $ | 7,739 |   |
|    Adjustments to                    reconcile net income to net cash and                            cash equivalents provided by                    operating activities: |   |   |       |                                         |       |   |   |   |
|       Depreciation                                                                                                                                                                                  |   |   | ** ** | **1,146**                                    | ** ** |   | 1,170 |   |
|       Provision                    for loan losses                                                                                                                                                  |   |   | ** ** | **1,486**                                    | ** ** |   | 1,709 |   |
|       Share-based                    compensation                                                                                                                                                   |   |   | ** ** | **18**                                       | ** ** |   | 28 |   |
|       Forfeiture                    of common stock                                                                                                                                                 |   |   | ** ** | **(20**                                      | **)**      |   | (42 | ) |
|       Compensation                    expensed through issuance of common stock                                                                                                                     |   |   | ** ** | **92**                                       | ** ** |   | 134 |   |
|       Excess                    tax benefits from share-based compensation                                                                                                                          |   |   | ** ** | **(93**                                      | **)**      |   | — |   |
|       Provision                    for deferred income taxes                                                                                                                                        |   |   | ** ** | **(434**                                     | **)**      |   | (839 | ) |
|       Increase                    in accrued interest receivable                                                                                                                                    |   |   | ** ** | **(1,249**                                   | **)**      |   | (803 | ) |
|       Amortization                    of discount on investment securities, net                                                                                                                     |   |   | ** ** | **176**                                      | ** ** |   | 287 |   |
|       (Increase)                    decrease in other assets                                                                                                                                        |   |   | ** ** | **(249**                                     | **)**      |   | 747 |   |
|       Increase                    in accrued interest and other liabilities                                                                                                                         |   |   | ** ** | **1,374**                                    | ** ** |   | 400 |   |
|       Loans                    originated for sale                                                                                                                                                  |   |   | ** ** | **(61,286**                                  | **)**      |   | (49,706 | ) |
|       Proceeds                    on sales of loans                                                                                                                                                 |   |   | ** ** | **60,233**                                   | ** ** |   | 42,696 |   |
|       Net                    gain on sales of loans                                                                                                                                                 |   |   | ** ** | **(527**                                     | **)**      |   | (381 | ) |
|                                                                                                                                                                                                                                   |        |        |
|                             **Net cash and cash equivalents provided by operating                    activities**                                                                         |   |   | **$**      | **8,739**                                    | ** ** | $ | 3,139 |   |
|                                                                                                                                                                                                                                   |        |        |
|                                                                                                                                                                                                                              |   |   |       |                                         |       |   |   |   |
| Cash Flows from                    Investing Activities                                                                                                                                                                           |   |   |       |                                         |       |   |   |   |
|    Proceeds from                    maturities of investment securities:                                                                                                                                           |   |   |       |                                         |       |   |   |   |
|       Available                    for sale                                                                                                                                                         |   |   | **$**      | **18,462**                                   | ** ** | $ | 15,460 |   |
|       Held                    to maturity                                                                                                                                                           |   |   | ** ** | **45**                                       | ** ** |   | 45 |   |
|    Purchases of investment                    securities available for sale                                                                                                                                        |   |   | ** ** | **(29,120**                                  | **)**      |   | (10,074 | ) |
|    Loans                    made to customers, net of collections                                                                                                                                                  |   |   | ** ** | **(15,264**                                  | **)**      |   | (81,417 | ) |
|    Purchases of property                    and equipment                                                                                                                                                          |   |   | ** ** | **(686**                                     | **)**      |   | (1,058 | ) |
|    Investment in tax                    credit real estate, net                                                                                                                                                    |   |   | ** ** | **171**                                      | ** ** |   | 279 |   |
|                                                                                                                                                                                                                                   |        |        |
|                            ** Net cash used in investing activities**                                                                                                                     |   |   | **$**      | **(26,392**                                  | **)**      | $ | (76,765 | ) |
|                                                                                                                                                                                                                                   |        |        |
|                                                                                                                                                                                                                              |   |   |
| Cash Flows from                    Financing Activities                                                                                                                                                                           |   |   |       |                                         |       |   |   |   |
|    Net                    increase in deposits                                                                                                                                                                     |   |   | **$**      | **21,351**                                   | ** ** | $ | 36,446 |   |
|    Net                    increase (decrease) in short-term borrowings                                                                                                                                             |   |   | ** ** | **(6,048**                                   | **)**      |   | 33,250 |   |
|    Stock                    options exercised                                                                                                                                                                      |   |   | ** ** | **96**                                       | ** ** |   | — |   |
|    Excess                    tax benefits from share-based compensation                                                                                                                                            |   |   | ** ** | **93**                                       | ** ** |   | — |   |
|    Borrowings from                    FHLB                                                                                                                                                                         |   |   | ** ** | **30,000**                                   | ** ** |   | 15,000 |   |
|    Payments on FHLB                    borrowings                                                                                                                                                                  |   |   | ** ** | **(20,000**                                  | **)**      |   | (10,000 | ) |
|    Borrowings from                    FRB                                                                                                                                                                          |   |   | ** ** | **8,000**                                    | ** ** |   | — |   |
|    Purchase of treasury                    stock                                                                                                                                                                   |   |   | ** ** | **(751**                                     | **)**      |   | (188 | ) |
|    Dividends paid                                                                                                                                                                                                  |   |   | ** ** | **(3,873**                                   | **)**      |   | (3,695 | ) |
|                                                                                                                                                                                                                                   |        |        |
|                             **Net cash provided by financing activities**                                                                                                                 |   |   | **$**      | **28,868**                                   | ** ** | $ | 70,813 |   |
|                                                                                                                                                                                                                                   |        |   |

 

 

Page            7 of 35

 

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# HILLS            BANCORPORATION            CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued)            (Amounts In Thousands)

|                                                                                                                                                                                                                          |            | Six Months Ended                    June 30, |        |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|--------|
|                                                                                                                                                                                                                          |            |                                         |
||
|                                                                                                                                                                                                                          |       |
|                                                                                                                                                                                                                     |       |                                         |   |   |   |   |
| **Increase (decrease) in cash and                    cash equivalents**                                                                                                                                                  | **$**      | **11,215**                                   |   | $ | (2,813 | ) |
|                                                                                                                                                                                                                     |
| Cash and cash                    equivalents:                                                                                                                                                                            |
|    Beginning of                    year                                                                                                                                                                   | ** ** | **23,397**                                   |   |   | 29,956 |   |
|                                                                                                                                                                                                                          |            |                                         |
|    End of                    period                                                                                                                                                                       | **$**      | **34,612**                                   |   | $ | 27,143 |   |
|                                                                                                                                                                                                                          |            |                                         |
|                                                                                                                                                                                                                     |
| Supplemental                    Disclosures                                                                                                                                                                              |       |                                         |   |   |   |   |
|    Cash                    payments for:                                                                                                                                                                  |       |                                         |   |   |   |   |
|       Interest                    paid to depositors                                                                                                                                       | **$**      | **17,410**                                   |   | $ | 12,309 |   |
|       Interest                    paid on other obligations                                                                                                                                | ** ** | **6,919**                                    |   |   | 6,803 |   |
|       Income                    taxes paid                                                                                                                                                 | ** ** | **3,980**                                    |   |   | 4,336 |   |
|                                                                                                                                                                                                                     |
|    Noncash financing                    activities:                                                                                                                                                       |       |                                         |   |   |   |   |
|       Increase                    (decrease) in maximum cash obligation                             related to ESOP                    shares | **$**      | **826**                                      |   | $ | (576 | ) |
|                                                                                                                                                                                                                          |

See Notes to Consolidated            Financial Statements.

 

 

Page            8 of 35

 

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**HILLS BANCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

| **Note 1.** | **Basis of Presentation** |
|-------------|---------------------------|

 

The            accompanying unaudited consolidated financial statements have been prepared in            accordance with accounting principles generally accepted in the United States of            America for interim financial reporting and with instructions for Form 10-Q and            Regulation S-X. These financial statements include all adjustments (consisting of            normal recurring accruals) which in the opinion of management are considered necessary            for the fair presentation of the financial position and results of operations for the            periods shown. Certain prior year amounts may be reclassified to conform to the current            year presentation.

             

Operating results for the six month period ended June 30, 2007 are not            necessarily indicative of the results that may be expected for the fiscal year ending            December 31, 2007. For further information, refer to the consolidated financial            statements and footnotes thereto included in the Form 10-K Annual Report of Hills            Bancorporation and subsidiary (the “Company”) for the year ended December            31, 2006 filed with the Securities Exchange Commission on March 9, 2007.

 

| **Note 2.** | **Earnings Per Share** |
|-------------|------------------------|

 

Basic            earnings per share amounts are computed by dividing net income (the numerator) by the            weighted average number of common shares outstanding (the denominator) during the            period. Diluted per share amounts assume the conversion, exercise or issuance of all            potential common stock equivalents unless the effect is to reduce the loss or increase            the income per common share from continuing operations.

             

The            computation of basic and diluted earnings per share for the periods presented is as            follows:

             

|                                                                                                                                                                                                                            |        |        |        | Three months ended                    June 30, |        |        | Six months ended                    June 30, |        |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|------------------------------------------------|--------|--------|----------------------------------------------|--------|
|                                                                                                                                                                                                                            |        |        |        |                                           |        |        |                                              |   |
||
|                                                                                                                                                                                                                            |        |        |        |                                           |        |        |                                              |   |
|                                                                                                                                                                                                                       |   |   |   |                                           |   |   |                                         |   |   |   |   |   |   |   |
| Common                    shares outstanding at the beginning of the period                                                                                                                                                |   |   |   | 4,497,275                                      |   |   | 4,559,350                                    |   |   | 4,503,738 |   |   | 4,562,237 |   |
| Weighted average number                    of net shares issued (redeemed)                                                                                                                                                 |   |   |   | 1,994                                          |   |   | 73                                           |   |   | 270 |   |   | (1,928 | ) |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |
|                             **Weighted average shares outstanding (basic)**                                                                                                        |   |   |   | 4,499,269                                      |   |   | 4,559,423                                    |   |   | 4,504,008 |   |   | 4,560,309 |   |
| Weighted average of                    potential dilutive shares                       attributable to stock options granted, computed under                       the treasury stock method |   |   |   | 26,945                                         |   |   | 27,373                                       |   |   | 27,130 |   |   | 27,493 |   |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |
|                            ** Weighted average number of shares (diluted)**                                                                                                        |   |   |   | 4,526,214                                      |   |   | 4,586,796                                    |   |   | 4,531,138 |   |   | 4,587,802 |   |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |
|                                                                                                                                                                                                                            |        |        |   |                                           |
| Net income (In                    Thousands)                                                                                                                                                                               |   |   | $      | 4,067                                          |   | $      | 3,790                                        |   | $ | 8,072 |   | $ | 7,739 |   |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |
|                                                                                                                                                                                                                       |   |   |
| Earnings per                    share:                                                                                                                                                                                     |   |   |   |                                           |   |   |                                         |   |   |   |   |   |   |   |
|    Basic                                                                                                                                                                                                    |   |   | $      | 0.90                                           |   | $      | 0.83                                         |   | $ | 1.79 |   | $ | 1.70 |   |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |
|    Diluted                                                                                                                                                                                                  |   |   | $      | 0.90                                           |   | $      | 0.83                                         |   | $ | 1.78 |   | $ | 1.69 |   |
|                                                                                                                                                                                                                            |        |   |        |                                           |        |   |                                              |   |

| **Note 3.** | **Recent Accounting Pronouncements** |
|-------------|--------------------------------------|

 

In            March 2006, the FASB issued FASB Statement No. 156 (“FAS 156”),*Accounting for Servicing of Financial Assets and amendment of FASB            Statement No. 140 (“FAS 140”), Accounting for Transfers and Extinguishment            of Liabilities.*FAS 156 requires that all separately            recognized servicing assets and servicing liabilities be initially measured at fair            value, if practicable. The Company elected the fair value measurement method with            changes in fair value reflected in earnings for subsequent measurements. FAS 156 was            effective for the Company as of January 1, 2007. The adoption of this statement did not            have a significant effect on the Company’s financial statements.

 

 

 

Page            9 of 35

 

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**HILLS BANCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(Unaudited)**

 

| **Note 3.** | **Recent Accounting Pronouncements                            (continued)** |
|-------------|-----------------------------------------------------------------------------|

 

In July            2006, the FASB issued FASB Interpretation No. 48,*Accounting            for Uncertainty in Income Taxes.*FIN 48 requires that the            Company recognize in its financial statements, the impact of a tax position if that            position is more likely than not of being sustained on audit based on the technical            merits of the position. The provisions of FIN 48 were effective as of January 1, 2007.            The adoption of the Interpretation did not have a significant effect on the            Company’s financial statements. See Footnote 7.

 

In            September 2006, the FASB issued FASB Statement No. 157,*Fair            Value Measurements.*The Statement provides a single            definition of fair value, a framework for measuring fair value and expanded disclosures            concerning fair value. Previously, different definitions of fair value were contained            in various accounting pronouncements that prescribe fair value as the relevant measure            of value, except FAS 123R and related interpretation and pronouncements that require or            permit measurement similar to fair value but are not intended to measure fair value.            The Statement is effective for financial statements issued for year beginning after            November 15, 2007. The Company is currently evaluating the impact that the Statement            will have on its consolidated financial statements.

 

In            February 2007, the FASB issued FASB Statement No. 159,*The            Fair Value Option for Financial Assets and Financial Liabilties – Including an            Amendment of FASB Statement No. 115*(“FAS 159). FAS 159            permits companies to choose to measure many financial instruments and certain other            items at fair value that are not currently required to be measured at fair value. The            objective of FAS 159 is to provide opportunities to mitigate volatility in reported            earnings caused by measuring related assets and liabilities differently without having            to apply hedge accounting provisions. FAS 159 also establishes presentation and            disclosure requirements designed to facilitate comparisons between companies that            choose different measurement attributes for similar types of assets and liabilities.            The Statement is effective for financial statements issued for the year beginning after            November 15, 2007. The Company is currently evaluating the impact that the Statement            will have on its consolidated financial statements.

 

| **Note 4.** | **Employee Benefit Plans** |
|-------------|----------------------------|

 

The            Company has a Stock Option and Incentive Plan for certain key employees and directors            whereby shares of common stock have been reserved for awards in the form of stock            options or restricted stock awards. Under the plan, the aggregate number of options and            shares granted cannot exceed 198,000 shares. A Stock Option Committee may grant options            at prices equal to the fair value of the stock at the date of the grant. Options expire            10 years from the date of the grant. Director options granted on or before December 31,            2006 may be exercised immediately. Director options granted on or after January 1, 2007            and officers’ rights under the plan vest over a five-year period from the date of            the grant.

 

Information concerning the issuance of stock options is presented in the            following table:

|                                                         |        |        |        | Options |        |        | Weighted-Average                    Exercise Price |        |        | Weighted-Average Remaining                    Contractual Term (years) |        |        | Aggregate                    Intrinsic Value                    (In Thousands) |        |
|---------------------------------------------------------|--------|--------|--------|---------|--------|--------|----------------------------------------------------|--------|--------|------------------------------------------------------------------------|--------|--------|--------------------------------------------------------------------------------|--------|
|                                                         |   |
| Outstanding                    at January 1, 2007       |   |   |   | 57,195  |   |   | $26.79                                             |   |   | 4.88                                                                   |   |   | $1,532                                                                         |   |
|                                                         |   |
| Options outstanding at                    June 30, 2007 |   |   |   | 55,110  |   |   |   30.36                                  |   |   | 5.35                                                                   |   |   |   1,673                                                              |   |
|                                                         |   |
| Options exercisable at                    June 30, 2007 |   |   |   | 31,930  |   |   |   27.45                                  |   |   | 4.53                                                                   |   |   |     876                                                    |   |
|                                                         |   |

Options            for 4,580 shares of stock were granted during the second quarter of 2007. The            weighted-average value of the options granted was $16.98 per share.

 

 

Page            10 of 35

 

----

 

 

**HILLS BANCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(Unaudited)**

 

| **Note 4.** | **Employee Benefit Plans (continued)** |
|-------------|----------------------------------------|

 

The            fair value of each option is estimated as of the date of grant using a Black-Scholes            option pricing model. The expected lives of options granted incorporate historical            employee exercise behavior. The risk-free rate for periods that coincide with the            expected life of the options is based on the annual 10 year interest rate swap rate as            published by the Federal Reserve Bank. Expected volatility is based on volatility            levels of the Company’s peer’s common stock as the Company’s stock            has limited trading activity. Expected dividend yield was based a set dividend rate.            Significant assumptions related to the options granted in 2007 include:

|   |                                         |                 |        |
|--------|-----------------------------------------|-----------------|--------|
|   | Risk-free interest rate                 | 5.21%      |   |
|   | Expected option                    life | 7.5 years  |   |
|   | Expected volatility                     | 25.33%     |   |
|   | Expected                    dividends   | 1.69%      |   |

 

At June            30, 2007, 115,635 shares were available for issuance under the plan. Stock options for            6,665 shares with a weighted-average exercise price of $14.57 were exercised during the            six months ended June 30, 2007. The intrinsic value of the options exercised was            $97,088.

 

As of            June 30, 2007, there was $34,472 in unrecognized compensation cost for stock options            granted under the plan compared to $52,600 as of June 30, 2006. This unrecognized cost            is expected to be recognized over a weighted-average period of 1.49 years.

 

| **Note 5.** | **Stock Repurchase Program** |
|-------------|------------------------------|

 

In July            of 2005, the Company’s Board of Directors authorized a program to repurchase up            to a total of 750,000 shares of the Company’s common stock (the “2005 Stock            Repurchase Program”). This authorization will expire on December 31, 2009. The            Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made            from time to time in private transactions at a price equal to the most recent quarterly            independent appraisal of the shares of the Company’s common stock and with the            Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly            basis. The amount and timing of stock repurchases will be based on various factors,            such as the Board’s assessment of the Company’s capital structure and            liquidity, the amount of interest shown by shareholders in selling shares of stock to            the Company at their appraised value, and applicable regulatory and legal factors. The            Company has purchased 82,549 shares of its common stock in privately negotiated            transactions from August 1, 2005 through June 30, 2007. Of these 82,549 shares, 6,683            shares were purchased during the quarter ended June 30, 2007, at an average price per            share of $51.98.

 

 

Page            11 of 35

 

----

 

**HILLS BANCORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

**(Unaudited)**

 

| **Note 6.** | **Commitments and Contingencies** |
|-------------|-----------------------------------|

 

The            Company’s subsidiary, Hills Bank and Trust (the “Bank”) is a party to            financial instruments with off-balance–sheet risk in the normal course of            business to meet the financing needs of its customers. These financial instruments            include commitments to extend credit, credit card participations and standby letters of            credit. These instruments involve, to varying degrees, elements of credit risk in            excess of the amount recognized in the consolidated balance sheets.

 

The            Bank’s exposure to credit loss in the event of nonperformance by the other party            to the financial instrument for commitments to extend credit, credit card            participations and standby letters of credit is represented by the contractual amount            of those instruments. The Bank uses the same credit policies in making commitments and            conditional obligations as it does for on-balance sheet instruments. A summary of the            Bank’s commitments at June 30, 2007 and December 31, 2006 is as            follows:

 

|                                                                                      |        |        |       | **June 30,                            2007** |        |        | December 31,                            2006 |        |
|--------------------------------------------------------------------------------------|--------|--------|------------|----------------------------------------------|--------|--------|----------------------------------------------|--------|
|                                                                                      |        |        |            |
| (Amounts In                            Thousands)                                    |
| Firm loan                    commitments and unused portion of lines of credit:      |   |   |       |                                         |   |   |                                         |   |
|    Home                    equity loans                               |   |   | **$**      | **20,149**                                   |   | $      | 18,796                                       |   |
|    Credit                    card participations                      |   |   | ** ** | **29,879**                                   |   |   | 28,091                                       |   |
|    Commercial, real estate                    and home construction   |   |   | ** ** | **82,967**                                   |   |   | 83,699                                       |   |
|    Commercial lines and                    real estate purchase loans |   |   | ** ** | **98,776**                                   |   |   | 70,200                                       |   |
| Outstanding letters of                    credit                                     |   |   | ** ** | **9,965**                                    |   |   | 10,107                                       |   |

 

Commitments for commercial and real estate loans increased $28.6 million            since December 31, 2006. The majority of this increase is due to the volume of            residential real estate loan commitments as of June 30, 2007. Real estate loan            commitments were $34.9 million at June 30, 2007 and $3.6 million at December 31, 2006,            an increase of $21.3 million.

 

| **Note 7.** | **Income Taxes** |
|-------------|------------------|

 

Federal            income tax expense for the six months ended June 30, 2007 and 2006 was computed using            the consolidated effective federal tax rate. The Company also recognized income tax            expense pertaining to state franchise taxes payable individually by the subsidiary            bank. On January 1, 2007, the Company adopted FIN 48,*Accounting for Uncertainty in Income Taxes.*The evaluation was performed for those tax years which remain open to            audit. The Company files a consolidated tax return for federal purposes and separate            tax returns for the State of Iowa purposes. The tax years ended December 31, 2006, 2005            and 2004, remain subject to examination by the Internal Revenue Service. For state tax            purposes, the tax years ended December 31, 2006, 2005 and 2004, remain open for            examination. As a result of the implementation of FIN 48, the Company did not recognize            any increase or decrease for unrecognized tax benefits. There were no material            unrecognized tax benefits on January 1, 2007 and June 30, 2007. No interest or            penalties on these unrecognized tax benefits has been recorded. As of June 30, 2007,            the Company does not anticipate any significant increase or decrease in unrecognized            tax benefits during the remainder of 2007.

 

 

Page            12 of 35

 

----

**HILLS BANCORPORATION**

 

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

 

The            following is management’s discussion and analysis of the financial condition of            Hills Bancorporation (“Hills Bancorporation” or “the Company”)            and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for            the dates and periods indicated. The discussion and analysis should be read in            conjunction with the consolidated financial statements and the accompanying            footnotes.

 

**Special Note Regarding Forward Looking Statements**

 

This            report contains, and future oral and written statements of the Company 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            the Company. Actual results may differ materially from those included in the            forward-looking statements. Forward-looking statements, which may be based upon            beliefs, expectations and assumptions of the Company’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 the Company            undertakes no obligation to update any statement in light of new information or future            events.

 

The            Company’s ability to predict results or the actual effect of future plans or            strategies is inherently uncertain. Factors which could have a material adverse effect            on the operations and future prospects of the Company include, but are not limited to,            the following:

 

|   | **•** | The strength of the United States economy in general and                            the strength of the local economies in which the Company conducts its                            operations which may be less favorable than expected and may result in,                            among other things, a deterioration in the credit quality and value of                            the Company’s assets. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The effects of, and changes in, laws, regulations and                            policies affecting banking, securities, insurance and monetary and                            financial matters as well as any laws otherwise affecting the                            Company. |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The effects of changes in interest rates (including the                            effects of changes in the rate of prepayments of the Company’s                            assets) and the policies of the Board of Governors of the Federal                            Reserve System. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The ability of the Company to compete with other                            financial institutions as effectively as the Company currently intends                            due to increases in competitive pressures in the financial services                            sector. |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The ability of the Company to obtain new customers and                            to retain existing customers. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The timely development and acceptance of products and                            services, including products and services offered through alternative                            delivery channels such as the Internet. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | Technological changes implemented by the Company and by                            other parties, including third party vendors, which may be more                            difficult or more expensive than anticipated or which may have                            unforeseen consequences to the Company and its customers. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The ability of the Company to develop and maintain                            secure and reliable electronic systems. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------|

 

 

Page            13 of 35

 

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**HILLS BANCORPORATION**

 

| **Item                    2.** | **Management’s                    Discussion and Analysis of Financial Condition And Results of Operations                    (continued)** |
|--------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | The ability of the Company to retain key executives and                            employees and the difficulty that the Company may experience in                            replacing key executives and employees in an effective                            manner. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | Consumer spending and saving habits which may change in                            a manner that affects the Company’s business                            adversely. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The economic impact of terrorist attacks and military                            actions. |
|--------|------------|-------------------------------------------------------------------------------------------|

             

|   | **•** | Business combinations and the integration of acquired                            businesses and assets which may be more difficult or expensive than                            expected. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The costs, effects and outcomes of existing or future                            litigation. |
|--------|------------|----------------------------------------------------------------------------------------------|

             

|   | **•** | Changes in accounting policies and practices, as may be                            adopted by state and federal regulatory agencies and the Financial                            Accounting Standards Board. |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | The ability of the Company to manage the risks                            associated with the foregoing as well as anticipated. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------|

             

These            risks and uncertainties should be considered in evaluating forward-looking statements            and undue reliance should not be placed on such statements. Additional information            concerning the Company and its business, including other factors that could materially            affect the Company’s financial results, is included in the Company’s            filings with the Securities and Exchange Commission.

 

**Critical Accounting Policies**

 

The            Company’s financial statements are prepared in accordance with accounting            principles generally accepted in the United States of America. The financial            information contained within these statements is, to a significant extent, financial            information that is based on approximate measures of the financial effects of            transactions and events that have already occurred. Based on its consideration of            accounting policies that involve the most complex and subjective decisions and            assessments, management has identified its most critical accounting policies to be            those which are related to the allowance for loan losses. The Company’s allowance            for loan loss methodology incorporates a variety of risk considerations, both            quantitative and qualitative in establishing an allowance for loan loss that management            believes is appropriate at each reporting date. Quantitative factors include the            Company’s historical loss experience, delinquency and charge-off trends,            collateral values, changes in non-performing loans, and other factors. Quantitative            factors also incorporate known information about individual loans, including            borrowers’ sensitivity to interest rate movements. Qualitative factors include            the general economic environment in the Company’s markets, including economic            conditions throughout the Midwest and in particular, the state of certain industries.            Size and complexity of individual loans in relation to loan structure, existing loan            policies and pace of portfolio growth are other qualitative factors that are considered            in the methodology. As the Company adds new products and increases the complexity of            its loan portfolio, it will enhance its methodology accordingly. This discussion and            analysis should be read in conjunction with the Company’s financial statements            and the accompanying notes presented elsewhere herein, as well as the            Management’s Discussion and Analysis of Financial Condition and Results of            Operation that is included. Although management believes the levels of the allowance as            of June 30, 2007 and December 31, 2006 were adequate to absorb probable losses inherent            in the loan portfolio, a decline in local economic conditions, or other factors, could            result in increasing losses that cannot be reasonably predicted at this            time.

 

 

Page            14 of 35

 

----

 

**HILLS BANCORPORATION**

 

**Item            2.   Management’s Discussion and Analysis of Financial Condition And            Results of Operations (continued)**

 

**Overview**

 

The            Company is a holding company engaged in the business of commercial banking. The            Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the            “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904.            The Bank is a full-service commercial bank extending its services to individuals,            businesses, governmental units and institutional customers primarily in the communities            of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona, Wellman, Cedar            Rapids and Marion, Iowa. At June 30, 2007, the Bank has thirteen full-service            locations.

 

Net            income for the six-month period ended June 30, 2007 was $8.07 million compared to $7.74            million for the same six months of 2006, an increase of 4.30%. The $472,000 increase in            net income before income taxes is due to the combined result of an increase in net            interest income of $448,000, other income of $538,000, the decrease in the provision            for loan losses of $223,000 and expenses increasing $737,000. Return on average equity            was 13.49% for the six months ended June 30, 2007 compared to 14.07% for the same            period in 2006. Return on average assets was 1.03% in 2007 compared to 1.06% in 2006.            Dividends of $.86 per share were paid in January 2007 to 1,535 shareholders. The 2007            dividend was a 6.17% increase over the prior year’s dividend of $.81 per            share.

 

The            Bank’s net interest income is the largest component of revenue and it is            primarily a function of the average earnings assets and the net interest margin            percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.23%            compared to 3.39% in 2006. Average earning assets were $1.491 billion in 2007 and            $1.391 billion in 2006.

 

Highlights noted on the balance sheet as of June 30, 2007 for the            Company included the following:

| **•** | Total assets are over $1.5 billion, at $1.589                            billion. |
|------------|-----------------------------------------------------------------------------------|

| **•** | Net loans are $1.298 billion. |
|------------|-------------------------------|

| **•** | Loan growth of $15.4 million since December 31,                            2006. |
|------------|----------------------------------------------------------------------------------|

| **•** | Deposit growth of $21.4 million since December 31,                            2006. |
|------------|-------------------------------------------------------------------------------------|

 

A detailed discussion of the financial condition and results of            operations follows this overview.

 

**Financial Condition**

 

The            asset growth for the six months ended June 30, 2007 of $37.7 million included a net            loan increase of $15.4 million, an increase in federal funds sold of $8.1 million and            an increase in investment securities of $8.8 million. The upward movement of the            federal funds target rate started on June 30, 2004 when the rate was increased from            1.00% to 1.25%; the rate increased 17 times to 5.25% at June 30, 2007. The Federal            Reserve Open Market Committee has not changed the target rate at its eight meetings            since June 29, 2006. Interest rates on loans are generally affected by these increases            since interest rates for the U.S. Treasury market normally increase when the Federal            Reserve Board raises the federal funds target rate. In pricing of loans and deposits,            the Bank considers the U.S. Treasury indexes as benchmarks in determining interest            rates. Increases in interest rates may at some point materially reduce the loan demand            and slow the economy, but at the current interest rate levels, demand for loans remains            good. The overall economy in the Company’s principal place of business, Johnson            and Linn Counties, remains good with unemployment levels that remain low.

 

 

Page            15 of 35

 

----

**HILLS BANCORPORATION**

 

**Item            2.  Management’s Discussion and Analysis of Financial Condition And Results            of Operations (continued)**

 

The            tables below set forth the composition of the loan portfolio as of June 30, 2007 and            December 31, 2006 (dollars in thousands), along with changes in the allowance for loan            losses and non-performing loan information: 

 

|                                              |                                                   |        |                                                   |        | June 30, 2007 |        |        | December 31, 2006 |        |
|---------------------------------------------------|---------------------------------------------------|--------|---------------------------------------------------|--------|---------------|--------|--------|-------------------|--------|
|                                                   |                                                   |        |                                                   |        |               |        |        |                   |
||
|                                                   |                                                   |        |                                                   |        |               |        |        |                   |
| (Amounts In                            Thousands) |                                                   |        | (Amounts In                            Thousands) |
|                                              |                                              |   |                                              |   |          |   |   |              |   |   |   |   |   |   |   |
|                                              | Agricultural                                      |   |                                              | $      | 48,334        |   |   | 3.68              | %      | $ | 49,223 |   |   | 3.80 | % |
|                                              | Commercial and                    financial       |   |                                              |   | 130,500       |   |   | 9.95              |   |   | 118,339 |   |   | 9.12 |   |
|                                              | Real estate:                                      |   |                                              |   |          |   |   |              |   |   |   |   |   |   |   |
|                                              |    Construction                    |   |                                              |   | 109,163       |   |   | 8.32              |   |   | 114,199 |   |   | 8.80 |   |
|                                              |    Mortgage                        |   |                                              |   | 995,181       |   |   | 75.86             |   |   | 983,489 |   |   | 75.83 |   |
|                                              | Loans to                    individuals           |   |                                              |   | 28,677        |   |   | 2.19              |   |   | 31,827 |   |   | 2.45 |   |
|                                                   |                                                   |        |                                                   |        |               |        |        |                   |
|                                              |                                              |   |                                              | $      | 1,311,855     |   |   | 100.00            | %      | $ | 1,297,077 |   |   | 100.00 | % |
|                                                   |                                                   |        |                                                   |        |          |        |        |                   |
|                                              | Less allowance for loan                    losses |   |                                              |   | 18,850        |   |   |              |   |   | 17,850 |   |   |   |   |
|                                                   |                                                   |        |                                                   |        |               |   |        |
|                                              |                                              |   |                                              | $      | 1,293,005     |   |   |              |   | $ | 1,279,227 |   |   |   |   |
|                                                   |                                                   |        |                                                   |        |               |   |        |

Loan            growth of $12.2 million in commercial and financial loans is due to extensions of            credit to existing customers.

 

The            Bank has an established formal loan origination policy. In general, the loan            origination policy attempts to reduce the risk of credit loss to the Bank by requiring            that, among other things, maintenance of minimum loan to value ratios, evidence of            appropriate levels of insurance carried by borrowers and documentation of appropriate            types and amounts of collateral and sources of expected payment.

 

Changes            in the allowance for loan losses for the periods shown in the following table were as            follows:

 

|                                              |                                                                         |        |                                                   |        | Three Months Ended                    June 30, |        |        | Six Months Ended                    June 30, |        |
|---------------------------------------------------|-------------------------------------------------------------------------|--------|---------------------------------------------------|--------|------------------------------------------------|--------|--------|----------------------------------------------|--------|
|                                                   |                                                                         |        |                                                   |        |                                                |        |        |                                              |
||
|                                                   |                                                                         |        |                                                   |        |                                                |        |        |                                              |
| (Amounts In                            Thousands) |                                                                         |        | (Amounts In                            Thousands) |
|                                              |                                                                    |   |                                              |   |                                           |   |   |                                         |   |   |   |   |   |   |   |
|                                              | Balance,                    beginning                                   |   |                                              | $      | 18,410                                         |   | $      | 16,150                                       |   | $ | 17,850 |   | $ | 15,360 |   |
|                                              |     Provision charged                    to expense |   |                                              |   | 954                                            |   |   | 1,054                                        |   |   | 1,486 |   |   | 1,709 |   |
|                                              |     Recoveries                                      |   |                                              |   | 259                                            |   |   | 281                                          |   |   | 723 |   |   | 781 |   |
|                                              |     Loans charged                    off            |   |                                              |   | (773                                           | )      |   | (385                                         | )      |   | (1,209 | ) |   | (750 | ) |
|                                                   |                                                                         |        |                                                   |        |                                                |        |        |                                              |
|                                              | Balance, ending                                                         |   |                                              | $      | 18,850                                         |   | $      | 17,100                                       |   | $ | 18,850 |   | $ | 17,100 |   |
|                                                   |                                                                         |        |                                                   |        |                                                |        |        |                                              |

 

Non-performing loan information at June 30, 2007 and December 31, 2006,            was as follows:

 

|                   |                                                                      |        |        |        | June 30, 2007 |        |         | December 31, 2006 |        |
|------------------------|----------------------------------------------------------------------|--------|--------|--------|---------------|--------|---------|-------------------|--------|
|                        |                                                                 |   |        |
| (Amounts in thousands) |
|                   |                                                                 |   |   |   |          |   |    |              |   |
|                   | Non-accrual                    loans                                 |   |   | $      | 651           |   | $  | 879               |   |
|                   |                                                                 |   |   |   |          |   |    |              |   |
|                   | Accruing loans past due                    ninety days or more       |   |   |   | 5,735         |   |    | 4,983             |   |
|                   |                                                                 |   |   |   |          |   |    |              |   |
|                   | Restructured                    loans                                |   |   |   | —       |   |    | —           |   |
|                   |                                                                 |   |   |   |          |   |    |              |   |
|                   | Non-performing loans                    (includes non-accrual loans) |   |   |   | 34,921        |   |    | 14,681            |   |

 

 

Page            16 of 35

 

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**HILLS BANCORPORATION**

 

**Item            2.  Management’s Discussion and Analysis of Financial Condition And            Results of Operations (continued)**

 

Non-performing loans increased by $20.2 million from December 31, 2006            to June 30, 2007. Non-performing loans include any loan that has been placed on            nonaccrual status. Non-performing loans also include loans that based on            management’sevaluation of current information and events,            the Bank expects to be unable to collect in full according to the contractual terms of            the original loan agreement. These loans are also considered impaired loans. This            increase in non-performing loans is due to deterioration in the credit quality of four            borrower relationships having an aggregate balance of approximately $19.2 million as of            June 30, 2007. The Bank believes these loans are adequately collateralized by real            estate.

 

Federal            funds sold increased from zero at December 31, 2006 to $8.1 million at June 30, 2007.            Deposit growth of $21.4 million exceeded the funds required for loan growth.

 

The            estimated fair value of the investment securities held by the Company increased by $8.8            million from December 31, 2006 to June 30, 2007. This increase resulted from purchases            of securities of approximately $10.0 million in excess of maturities during the            six-month period ended June 30, 2007. The purchases were offset by a decline in the            market value of securities available for sale of $1.2 million since December 31, 2006.            The carrying values of investment securities for June 30, 2007 and December 31, 2006            are summarized in the following table (dollars in thousands):

 

|   |                                                                                                                         |        |        |        | June 30, 2007 |        |        | December 31,                    2006 |        |
|--------|-------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|---------------|--------|--------|--------------------------------------|--------|
|        |                                                                                                                         |        |        |        |               |        |        |
||
|        |                                                                                                                         |        |        |        |               |        |        |
|   | **Securities available for                    sale**                                                                    |   |   |   |          |   |   |                                 |   |   |   |   |   |   |   |
|   |                                                                                                                    |   |   |   |          |   |   |                                 |   |   |   |   |   |   |   |
|   | U.S. Government                    agencies                       and corporations                       |   |   | $      | 102,061       |   |   | 54.62                                | %      | $ | 94,068 |   |   | 52.83 | % |
|   |                                                                                                                    |   |   |   |          |   |   |                                 |   |   |   |   |   |   |   |
|   | State and political                       subdivisions                                                   |   |   |   | 84,796        |   |   | 45.38                                |   |   | 83,989 |   |   | 47.17 |   |
|        |                                                                                                                         |        |        |        |               |        |        |
|   |                                                                                                                    |   |   |   |          |   |   |                                 |   |   |   |   |   |   |   |
|   | Total securities                       available for sale                                                |   |   | $      | 186,857       |   |   | 100.00                               | %      | $ | 178,057 |   |   | 100.00 | % |
|        |                                                                                                                         |        |        |        |               |        |        |
|   |                                                                                                                    |   |   |
|   | **Securities held                    to maturity**                                                                      |   |   |   |          |   |   |                                 |   |   |   |   |   |   |   |
|   |    State                    and political                          subdivisions |   |   | $      | 125           |   |   | 100.00                               | %      | $ | 170 |   |   | 100.00 | % |
|        |                                                                                                                         |        |        |        |               |        |        |

 

Deposit            growth was $21.4 million in the first six months of 2007. Repurchase agreements            decreased $3.8 million in the same period. Short-term borrowings at December 31, 2006            included federal funds purchased that decreased $2.2 million to $8.5 million as of June            30, 2007. The borrowings from the Federal Home Loan Bank (FHLB) decreased by $20            million with the maturity in June 2007 of an advance with the interest rate of 4.48%.            The Company borrowed an additional $30 million in June 2007. One $15 million advance is            at a rate of 4.62% for ten years and is callable in one year. The second $15 million            advance is at a rate of 4.89% for ten years that is callable in three years. The            Company also borrowed $8 million from the Federal Reserve Bank on June 29, 2007. These            funds were a short-term borrowing at 6.25% and were repaid on July 2, 2007. In the            opinion of the Company’s management, the Company continues to have sufficient            liquidity resources available to fund expected additional loan growth.

 

 

Page            17 of 35

 

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**HILLS BANCORPORATION**

 

**Item            2.  Management’s Discussion and Analysis of Financial Condition And            Results of Operations (continued)**

 

**Dividends and Equity**

 

In            January 2007, Hills Bancorporation paid a dividend of $3,873,000 or $.86 per share, a            6.17% increase from the $.81 per share paid in January 2006. After payment of the            dividend and the adjustment for accumulated other comprehensive income,            stockholders’ equity as of June 30, 2007 totaled $120.8 million. Under risk-based            capital rules, the total amount of risk based capital of the Company as of June 30,            2007, was 12.75% of risk-adjusted assets, and is substantially in excess of the            required minimum of 8.00%. Risk-based capital was 13.38% and 13.31% as of June 30 and            December 31, 2006, respectively. As of June 30, 2007, the most recent notifications            from the Federal Reserve System categorized the Bank as well capitalized under the            regulatory framework for prompt corrective action. There are no conditions or events            since that notification that management believes have changed the Company’s            category.

 

**Discussion of operations for the six months ended June 30, 2007            and 2006** 

 

**Net            Income Overview**

 

Net            income increased $333,000 for the six months ended June 30, 2007 compared to the first            six months of 2006. Total net income was $8,072,000 in 2007 and $7,739,000 in the            comparable period in 2006. The changes in net income in 2007 from the first six months            of 2006 were the result of the following:

 

| **•** | Net interest income increased by $448,000. |
|------------|--------------------------------------------|

| **•** | The provision for loan losses decreased by                            $223,000. |
|------------|---------------------------------------------------------------------------------|

| **•** | Other income increased by $538,000. |
|------------|-------------------------------------|

| **•** | Other expenses increased by $737,000. |
|------------|---------------------------------------|

| **•** | Income taxes increased by $139,000. |
|------------|-------------------------------------|

 

For the            six-month periods ended June 30, 2007 and 2006, basic earnings per share were $1.79 and            $1.70, respectively. Diluted earnings per share were $1.78 for the six months ended            June 30, 2007 compared to $1.69 for the same period in 2006.

 

Quarterly fluctuations in the Company’s net income continue to be            driven primarily by two important factors. The first important factor is the            interaction between changes in net interest margin and changes in average earnings            assets. Net interest income of $22.9 million for the first six months of 2007 was            derived from the Company’s $1.491 billion of average earning assets during that            period and its net interest margin of 3.23%. Average earning assets in the six months            ending June 30, 2006 were $1.391 billion and the net interest margin was 3.39%. The            margin compression was the result of the continued flattening of the yield curve and            pricing pressure on loans and short-term deposits. The importance of net interest            margin is illustrated by the fact that a decrease in the net interest margin of 10            basis points to 3.13% would have resulted approximately in a $739,000 decrease in            income before income taxes in the six month period ending June 30, 2007. Similarly, an            increase in the net interest margin of 10 basis points to 3.33% would have resulted in            approximately a $739,000 increase in net interest income before taxes. Despite the            decline in the net interest margin, the net interest income for the Company increased            due to the increase in average earning assets over the similar six-month period in            2006.

 

The            second significant factor affecting the Company’s net income is the provision for            loan losses. The majority of the Company’s interest-earning assets are in loans            outstanding, which amounted to more than $1.298 billion at June 30, 2007. The provision            adjustment is computed on a quarterly basis and is a result of management’s            determination of the quality of the loan portfolio. The provision reflects a number of            factors including the size of the loan portfolio, loan concentrations, the level of            non-performing loans (which includes non-accrual loans) and loans past due 90 days or            more. The provision for loan losses was $1,486,000 in the first six months of 2007            compared to $1,709,000 the same period in 2006.

 

 

Page            18 of 35

 

----

 

**HILLS BANCORPORATION**

 

**Item            2. Management’s Discussion and Analysis of Financial Condition And Results of            Operations (continued)**

 

**Discussion of operations for the six months ended June 30, 2007            and 2006 (continued)**

 

**Net            Interest Income**