**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C.  20549**

 

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**FORM 10-Q**

 

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period ended September 30, 2005**

 

**CommissionFile Number: 0-19972**

 

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**HFFINANCIAL CORP.**

(Exactname of registrant as specified in its charter.)

 
| **Delaware**                                              | ** ** | **46-0418532**                          |
|-----------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of                           |       | (I.R.S. Employer Identification Number) |
| incorporation or organization)                            |       |                                    |
|                                                      |       |                                    |
| **225 South Main Avenue,**                                |       |                                    |
| **Sioux Falls, SD**                                       | ** ** | **57104**                               |
| (Address of principal executive office)                   |       | (ZIP Code)                              |
|                                                      |       |                                    |
| **(605) 333-7556**                                        |
| (Registrant’s telephone number, including area code) |

 

Indicate by check mark whether theregistrant  (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Yes o  No ý

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act.)YES o  NO ý

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 

As of November 9,2005 there were 3,574,124 issued and outstanding shares of the Registrant’sCommon Stock, with $.01 par value.

 

 

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**HFFINANCIAL CORP.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **PART I –  FINANCIAL INFORMATION** |                                                                                                 |
|-----------------------------------------------|------------------------------------------------------------------------------------------------------|
|                                          |                                                                                                 |   |
| Item 1.                                       | Financial Statements (Unaudited):                                                                    |   |
|                                          |                                                                                                 |   |
|                                          | Consolidated Statements of  Financial Condition As of September 30, 2005 and June 30, 2005 |   |
|                                          |                                                                                                 |   |
|                                          | Consolidated Statements of Income for the Three  Months Ended September 30, 2005 and 2004       |   |
|                                          |                                                                                                 |   |
|                                          | Consolidated Statements of  Cash Flows for the Three Months Ended September 30, 2005 and 2004   |   |
|                                          |                                                                                                 |   |
|                                          | Notes to Consolidated Financial Statements                                                           |   |
|                                          |                                                                                                 |   |
| Item 2.                                       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations          |   |
|                                          |                                                                                                 |   |
| Item 3.                                       | Quantitative  and Qualitative Disclosures about Market Risk                                          |   |
|                                          |                                                                                                 |   |
| Item 4.                                       | Controls and  Procedures                                                                             |   |
|                                          |                                                                                                 |   |
| **PART II – OTHER INFORMATION**     |                                                                                                 |
|                                          |                                                                                                 |   |
| Item 1.                                       | Legal Proceedings                                                                                    |   |
|                                          |                                                                                                 |   |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                         |   |
|                                          |                                                                                                 |   |
| Item 3.                                       | Defaults  upon Senior Securities                                                                     |   |
|                                          |                                                                                                 |   |
| Item 4.                                       | Submission  of Matters to a Vote of Security Holders                                                 |   |
|                                          |                                                                                                 |   |
| Item 5.                                       | Other Information                                                                                    |   |
|                                          |                                                                                                 |   |
| Item 6.                                       | Exhibits                                                                                             |   |
|                                          |                                                                                                 |   |
| Form 10-Q                                | Signature Page                                                                                       |   |

 

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.****           Financial Statements**

 

HF FINANCIAL CORP. ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in Thousands)

 
| ** **                                                                                                                                                          | ** ** | **September 30, 2005** | ** ** | **June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **(Unaudited)**             | ** ** | **(Audited)**          | ** ** |
| **ASSETS**                                                                                                                                                          |       |                        |       |                   |       |
| Cash and cash equivalents                                                                                                                                           |       | $                           | 19,093     |                   | $          | 18,248 |   |
| Securities available for sale                                                                                                                                       |       | 149,960                     |       | 142,429                |       |
| Federal Home Loan Bank stock                                                                                                                                        |       | 7,236                       |       | 7,699                  |       |
| Loans held for sale                                                                                                                                                 |       | 17,265                      |       | 10,238                 |       |
|                                                                                                                                                                |       |                        |       |                   |       |
| Loans and leases receivable                                                                                                                                         |       | 678,124                     |       | 675,657                |       |
| Allowance for loan and lease losses                                                                                                                                 |       | (5,321                      | )          | (5,076                 | )          |
| Net loans  and leases receivable                                                                                                                                    |       | 672,803                     |       | 670,581                |       |
|                                                                                                                                                                |       |                        |       |                   |       |
| Accrued interest receivable                                                                                                                                         |       | 6,309                       |       | 5,087                  |       |
| Office properties and equipment, net of  accumulated depreciation                                                                                                   |       | 13,451                      |       | 12,978                 |       |
| Foreclosed real estate and other properties                                                                                                                         |       | 1,446                       |       | 1,387                  |       |
| Cash value of life insurance                                                                                                                                        |       | 12,651                      |       | 12,530                 |       |
| Servicing rights                                                                                                                                                    |       | 5,344                       |       | 5,211                  |       |
| Goodwill, net                                                                                                                                                       |       | 4,951                       |       | 4,951                  |       |
| Other assets                                                                                                                                                        |       | 7,409                       |       | 6,535                  |       |
| Total assets                                                                                                                                                        |       | $                           | 917,918    |                   | $          | 897,874 |   |
|                                                                                                                                                                |       |                        |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                       |       |                        |       |                   |       |
| **LIABILITIES**                                                                                                                                                     |       |                        |       |                   |       |
| Deposits                                                                                                                                                            |       | $                           | 677,291    |                   | $          | 681,216 |   |
| Advances from Federal Home Loan Bank and  other borrowings                                                                                                          |       | 135,226                     |       | 119,664                |       |
| Subordinated debentures payable to trusts                                                                                                                           |       | 27,837                      |       | 27,837                 |       |
| Advances by borrowers for taxes and  insurance                                                                                                                      |       | 10,747                      |       | 6,446                  |       |
| Accrued expenses and other liabilities                                                                                                                              |       | 12,343                      |       | 9,076                  |       |
| Total  liabilities                                                                                                                                                  |       | 863,444                     |       | 844,239                |       |
|                                                                                                                                                                |       |                        |       |                   |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                       |       |                        |       |                   |       |
| Preferred  stock, $.01 par value, 500,000 shares authorized, none outstanding                                                                                       |       | —                      |       | —                 |       |
| Series A  Junior Participating Preferred Stock, $1.00 stated value, 50,000 shares  authorized, none outstanding                                                |       | —                      |       | —                 |       |
| Common  stock, $.01 par value, 10,000,000 shares authorized, 5,549,892 and 5,462,066  shares issued at September 30, 2005 and June 30, 2005, respectively |       | 55                          |       | 55                     |       |
| Common stock  subscribed for but not issued, 66,644 shares at June 30, 2005                                                                                    |       | —                      |       | 1,266                  |       |
| Additional  paid-in capital                                                                                                                                         |       | 20,858                      |       | 19,190                 |       |
| Retained  earnings, substantially restricted                                                                                                                        |       | 65,906                      |       | 65,267                 |       |
| Deferred  compensation                                                                                                                                              |       | (2,180                      | )          | (2,140                 | )          |
| Accumulated  other comprehensive income (loss), net of related deferred tax effect                                                                                  |       | (998                        | )          | (836                   | )          |
| Less cost of  treasury stock, 1,977,836 and 1,977,836 shares at September 30, 2005 and  June 30, 2005, respectively                                       |       | (29,167                     | )          | (29,167                | )          |
| Total  stockholders’ equity                                                                                                                                    |       | 54,474                      |       | 53,635                 |       |
| Total  liabilities and stockholders’ equity                                                                                                                    |       | $                           | 917,918    |                   | $          | 897,874 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

1

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HF FINANCIAL CORP. ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands,Except Per Share Data)

(Unaudited)

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **September 30,** | ** ** |
| ** **                                                              | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                    |       |                   |       |   |   |
| Interest, dividend and loan fee income:                                 |       |                   |       |   |   |
| Loans and  leases receivable                                            |       | $                      | 11,121     |   | $ | 9,734 |   |
| Investment  securities and interest-earning deposits                    |       | 1,351                  |       | 956 |   |
|                                                                    |       | 12,472                 |       | 10,690 |   |
| Interest expense:                                                       |       |                   |       |   |   |
| Deposits                                                                |       | 4,296                  |       | 2,771 |   |
| Advances  from Federal Home Loan Bank and other borrowings              |       | 1,841                  |       | 1,379 |   |
|                                                                    |       | 6,137                  |       | 4,150 |   |
| **Net  interest income**                                                |       | 6,335                  |       | 6,540 |   |
|                                                                    |       |                   |       |   |   |
| Provision for losses on loans and leases                                |       | 462                    |       | 179 |   |
|                                                                    |       |                   |       |   |   |
| **Net  interest income after provision for losses on loans and leases** |       | 5,873                  |       | 6,361 |   |
|                                                                    |       |                   |       |   |   |
| Noninterest income:                                                     |       |                   |       |   |   |
| Fees on  deposits                                                       |       | 1,176                  |       | 1,120 |   |
| Loan  servicing income                                                  |       | 312                    |       | 372 |   |
| Gain on sale  of loans, net                                             |       | 255                    |       | 102 |   |
| Trust income                                                            |       | 195                    |       | 159 |   |
| Gain on sale  of securities, net                                        |       | —                 |       | 13 |   |
| Other                                                                   |       | 447                    |       | 432 |   |
|                                                                    |       | 2,385                  |       | 2,198 |   |
| Noninterest expense:                                                    |       |                   |       |   |   |
| Compensation  and employee benefits                                     |       | 4,303                  |       | 3,998 |   |
| Occupancy  and equipment                                                |       | 780                    |       | 783 |   |
| Other                                                                   |       | 1,591                  |       | 1,550 |   |
|                                                                    |       | 6,674                  |       | 6,331 |   |
|                                                                    |       |                   |       |   |   |
| **Income  before income taxes**                                         |       | 1,584                  |       | 2,228 |   |
|                                                                    |       |                   |       |   |   |
| Income tax expense                                                      |       | 561                    |       | 768 |   |
|                                                                    |       |                   |       |   |   |
| **Net  income**                                                         |       | $                      | 1,023      |   | $ | 1,460 |   |
| ** **                                                              |       |                   |       |   |   |
| **Comprehensive income**                                                |       | $                      | 861        |   | $ | 2,425 |   |
| **Cash dividends paid per share**                                       |       | $                      | 0.1100     |   | $ | 0.1075 |   |
|                                                                    |       |                   |       |   |   |
| **Earnings per share:**                                                 |       |                   |       |   |   |
| Basic                                                                   |       | $                      | 0.29       |   | $ | 0.41 |   |
| Diluted                                                                 |       | $                      | 0.29       |   | $ | 0.41 |   |

 

*See accompanying notes to unauditedconsolidated financial statements.*

 

2

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HF FINANCIAL CORP. ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)

 
| ** **                                                                                     | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Cash flows from operating activities**                                                       |       |                                      |       |   |   |
| Net income                                                                                     |       | $                                         | 1,023      |   | $ | 1,460 |   |
| Adjustments  to reconcile net income to net cash (used in) operating activities:               |       |                                      |       |   |   |
| Provision  for losses on loans and leases                                                      |       | 462                                       |       | 179 |   |
| Depreciation                                                                                   |       | 361                                       |       | 359 |   |
| Amortization  of discounts and premiums on securities and other                                |       | 516                                       |       | 422 |   |
| Stock based  compensation                                                                      |       | 184                                       |       | 152 |   |
| Deferred  income taxes (credits)                                                               |       | (4                                        | )          | (22 | ) |
| Loans  originated for resale                                                                   |       | (32,772                                   | )          | (20,632 | ) |
| Proceeds  from the sale of loans                                                               |       | 27,172                                    |       | 15,092 |   |
| (Gain) on  sale of loans, net                                                                  |       | (255                                      | )          | (102 | ) |
| Realized  (gain) on sale of securities, net                                                    |       | —                                    |       | (13 | ) |
| Losses and  provision for losses on sales of foreclosed real estate and other properties,  net |       | 14                                        |       | 26 |   |
| (Gain) on  disposal of office properties and equipment, net                                    |       | (2                                        | )          | — |   |
| Change in  other assets and liabilities                                                        |       | 1,156                                     |       | (163 | ) |
| Net cash  (used in) operating activities                                                       |       | (2,145                                    | )          | (3,242 | ) |
| ** **                                                                                     |       |                                      |       |   |   |
| **Cash flows from investing activities**                                                       |       |                                      |       |   |   |
| Loans and  leases purchased                                                                    |       | —                                    |       | (843 | ) |
| Loans and  leases originated and held                                                          |       | (85,281                                   | )          | (65,394 | ) |
| Principal  collected on loans and leases                                                       |       | 81,191                                    |       | 49,018 |   |
| Securities  available for sale:                                                                |       |                                      |       |   |   |
| Sales and  maturities and repayments                                                           |       | 10,535                                    |       | 19,599 |   |
| Purchases                                                                                      |       | (18,655                                   | )          | (7,805 | ) |
| Purchase of  Federal Home Loan Bank stock                                                      |       | (1,342                                    | )          | (1,272 | ) |
| Redemption  of Federal Home Loan Bank stock                                                    |       | 1,805                                     |       | 356 |   |
| Proceeds  from sale of office properties and equipment                                         |       | 2                                         |       | — |   |
| Purchase of  office properties and equipment                                                   |       | (834                                      | )          | (292 | ) |
| Purchase of  servicing rights                                                                  |       | (284                                      | )          | (313 | ) |
| Proceeds  from sale of foreclosed real estate and other properties, net                        |       | 121                                       |       | 270 |   |
| Net cash  (used in) investing activities                                                       |       | (12,742                                   | )          | (6,676 | ) |
|                                                                                                |            |                                           |            |  |  |  |  |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

3

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HF FINANCIAL CORP. ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(Dollars in Thousands)

(Unaudited)

 
| ** **                                                             | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                   |       |                                      |       |   |   |
| **Cash flows from financing activities**                               |       |                                      |       |   |   |
| Net  (decrease) in deposit accounts                                    |       | $                                         | (3,925     | ) | $ | (15,750 | ) |
| Proceeds of  advances from Federal Home Loan Bank and other borrowings |       | 145,678                                   |       | 119,759 |   |
| Payments on  advances from Federal Home Loan Bank and other borrowings |       | (130,116                                  | )          | (98,624 | ) |
| Increase in  advances by borrowers                                     |       | 4,301                                     |       | 2,097 |   |
| Purchase of  treasury stock                                            |       | —                                    |       | (673 | ) |
| Proceeds  from issuance of common stock                                |       | 178                                       |       | 88 |   |
| Cash  dividends paid                                                   |       | (384                                      | )          | (381 | ) |
| Net cash  provided by financing activities                             |       | 15,732                                    |       | 6,516 |   |
|                                                                   |       |                                      |       |   |   |
| Increase  (decrease) in cash and cash equivalents                      |       | 845                                       |       | (3,402 | ) |
|                                                                   |       |                                      |       |   |   |
| Cash and cash equivalents                                              |       |                                      |       |   |   |
| Beginning                                                              |       | 18,248                                    |       | 20,474 |   |
| Ending                                                                 |       | $                                         | 19,093     |   | $ | 17,072 |   |
|                                                                   |       |                                      |       |   |   |
| Supplemental Disclosures of Cash Flows  Information                    |       |                                      |       |   |   |
| Cash  payments for interest                                            |       | $                                         | 5,420      |   | $ | 3,854 |   |
| Cash  payments for income and franchise taxes, net                     |       | 919                                       |       | 325 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

4

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**HFFINANCIAL CORP. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

ForThe Three Months Ended September 30, 2005 and 2004

(Unaudited)

 

**NOTE 1.****                                                 SELECTEDACCOUNTING POLICIES**

 

*Basis of presentation:*

 

The consolidated financial information of HFFinancial Corp. (the “Company”) and its wholly-owned subsidiaries included inthis Quarterly Report on Form 10-Q is unaudited.  However, in the opinion of management,adjustments (consisting of normal recurring adjustments) necessary for a fairpresentation for the interim periods have been included.  Results for any interim period are notnecessarily indicative of results to be expected for the fiscal year.  Interim consolidated financial statements andthe notes thereto should be read in conjunction with the consolidated financialstatements and notes thereto included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended June 30, 2005 (“Fiscal 2005”), filed with theSecurities and Exchange Commission.  Theaccounting and reporting policies of the Company and its subsidiaries conformto accounting principles generally accepted in the United States of America (“GAAP”)and to general practice within the industry.

 

The interim consolidated financial statementsinclude the accounts of the Company, its wholly-owned subsidiaries, HomeFederal Bank (the “Bank”), HF Financial Group, Inc. (“HF Group”) andHomeFirst Mortgage Corp. (the “Mortgage Corp.”), and the Bank’s wholly-ownedsubsidiaries, Mid America Capital Services, Inc. (“Mid America Capital”),Hometown Insurors, Inc. (“Hometown”), Home Federal Securitization Corp. (“HFSC”),Mid-America Service Corporation and PMD, Inc.  The interim consolidated financial statementsreflect the deconsolidation of the subsidiary trusts of the Company, HFFinancial Capital Trust I (“Trust I”), HF Financial Capital Trust II (“Trust II”),HF Financial Capital Trust III (“Trust III”) and HF Financial Capital Trust IV(“Trust IV”).  All intercompany balancesand transaction have been eliminated in consolidation.

 

Stock-based compensation:  In December 2004, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 123R, *“Share-Based Payment,”*which requires all companies to measure compensation cost for all share-basedpayments (including stock options) at fair value and to record such expense intheir consolidated financial statements. SFAS No. 123R is a revision of SFAS No. 123, *“Accounting for Stock-Based Compensation,”*andsupersedes Accounting Principles Board (“APB”) Opinion No. 25, *“Accounting for Stock Issued to Employees”*.

 

The Company adopted SFAS No. 123R effective as of July 1,2005, using the Black-Scholes option-pricing model and the modified prospectivemethod in which compensation cost is recognized for all awards grantedsubsequent to the Company’s adoption of this statement as well as for theunvested portion of awards outstanding as of the Company’s adoption of thisstatement.  Prior to July 1, 2005,the Company accounted for stock-based compensation in accordance with APB No. 25and related interpretations. As such, no stock-based employee compensation costwas recognized for grants under the Company’s stock option and incentive plans,as all options granted under those plans had an exercise price equal to themarket value of the underlying common stock on the date of grant.  These stock option and incentive plans aredescribed more fully in Part II, Item 8 “Financial Statements andSupplementary Data” of the Company’s Annual Report on Form 10-K for Fiscal2005, under Note 17 of “Notes to Consolidated Financial Statements.”

 

5

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The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS 123R to stock-based employee compensation for the quarter ended September 30,2004.

 
| ** **                                                                                                                                        | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                                                                                              |       |                                      |       |   |   |
| Net income,  as reported (1)                                                                                                                      |       | $                                         | 1,023      |   | $ | 1,460 |   |
| Add: Total  stock-based employee compensation expense included in reported net income,  net of related tax effects                                |       |                                      |       | 31 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects (2) |       |                                      |       | (72 | ) |
| Pro forma  net income                                                                                                                             |       | $                                         | 1,023      |   | $ | 1,419 |   |
|                                                                                                                                              |       |                                      |       |   |   |
| Basic  earnings per share:                                                                                                                        |       |                                      |       |   |   |
| As reported                                                                                                                                       |       | $                                         | 0.29       |   | $ | 0.41 |   |
| Pro forma                                                                                                                                         |       |                                      |       | 0.40 |   |
|                                                                                                                                              |       |                                      |       |   |   |
| Diluted  earnings per share:                                                                                                                      |       |                                      |       |   |   |
| As reported                                                                                                                                       |       | 0.29                                      |       | 0.41 |   |
| Pro forma                                                                                                                                         |       |                                      |       | 0.39 |   |

 

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(1)   Includes expense related tostock-based employee compensation for the three months ended September 30,2005 due to the adoption of SFAS No. 123R.

(2)   Includes expense related to restricted stockreported in net income.

 

**NOTE 2.****                                                 REGULATORYCAPITAL**

 

The following table sets forth the Bank’scompliance with its minimum capital requirements for a well-capitalizedinstitution at September 30, 2005:

 

| ** **                                         | ** ** | **Amount**                 | ** ** | **Percent** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|-------------|------------|
| ** **                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Tier I (core) capital (to adjusted total  assets): |       |                       |       |        |       |
| Required                                           |       | $                          | 45,577     |        | 5.00       | % |
| Actual                                             |       | 74,975                     |       | 8.23        |       |
| Excess over  required                              |       | 29,398                     |       | 3.23        |       |
|                                               |       |                       |       |        |       |
| Risk-based capital (to risk-weighted  assets):     |       |                       |       |        |       |
| Required                                           |       | $                          | 72,255     |        | 10.00      | % |
| Actual                                             |       | 77,020                     |       | 10.66       |       |
| Excess over  required                              |       | 4,765                      |       | 0.66        |       |

 

6

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**NOTE 3.****                                                ****EARNINGS PER SHARE**

 

Basic earnings per shareis computed by dividing income available to common stockholders (the numerator)by the weighted-average number of common shares outstanding  (the denominator) during the period.  Shares issued during the period and sharesreacquired during the period are weighted for the portion of the period thatthey were outstanding. The weighted average number of basic common sharesoutstanding for the three month periods ended September 30, 2005 and 2004was 3,497,287 and 3,533,847, respectively.

 

Dilutive earnings per share is similar to thecomputation of basic earnings per share except that the denominator isincreased to include the number of additional common shares that would havebeen outstanding if the dilutive options outstanding had been exercised. Theweighted average number of common and dilutive potential common sharesoutstanding for the three month periods ended September 30, 2005 and 2004was 3,582,070 and 3,604,681, respectively.

 

**NOTE 4.****                                                 CONSUMERAUTOMOBILE LOAN SECURITIZATION**

 

On January 31, 2003, the Banksecuritized and sold motor vehicle installment loans with principal balancestotaling $50.0 million through HFSC and Home Federal Automobile SecuritizationTrust 2003-A (“Automobile Securitization Trust”).  As part of the sales transaction, the Bankretains servicing responsibilities.  Inaddition, the Bank retains the rights to cash flows remaining after investorsin the Automobile Securitization Trust have received their contractual paymentsand has pledged a $1.5 million reserve fund to the Automobile SecuritizationTrust.  These retained interests aresubordinated to investors’ interests. The investors and Automobile Securitization Trust have no recourse tothe Bank’s other assets for failure of debtors to pay when due.  The pass through rate to investors is 2.65%.

 

The gain recognized onthe sale of these loans was determined by allocating the carrying amount of theloans between the loans sold and the interests retained.  The Bank determined that 50 basis points ofthe 100 basis points servicing contract represented was excess servicing andwas capitalized as part of the transaction utilizing a market discount rate of10.0%.  This asset is amortized inproportion to, and over the period of, estimated net servicing income.

 

The Company has the option to execute a cleanup call when the totaloutstanding balance is at 10% or less of the original pool balance, or $5.0million.  Based on management’sestimates, this cleanup call could be executed in the second quarter of thecurrent fiscal year ending June 30, 2006 (“Fiscal 2006”).

 

7

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Key economic assumptions used and thesensitivity of fair value of the retained interest as of September 30,2005 are as follows:

 
| ** **                                  | ** ** | **Retained**               | ** ** | **Servicing** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|---------------|------------|
| ** **                                  | ** ** | **Interest**               | ** ** | **Rights**    | ** ** |
| ** **                                  | ** ** | **(Dollars in Thousands)** | ** ** |
|                                        |       |                       |       |          |       |
| Fair Value                                  |       | $                          | 1,525      |          | $          | 4 |   |
| Weighted average life (in years)            |       | 1.67                       |       | 1.67          |       |
| Prepayment speed (ABS annual rate):         |       | 20.40                      | %          | 20.40         | %          |
| Impact on  fair value of 10% adverse change |       | $                          | —     |          | $          | — |   |
| Impact on  fair value of 20% adverse change |       | (1                         | )          | —        |       |
| Credit losses (annual rate):                |       | 1.13                       | %          | 1.13          | %          |
| Impact on  fair value of 10% adverse change |       | $                          | (1         | )             | $          | — |   |
| Impact on  fair value of 20% adverse change |       | (2                         | )          | —        |       |
| Discount rate:                              |       | 5.26                       | %          | 10.00         | %          |
| Impact on  fair value of 10% adverse change |       | $                          | (1         | )             | $          | — |   |
| Impact on  fair value of 20% adverse change |       | (3                         | )          | —        |       |

 

These sensitivities are hypothetical andshould be used with caution.  Changes infair value based on a 10.0% variation in assumptions generally cannot beextrapolated because the relationship of the change in assumption to the changein fair value may not be linear.  Also,in this table, the effect of a variation in a particular assumption on the fairvalue of the retained interest is calculated without changing any otherassumption.  In reality, changes in onefactor may result in changes in another (for example, increases in marketinterest rates may result in lower prepayments and increased credit losses),which might magnify or counteract the sensitivities.

 

8

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**NOTE 5.****                              INVESTMENTSIN SECURITIES**

 

Theamortized cost and fair values of investments in securities, all of which areclassified as available for sale according to management’s intent, are asfollows:

 

| ** **                 | ** ** | **September 30, 2005** | ** ** |
|----------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | ** **                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amortized**               | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                 | ** ** | **Cost**                    | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)**  | ** ** |
|                       |       |                        |       |   |   |   |   |   |   |
| Debt securities:           |       |                        |       |   |   |   |   |   |   |
| U.S.  government agencies  |       | $                           | 5,000      |   | $ | — |   | $ | (28 | ) | $ | 4,972 |   |
| Federal Home  Loan Bank    |       | 6,390                       |       | 31 |   | (12 | ) | 6,409 |   |
| Municipal  bonds           |       | 2,698                       |       | 1 |   | (17 | ) | 2,682 |   |
| Preferred  Term Securities |       | 11,019                      |       | 68 |   | — |   | 11,087 |   |
|                       |       | 25,107                      |       | 100 |   | (57 | ) | 25,150 |   |
|                       |       |                        |       |   |   |   |   |   |   |
| Equity securities:         |       |                        |       |   |   |   |   |   |   |
| FNMA                       |       | 8                           |       | 10 |   | — |   | 18 |   |
| Federal Ag  Mortgage       |       | 7                           |       | 2 |   | — |   | 9 |   |
| Other  Investments         |       | 38                          |       | — |   | — |   | 38 |   |
|                       |       | 53                          |       | 12 |   | — |   | 65 |   |
|                       |       |                        |       |   |   |   |   |   |   |
| Mortgage-backed securities |       | 126,424                     |       | 6 |   | (1,685 | ) | 124,745 |   |
|                       |       | $                           | 151,584    |   | $ | 118 |   | $ | (1,742 | ) | $ | 149,960 |   |

 

| ** **                 | ** ** | **September 30, 2004** | ** ** |
|----------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | ** **                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amortized**               | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                 | ** ** | **Cost**                    | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)**  | ** ** |
|                       |       |                        |       |   |   |   |   |   |   |
| Debt securities:           |       |                        |       |   |   |   |   |   |   |
| U.S.  government agencies  |       | $                           | 2,999      |   | $ | 14 |   | $ | — |   | $ | 3,013 |   |
| Federal Home  Loan Bank    |       | 1,000                       |       | 18 |   | — |   | 1,018 |   |
| Municipal  bonds           |       | 3,865                       |       | 15 |   | (5 | ) | 3,875 |   |
| Preferred  Term Securities |       | 9,000                       |       | 34 |   | — |   | 9,034 |   |
|                       |       | 16,864                      |       | 81 |   | (5 | ) | 16,940 |   |
|                       |       |                        |       |   |   |   |   |   |   |
| Equity securities:         |       |                        |       |   |   |   |   |   |   |
| FNMA                       |       | 8                           |       | 17 |   | — |   | 25 |   |
| Federal Ag  Mortgage       |       | 7                           |       | 2 |   | — |   | 9 |   |
| Other  Investments         |       | —                      |       | — |   | — |   | — |   |
|                       |       | 15                          |       | 19 |   | — |   | 34 |   |
|                       |       |                        |       |   |   |   |   |   |   |
| Mortgage-backed securities |       | 95,951                      |       | 154 |   | (899 | ) | 95,206 |   |
|                       |       | $                           | 112,830    |   | $ | 254 |   | $ | (904 | ) | $ | 112,180 |   |

 

9

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The followingtable presents the fair value and age of gross unrealized losses by investmentcategory at September 30, 2005 in accordance with Emerging Issues TaskForce Issue No. 03-1, “*The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”*

 

| ** **                  | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total**  | ** ** |
|-----------------------------|------------|----------------------------|------------|-----------------------|------------|------------|------------|
| ** **                  | ** ** | ** **                 | ** ** | **Gross**             | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                  | ** ** | **Fair**                   | ** ** | **Unrealized**        | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                  | ** ** | **Value**                  | ** ** | **(Losses)**          | ** ** | **Value**  | ** ** | **(Losses)** | ** ** | **Value** | ** ** | **(Losses)** | ** ** |
| ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Debt securities:            |       |                       |       |                  |       |       |       |   |   |   |   |   |   |
| U.S.  government agencies   |       | $                          | 4,972      |                  | $          | (28        | )          | $ | — |   | $ | — |   | $ | 4,972 |   | $ | (28 | ) |
| Federal Home  Loan Bank     |       | 1,488                      |       | (12                   | )          | —     |       | — |   | 1,488 |   | (12 | ) |
| Municipal  bonds            |       | 1,819                      |       | (9                    | )          | 517        |       | (8 | ) | 2,336 |   | (17 | ) |
| Mortgage-backed  securities |       | 75,193                     |       | (866                  | )          | 47,424     |       | (819 | ) | 122,617 |   | (1,685 | ) |
|                        |       | $                          | 83,472     |                  | $          | (915       | )          | $ | 47,941 |   | $ | (827 | ) | $ | 131,413 |   | $ | (1,742 | ) |

 

Managementdoes not believe any individual unrealized losses as of September 30, 2005represent an other-than-temporary impairment. The unrealized losses reported for mortgage-backed securities relate tosecurities issued by the Federal National Mortgage Association (“FNMA”), theGovernment National Mortgage Association and the Federal Home Loan MortgageCorporation (“FHLMC”).  These unrealizedlosses are primarily attributable to changes in interest rates and as a groupwere less than 1.3% of its respective amortized cost basis at September 30,2005.  The Company has the ability tohold the securities to maturity or for a time necessary to recover theamortized cost.

 

The Company investsin investment securities issued by FNMA and FHLMC.  FNMA and FHLMC are government-sponsoredenterprises (“GSEs”).  GSE, as defined inthe Omnibus Budget Reconciliation Act of 1990, refers to a private corporationthat operates under a charter granted by Congress.  The majority of the members of the board ofdirectors of a GSE must be elected by the private shareholders, though some portionmay be appointed by Congress or the President. The central function of a GSE is to serve as a financial intermediary,making loans or issuing loan guarantees to borrowers or sectors identified inthe enabling legislation.  A GSE mayraise funds in a variety of ways, but in no case are the liabilities of the GSEto be backed by the full faith and credit of the federal government.  The legislation specifically states that aGSE does not have the power to tax or regulate and cannot make financialcommitments in the name of the federal government and that members of its staffare not employees of the federal government. However, management believes that GSEs are generally perceived by thecredit markets to have an implicit federal government guarantee backing itsobligations.

 

Management cannotpredict the role of GSEs in the future or how Congress would respond toaccounting or credit issues that may affect GSEs.  Management presently expects to continue toinvest in investment securities issued by FNMA and FHLMC in the normal courseof business.  If Congress would evereliminate the implicit guarantee associated with securities issued by GSEs, theoutcome would most likely be adverse to the Company.

 

10

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**NOTE 6.****                                                 SEGMENTREPORTING**

 

Operating segments are defined as componentsof an enterprise for which separate financial information is available that isevaluated regularly by the chief operating decision makers in deciding how toallocate resources and in assessing performance.  The Company’s reportable segments are “banking”(including leasing activities) and “other”. The “banking” segment is conducted through the Bank and Mid AmericaCapital and the “other” segment is composed of smaller nonreportable segments,the Company and inter-segment eliminations.

 

The management approach is used as theconceptual basis for identifying reportable segments and is based on the waythat management organizes the segments within the enterprise for makingoperating decisions, allocating resources and monitoring performance, which isprimarily based on products.

 
| **Three Months Ended September 30, 2005** | ** ** | **Banking**                | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|-----------|------------|-----------|------------|
| ** **                                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                                           |       |                       |       |      |       |      |       |   |   |   |
| Net interest income                            |       | $                          | 7,142      |      | $          | (807      | )          | $ | 6,335 |   |
| Intersegment interest income                   |       | (298                       | )          | 298       |       | —    |       |
| Provision for losses on loans and leases       |       | (462                       | )          | —    |       | (462      | )          |
| Noninterest income                             |       | 2,436                      |       | (51       | )          | 2,385     |       |
| Intersegment noninterest income                |       | (52                        | )          | 52        |       | —    |       |
| Noninterest expense                            |       | (6,480                     | )          | (194      | )          | (6,674    | )          |
| Intersegment noninterest expense               |       | 1                          |       | (1        | )          | —    |       |
| Income  (loss) before income taxes             |       | $                          | 2,287      |      | $          | (703      | )          | $ | 1,584 |   |
|                                           |       |                       |       |      |       |      |       |
| Total assets at September 30, 2005        |       | $                          | 916,639    |      | $          | 1,279     |       | $ | 917,918 |   |

 
| **Three Months Ended September 30, 2004** | ** ** | **Banking**                | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|-----------|------------|-----------|------------|
| ** **                                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                                           |       |                       |       |      |       |      |       |
| Net interest income                            |       | $                          | 7,155      |      | $          | (615      | )          | $ | 6,540 |   |
| Intersegment interest income                   |       | (246                       | )          | 246       |       | —    |       |
| Provision for losses on loans and leases       |       | (179                       | )          | —    |       | (179      | )          |
| Noninterest income                             |       | 2,224                      |       | (26       | )          | 2,198     |       |
| Intersegment noninterest income                |       | (92                        | )          | 92        |       | —    |       |
| Noninterest expense                            |       | (6,053                     | )          | (278      | )          | (6,331    | )          |
| Intersegment noninterest expense               |       | 1                          |       | (1        | )          | —    |       |
| Income  (loss) before income taxes             |       | $                          | 2,810      |      | $          | (582      | )          | $ | 2,228 |   |
|                                           |       |                       |       |      |       |      |       |
| Total assets at September 30, 2004        |       | $                          | 853,885    |      | $          | 3,322     |       | $ | 857,207 |   |

 

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**NOTE 7.****                                                 DEFINEDBENEFIT PLAN**

 

The Company has a noncontributory (cashbalance) defined benefit pension plan covering all employees of the Company andits wholly-owned subsidiaries who have attained the age of 21 and havecompleted 1,000 hours in a plan year. The benefits are based on 6% of each eligible participant’s annualcompensation, plus income earned in the accounts at a rate determined annuallybased on 30-year treasury note rates. The Company’s funding policy is to make the minimum annual requiredcontribution plus such amounts as the Company may determine to be appropriatefrom time to time.  One hundred percentvesting occurs after five years with a normal retirement age of 65.  Information relative to the components of netperiodic benefit cost for the Company’s defined benefit plan is presentedbelow:

 
| ** **                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **September 30,** | ** ** |
| ** **                         | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                               |       |                   |       |   |   |
| Service cost                       |       | $                      | 116,367    |   | $ | 113,535 |   |
| Interest cost                      |       | 91,238                 |       | 91,585 |   |
| Expected return on plan assets     |       | (93,185                | )          | (92,629 | ) |
| Amortization of prior losses       |       | —                 |       | 8,297 |   |
| Accretion of prior service cost    |       | —                 |       | — |   |
| Amortization of transition asset   |       | 2,908                  |       | 2,908 |   |
| Total costs  recognized in expense |       | $                      | 117,328    |   | $ | 123,696 |   |

 

The Company previously disclosed in itsconsolidated financial statements for Fiscal 2005, which are included in Part II,Item 8 “Financial Statements and Supplementary Data” of the Company’s AnnualReport on Form 10-K for Fiscal 2005, that it contributed $662,000 to fundits qualified pension plan.  During thequarter ended September 30, 2005, the Company made contributions of$610,000 to fund its qualified pension plan. The Company anticipates no additional contributions for Fiscal 2006.

 

**NOTE 8.****                                                 SUBSEQUENTEVENTS**

 

On July 20, 2005, the Company determined as doubtful as of June 30,2005, certain loan participation interests in the aggregate amount of $4.12million that the Bank owns as a participant in a loan to a certain borrowerbased in South Dakota.  The Bank is aparticipant in the loan with several other banks.  The downgrade by the Company of the loaninterests to doubtful caused the loan interests to be impaired and,accordingly, a material charge for impairment with respect to the loaninterests was necessary under generally accepted accounting principles.  In connection with such determination, theCompany recorded a total impairment of approximately $1.75 million inprovisions for loan losses as of June 30, 2005, relating to the loaninterests.

 

On November 7,2005, the participants in the loan, including the Bank, agreed to sell theirinterests in the loan to a third party. Accordingly, the Company will record a charge of approximately $1.05million in its second quarter of Fiscal 2006 and will reclassify the loaninterests as held for sale until the completion of the sale of the loan, whichis expected to occur over the next several months.

 

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

 

**Forward-Looking Statements**

 

ThisQuarterly Report on Form 10-Q and other reports issued by the Company,including reports filed with the Securities and Exchange Commission, contain “forward-lookingstatements” that deal with future results, expectations, plans andperformance.  In addition, the Company’smanagement may make forward-looking statements orally to the media, securitiesanalysts, investors or others.  Theseforward-looking statements might include one or more of the following:

 

**•**                  Projections of income, loss,revenues, earnings or losses per share, dividends, capital expenditures,capital structure, tax benefit or other financial items.

**•**                  Descriptions of plans or objectivesof management for future operations, products or services, transactions,investments and use of subordinated debentures payable to trusts.

**•**                  Forecasts of future economicperformance.

**•**                  Use and descriptions of assumptionsand estimates underlying or relating to such matters.

 

Forward-lookingstatements can be identified by the fact that they do not relate strictly tohistorical or current facts.  They ofteninclude words such as “optimism,” “look-forward,” “bright,” “believe,” “expect,”“anticipate,” “intend,” “plan,” “estimate” or words of similar meaning, orfuture or conditional verbs such as “will,” “would,” “should,” “could” or “may.”

 

Forward-lookingstatements about the Company’s expected financial results and other plans aresubject to certain risks, uncertainties and assumptions.  These include, but are not limited to thefollowing: possible legislative changes and adverse economic, business andcompetitive conditions and developments (such as shrinking interest margins andcontinued short-term rate environments); deposit outflows; reduced demand forfinancial services and loan products; changes in accounting policies orguidelines, or in monetary and fiscal policies of the federal government;changes in credit and other risks posed by the Company’s loan portfolios; theability or inability of the Company to manage interest rate and other risks;unexpected or continuing claims against the Company’s self-insured health plan;the Company’s use of trust preferred securities; the ability or inability ofthe Company to successfully enter into a definitive agreement for and closeanticipated transactions; technological, computer-related or operationaldifficulties; adverse changes in securities markets; results of litigation; orother significant uncertainties.

 

Forward-lookingstatements speak only as of the date they are made.  The Company does not undertake to updateforward-looking statements to reflect circumstances or events that occur afterthe date the forward-looking statements are made.

 

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**Executive Summary**

 

The Company’s net income for the firstquarter of Fiscal 2006 was $1.0 million, or $0.29 per diluted share, comparedto $1.5 million, or $0.41 per diluted share for the first quarter of Fiscal2005.  Return on average equity was 7.59%at September 30, 2005 compared with 11.16% at September 30, 2004.

 

As previously reported, the Company downgradeda $4.1 participation loan as of June 30, 2005.  A provision for loan and lease losses chargeof $2.0 million, including a $1.8 million impaired loan valuation allowance,was recorded as of June 30, 2005. On November 7, 2005, the participants in the loan, including theBank, agreed to sell their interests in the loan to a third party.  Accordingly, the Company will record a chargeof approximately $1.05 million in its second quarter of Fiscal 2006 and willreclassify the loan interests as held for sale until the completion of the saleof the loan, which is expected to occur over the next several months.  See Note 8 of the “Notes to ConsolidatedFinancial Statements” which is included in Part I, Item 1 “FinancialStatements” of this Form 10-Q for additional information.

 

Net interest income for the first threemonths ended September 30, 2005 was $6.3 million, a decrease of $205,000,or 3.1%, over the same period a year ago. This decrease in net interest income was due to approximately $84,000 inlost income resulting from the aforementioned participation loan, $66,000 inloans placed into nonaccrual during the quarter and a decrease of $28,000 fromthe reduction in the Federal Home Loan Bank dividend rate.  For the three months ended September 30,2005, average interest-earning assets increased in volume 6.3% and averageinterest-bearing liabilities increased in volume 6.4%.

 

The net interest margin for the three monthsended September 30, 2005 was 3.01%, compared to 3.30% for the same perioda year ago, a decline of 29 basis points. The flattening of the treasury yield curve caused by increasingshort-term rates and lagging long-term rates continued to affect the Company’snet interest margin ratio during the quarter. The increase in interest rates for variable priced trust preferredsecurities tied to LIBOR caused a decrease in margin of six basis points.  Variability of the net interest margin ratiomay be affected by many aspects, including Federal Reserve policies forshort-term interest rates, competitive and economic factors and customerpreferences for various products and services. From September 30, 2004 to September 30, 2005, the FederalReserve increased short-term interest rates seven times at 25 basis pointseach, for a total increase of 175 basis points.

 

Total deposits at September 30, 2005were $677.3 million, an increase of $34.3 million, or 5.3%, from September 30,2004.  Interest expense on these depositswas $4.3 million for the quarter ended September 30, 2005, which is anincrease of $1.5 million, or 55.0%, over the same period a year ago.  In-market deposits increased from $597.3million at September 30, 2004 to $636.0 million at September 30,2005, an increase of $38.7 million, or 6.5%. For the same period, out-of-market deposits decreased from $45.7 millionto $41.3 million, respectively.  Theprimary factor affecting interest expense has been money market accounts.  The volume of money market accounts increasedby $10.2 million, or 4.9%, from September 30, 2004, to September 30,2005.  Interest expense for theseaccounts also increased by $796,000, or 95.7%, compared to the same period inthe prior fiscal year.  At September 30,2005, approximately 74% of all money market accounts were indexed with amonthly reset, tied to the 91-day Treasury bill, compared to approximately 36%at September 30, 2004.  With theactions taken by the Federal Reserve, the 91-day Treasury bill has risensignificantly from 1.70% at September 30, 2004 to 3.54% at September 30,2005, an increase of 184 basis points.

 

Nonperforming assets at September 30,2005 were $8.7 million in comparison to $2.4 million a year ago, an increase of$6.3 million or 267.9%.  The ratio ofnonperforming assets to total assets increased to 0.94% at September 30,2005, compared to 0.27% at September 30, 2004.  The allowance for loan and lease lossesincreased to $5.3 million at September 30, 2005 compared to $3.6 millionat September 30,

 

14

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2004, an increase of $1.7 million or 48.3%.  As a result of increases in nonperformingassets and the allowance for loan and lease losses, the ratio of allowance forloan and lease losses to nonperforming loans and leases decreased from 155.77%at September 30, 2004 to 62.42% at September 30, 2005.

 

Despite the downgrade of the participationloan, asset quality is and continues to be a primary focus for theCompany.  The allowance for loan andlease losses is calculated based on loan and lease levels, loan and lease losshistory, credit quality of the loan and lease portfolio, and environmentalfactors such as economic health of the region and management experience.  This risk rating analysis is designed to givethe Company a consistent and systematic methodology to determine proper levelsfor the allowance at a given time.

 

As publicly announced in April 2005, theCompany renewed its annual stock buyback program for the period from May 1,2005 to April 1, 2006.  During thefirst quarter ended September 30, 2005, the Company did not repurchase anyshares, as compared to 42,700 shares repurchased during the quarter ended September 30,2004.  Under the current stock buybackprogram, the Company has repurchased a total of 47,300 shares.  In October 2005, the Company announcedan increase in its quarterly cash dividend, from 11.0 cents to 11.25 cents pershare, resulting in an annualized increase of 2.3%.

 

The total risk-based capital ratio of 10.66%at September 30, 2005 is above the 10.47% at September 30, 2004, anincrease of 19 basis points.  This continuesto place the Bank in the “well capitalized” category within OTS regulation at September 30,2005 and is consistent within the “well capitalized” OTS category in which theCompany plans to operate.  The Companyhistorically has been able to manage the size of its assets through secondarymarket loan sales of single-family mortgages and student loans and a loansecuritization.

 

The Company focuses on balancing operatingcosts with operating revenue levels in order to provide better efficiencyratios over time and continues to review its operations for ways to reduce itscost structure while continuing to support long-term revenue enhancements.  Noninterest expense was $6.7 million for thequarter ended September 30, 2005 compared to $6.3 million at September 30,2004, an increase of 5.4%.  Compensationand employee benefits expense accounted for an increase of $305,000 due toincreases in employee compensation and net healthcare costs.  However, noninterest income was $2.4 millionfor the quarter ended September 30, 2005 compared to $2.2 million for thequarter ended September 30, 2004, an increase of 8.5%.  This increase was driven primarily byincreasing gains on sale of single-family mortgage loans, with additionalincreases reported for fees on deposits and trust income.

 

The Company adopted FAS 123R effective as of July 1,2005.  As a result, the Companyrecognized $39,000 in stock option expense for the three months ended September 30,2005 compared to no expense recognized for stock options granted under theCompany’s stock option and incentive plans for the same quarter in the priorfiscal year.  The Company also recognized$88,000 in restricted stock expense for the three months ended September 30,2005, compared to $31,000 for the same period a year ago.

 

The operating efficiency ratio at September 30,2005 was 72.41%, compared to 69.57% for the same time period a year ago, anincrease of 284 basis points.  Theoperating efficiency ratio excludes the impact of net interest expense on thevariable priced trust preferred securities. The Company has issued trust preferred securities primarily to providefunding for stock repurchases and to repay other borrowings.  Net interest expense on the $27.8 million oftrust preferred securities outstanding, increased to $497,000 for the firstquarter ended September 30, 2005, compared to $362,000 for the same perioda year ago, an increase of $135,000 or 37.3%. The total efficiency ratio was 76.54% at September 30, 2005,compared to 72.45% for the same period a year ago, an increase of approximately409 basis points.  It is the Company’sgoal to move the operating efficiency ratio towards the 50% level over the longterm.  Management believes that this canbe accomplished through steady growth of the balance sheet and the containmentof incremental operating expenses.

 

15

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**General**

 

The Company is afinancial services provider and, as such, has inherent risks that must bemanaged in order to achieve net income. Primary risks that affect net income include credit risk, liquidityrisk, operational risk, regulatory compliance risk and reputation risk.  The Company’s net income is derived bymanaging net interest margin, the ability to collect fees from services provided,by controlling the costs of delivering services and the management of loan andlease losses.  The primary source ofrevenues comes from the net interest margin, which represents the differencebetween income on interest-earning assets (i.e. loans and investmentsecurities) and expense on interest-bearing liabilities (i.e. deposits andborrowed funding).  The net interestmargin is affected by regulatory, economic and competitive factors thatinfluence interest rates, loan demand and deposit flows.  Fees earned include charges for depositservices, trust services and loan services. Personnel costs are the primary expenses required to deliver theservices to customers.  Other costsinclude occupancy and equipment and general and administrative expenses.

 

**Financial Condition Data**

 

At September 30, 2005, the Company hadtotal assets of $917.9 million, an increase of $20.0 million from the level at June 30,2005.  The increase in assets was dueprimarily to increases in securities available for sale of $7.5 million, loansheld for sale of $7.0 million and net loans and leases receivable of $2.2million.  The increase in liabilities of$19.2 million from June 30, 2005 to September 30, 2005 was primarilydue to an increase in advances from the FHLB and other borrowings of $15.6million offset by a decrease in deposits of $3.9 million.  In addition, stockholders’ equity increased$839,000 to $54.5 million at September 30, 2005 from $53.6 million at June 30,2005 primarily due to net income of $1.0 million.

 

The increase in securities available for saleof $7.5 million was primarily the result of purchases of $18.7 millionexceeding sales, maturities and repayments of $10.9 million.  The purchases of $18.7 million included variable-rate,mortgage-backed securities of $12.1 million.

 

The increase in loans held for sale of $7.0million was primarily due to mortgage loans held for sale increasing from $9.8million at June 30, 2005 to $15.3 million at September 30, 2005.  Student loans held for sale increased from$400,000 at June 30, 2005 to $2.0 million at September 30, 2005.

 

The increase in net loans and leases receivable of $2.2 million was dueprimarily to an increase in purchases and originations over sales, amortizationand repayments of principal**. **In addition, deferred fees anddiscounts decreased by $40,000.  Thisdecrease was primarily due to decreases of $36,000 in indirect automobile loansthat include prepaid dealer reserves and $30,000 for deferred fees anddiscounts on one-to four family residential mortgages.

 

Advances from the FHLBand other borrowings increased $15.6 million, which was primarily due to anincrease in FHLB borrowings.  Theincrease in FHLB borrowings was primarily the result of a $3.9 million decreasein deposits and a $2.2 million increase in net loans and leases receivable.

 

The $3.9 milliondecrease in deposits was due to decreases in savings accounts of $18.9 millionand noninterest bearing checking accounts of $7.4 million offset by increasesin money market accounts of $10.7 million, in-market certificates of deposit of$6.9 million, out-of-market certificates of deposit of $4.5 million andinterest bearing checking accounts of $295,000.

 

16

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The following tablesshow the composition of the Company’s loan and lease portfolio and depositaccounts at the dates indicated.

 
| ** **                              | ** ** | **At September 30, 2005** | ** ** | **At June 30, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                              | ** ** | ** **                     | ** ** | **Percent of**            | ** ** | ** ** | ** ** | **Percent of** | ** ** |
| ** **                              | ** ** | ** **                     | ** ** | **Loans in**              | ** ** | ** ** | ** ** | **Loans in** | ** ** |
| ** **                              | ** ** | **Amount**                     | ** ** | **Each Category**         | ** ** | **Amount** | ** ** | **Each Category** | ** ** |
| ** **                              | ** ** | **(Dollars in Thousands)**     | ** ** |
|                                    |       |                           |       |                      |       |   |   |   |   |
| One-to four-family (1)                  |       | $                              | 93,894     |                      | 13.84      | % | $ | 96,496 |   | 14.28 | % |
| Commercial business and real estate (2) |       | 216,280                        |       | 31.89                     | %          | 223,638 |   | 33.10 | % |
| Multi-family real estate                |       | 34,047                         |       | 5.02                      | %          | 34,123 |   | 5.05 | % |
| Equipment finance leases                |       | 35,647                         |       | 5.26                      | %          | 33,170 |   | 4.91 | % |
| Consumer Direct (3) (4)            |       | 113,378                        |       | 16.72                     | %          | 111,210 |   | 16.46 | % |
| Consumer Indirect                       |       | 94,713                         |       | 13.97                     | %          | 93,984 |   | 13.91 | % |
| Agricultural                            |       | 78,709                         |       | 11.61                     | %          | 74,010 |   | 10.95 | % |
| Construction and development            |       | 11,456                         |       | 1.69                      | %          | 9,026 |   | 1.34 | % |
| Total Loans  and Leases Receivable (5)  |       | $                              | 678,124    |                      | 100.00     | % | $ | 675,657 |   | 100.00 | % |

 

----

(1) Excludes $15,336 and$9,838 loans held for sale at September 30, 2005 and June 30, 2005,respectively.

(2) Includes $3,563 taxexempt leases at September 30, 2005.

(3) Includes mobile homeloans.

(4) Excludes $1,929 and$400 student loans held for sale at September 30, 2005 and June 30,2005, respectively.

(5) Includes deferredloan fees and discounts and undisbursed portion of loans in process.

 
| ** **                            | ** ** | **At September 30, 2005** | ** ** | **At June 30, 2005** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | ** **                     | ** ** | **Percent of**            | ** ** | ** ** | ** ** | **Percent of** | ** ** |
| ** **                            | ** ** | ** **                     | ** ** | **Deposits in**           | ** ** | ** ** | ** ** | **Deposits in** | ** ** |
| ** **                            | ** ** | **Amount**                     | ** ** | **Each Category**         | ** ** | **Amount** | ** ** | **Each Category** | ** ** |
| ** **                            | ** ** | **(Dollars in Thousands)**     | ** ** |
|                                  |       |                           |       |                      |       |   |   |   |   |
| Noninterest bearing checking accounts |       | $                              | 78,324     |                      | 11.57      | % | $ | 85,705 |   | 12.58 | % |
| Interest bearing accounts             |       | 50,415                         |       | 7.44                      | %          | 50,120 |   | 7.36 | % |
| Money market accounts                 |       | 219,807                        |       | 32.45                     | %          | 209,116 |   | 30.70 | % |
| Savings accounts                      |       | 44,342                         |       | 6.55                      | %          | 63,235 |   | 9.28 | % |
| Certificates of deposit               |       | 284,403                        |       | 41.99                     | %          | 273,040 |   | 40.08 | % |
| Total  Deposits                       |       | $                              | 677,291    |                      | 100.00     | % | $ | 681,216 |   | 100.00 | % |

 

**Analysis of Net Interest Income**

 

Net interest income represents the differencebetween income on interest-earning assets and expense on interest-bearingliabilities.  Net interest income dependsupon the volume of interest-earning assets and interest-bearing liabilities andthe interest rates earned or paid on them.

 

*Average Balances, Interest Rates and Yields.*  The following table presents for the periodsindicated, the total dollar amount of interest income from averageinterest-earning assets and the resulting yields, as well as the interestexpense on average interest-bearing liabilities, expressed both in dollars andrates, and the net interest margin.  Thetable does not reflect any effect of income taxes.  Average balances consist of daily averagebalances for the Bank with simple average balances for all othercompanies.  The average balances includenonaccruing loans and leases.  The yieldson loans and leases include origination fees, net of costs, which areconsidered adjustments to yield.

 

17

----

 

**Rate/Volume Analysis of Net Interest Income**

 
| ** **                                     | ** ** | **THREE MONTHS ENDED SEPTEMBER 30,** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | **Average**                               | ** ** | **Interest** | ** ** | ** ** | ** ** | **Average** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Outstanding**                           | ** ** | **Earned/** | ** ** | **Yield/** | ** ** | **Outstanding** | ** ** | **Earned/** | ** ** | **Yield/** | ** ** |
| ** **                                     | ** ** | **Balance**                               | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Paid** | ** ** | **Rate** | ** ** |
| ** **                                     | ** ** | **(Dollars in Thousands)**                | ** ** |
| Interest-earning  assets:                      |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Loans and  leases receivable (1) (3)      |       | $                                         | 684,378    |   | $ | 11,121 |   | 6.45 | % | $ | 663,500 |   | $ | 9,734 |   | 5.82 | % |
| Investment  securities (2) (3)            |       | 143,812                                   |       | 1,343 |   | 3.70 | % | 116,655 |   | 921 |   | 3.13 | % |
| FHLB stock                                     |       | 6,976                                     |       | 8 |   | 0.45 | % | 5,879 |   | 35 |   | 2.36 | % |
|                                           |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                 |       | 835,166                                   |       | $ | 12,472 |   | 5.92 | % | 786,034 |   | $ | 10,690 |   | 5.40 | % |
| Noninterest-earning  assets                    |       | 66,235                                    |       |   |   |   |   | 64,867 |   |   |   |   |   |
| Total assets                                   |       | $                                         | 901,401    |   |   |   |   |   | $ | 850,901 |   |   |   |   |   |
|                                           |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                 |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Checking and  money market                     |       | $                                         | 268,858    |   | $ | 1,787 |   | 2.64 | % | $ | 260,029 |   | $ | 895 |   | 1.37 | % |
| Savings                                        |       | 51,284                                    |       | 240 |   | 1.86 | % | 50,912 |   | 106 |   | 0.83 | % |
| Certificates  of deposit                       |       | 281,467                                   |       | 2,269 |   | 3.20 | % | 263,435 |   | 1,770 |   | 2.67 | % |
| Total  interest-bearing deposits               |       | 601,609                                   |       | 4,296 |   | 2.83 | % | 574,376 |   | 2,771 |   | 1.91 | % |
| FHLB  advances and other borrowings            |       | 124,328                                   |       | 1,329 |   | 4.24 | % | 106,367 |   | 1,006 |   | 3.75 | % |
| Subordinated  debentures payable to trusts     |       | 27,837                                    |       | 512 |   | 7.30 | % | 27,837 |   | 373 |   | 5.32 | % |
| Total  interest-bearing liabilities            |       | 753,774                                   |       | 6,137 |   | 3.23 | % | 708,580 |   | 4,150 |   | 2.32 | % |
| Noninterest-bearing  deposits                  |       | 75,257                                    |       |   |   |   |   | 70,806 |   |   |   |   |   |
| Other  liabilities                             |       | 18,460                                    |       |   |   |   |   | 19,166 |   |   |   |   |   |
| Total  liabilities                             |       | 847,491                                   |       |   |   |   |   | 798,552 |   |   |   |   |   |
| Equity                                         |       | 53,910                                    |       |   |   |   |   | 52,349 |   |   |   |   |   |
| Total  liabilities and equity                  |       | $                                         | 901,401    |   |   |   |   |   | $ | 850,901 |   |   |   |   |   |
|                                           |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income; interest rate spread (4) |       |                                      |       | $ | 6,335 |   | 2.69 | % |   |   | $ | 6,540 |   | 3.08 | % |
|                                           |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin (4) (5)              |       |                                      |       |   |   | 3.01 | % |   |   |   |   | 3.30 | % |
|                                           |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin, FTE (6)                  |       |                                      |       |   |   | 3.05 | % |   |   |   |   | 3.33 | % |

 

----

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

(2)  Includesfederal funds sold.

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

(4)  Percentagesfor the three months ended September 30, 2005 and September 30, 2004have been annualized.

(5)  Net interest margin is net interestincome divided by average interest-earning assets.

(6)  Net interestmargin expressed on a fully taxable equivalent basis.

 

18

----

 

The following schedule presentsthe dollar amount of changes in interest income and interest expense for majorcomponents of interest-earning assets and interest-bearing liabilities.  It distinguishes between the increases anddecreases due to fluctuating outstanding balances that are due to the levelsand volatility of interest rates.  Foreach category of interest-earning assets and interest-bearing liabilities,information is provided on changes attributable to (i) changes in volume(i.e., changes in volume multiplied by old rate) and (ii) changes in rate(i.e., changes in rate multiplied by old volume).  For purposes of this table, changesattributable to both rate and volume, which cannot be segregated, have beenallocated proportionately to the change due to volume and the change due torate.

 
| ** **                                | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2005 vs 2004**                          | ** ** |
| ** **                                | ** ** | ** **                                | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Increase**                              | ** ** | **(Decrease)** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Due to**                                | ** ** | **Due to** | ** ** | **Increase** | ** ** |
| ** **                                | ** ** | **Volume**                                | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**                | ** ** |
| Interest-earning assets:                  |       |                                      |       |   |   |   |   |
| Loans and  leases receivable (1)          |       | $                                         | 306        |   | $ | 1,081 |   | $ | 1,387 |   |
| Investment  securities (2)                |       | 214                                       |       | 208 |   | 422 |   |
| FHLB stock                                |       | 7                                         |       | (34 | ) | (27 | ) |
|                                      |       |                                      |       |   |   |   |   |
| Total interest-earning assets             |       | $                                         | 527        |   | $ | 1,255 |   | $ | 1,782 |   |
|                                      |       |                                      |       |   |   |   |   |
| Interest-bearing liabilities:             |       |                                      |       |   |   |   |   |
| Deposits:                                 |       |                                      |       |   |   |   |   |
| Checking and  money market                |       | $                                         | 30         |   | $ | 862 |   | $ | 892 |   |
| Savings                                   |       | 1                                         |       | 133 |   | 134 |   |
| Certificates  of deposit                  |       | 121                                       |       | 378 |   | 499 |   |
| Total  interest-bearing deposits          |       | 152                                       |       | 1,373 |   | 1,525 |   |
| FHLB advances and other borrowings        |       | 170                                       |       | 153 |   | 323 |   |
| Subordinated debentures payable to trusts |       | —                                    |       | 139 |   | 139 |   |
|                                      |       |                                      |       |   |   |   |   |
| Total interest-bearing liabilities        |       | $                                         | 322        |   | $ | 1,665 |   | $ | 1,987 |   |
|                                      |       |                                      |       |   |   |   |   |
| Net interest income increase              |       |                                      |       |   |   | $ | (205 | ) |

 

----

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

(2)  Includesfederal funds sold.

 

19

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**Application of Critical Accounting Policies**

 

GAAP requires managementto utilize estimates when reporting financial results.  The Company has identified the policiesdiscussed below as Critical Accounting Policies because the accountingestimates require management to make certain assumptions about matters that maybe uncertain at the time the estimate was made and a different method ofestimating could have been reasonably made that could have a material impact onthe presentation of the Company’s financial condition, changes in financialcondition or results of operations.

 

*Allowance for Loan and Lease Losses*– GAAP requires the Company to set aside reserves or maintain an allowanceagainst probable loan and lease losses in the loan and lease portfolio.  Management must develop a consistent andsystematic approach to estimate the appropriate balances that will cover theprobable losses.  Due to the uncertaintyof future events, the approach includes a process that may differ significantlyfrom other methodologies and still produce an estimate that is in accordancewith GAAP.

 

The allowance is compiled by utilizing theCompany’s loan and lease risk rating system, which is structured to identifyweaknesses in the loan and lease portfolio. The risk rating system has evolved to a process whereby managementbelieves the system will properly identify the credit risk associated with theloan and lease portfolio.  Due to thestratification of loans and leases for the allowance calculation, the estimateof the allowance for loan and lease losses could change materially if the loanand lease risk rating system would not properly identify the strength of alarge or a few large loan and lease customers. Although management believes that it uses the best information availableto determine the allowance, unforeseen market or borrower conditions couldresult in adjustments and net earnings being significantly affected ifcircumstances differ substantially from the assumptions used in making thefinal determinations.

 

*Mortgage ServicingRights (“MSR”)* – The Company records a servicingasset for contractually separated servicing from the underlying mortgage loans.  The asset is initially recorded at fair valueand represents an intangible asset backed by an income stream from the servicedassets.  The asset is amortized in proportionto and over the period of estimated net servicing income.

 

At each balance sheet date, the MSRs areanalyzed for impairment, which occurs when the fair value of the MSRs is lowerthan the amortized book value. The Company’s MSRs are primarily servicingrights acquired on South Dakota Housing Development Authority first time homebuyers program.  Due to the lack ofquoted markets for the Company’s servicing portfolio, the Company estimates thefair value of the MSRs using present value of future cash flow analysis.  If the analysis produces a fair value that isgreater than or equal to the amortized book value of the MSRs, no impairment isrecognized.  If the fair value is lessthan the book value, an expense for the difference is charged to earnings byinitiating a MSR valuation account.  Ifthe Company determines this impairment is temporary, any future changes in fairvalue are recorded as a change in earnings and the valuation.  If the Company determines the impairment tobe permanent, the valuation is written off against the MSRs, which results in anew amortized balance.

 

Due to the substantial decline in interestrates over the last several fiscal years, the Company has included MSRs as acritical accounting policy because the use of estimates for determining fairvalue using present value concepts may produce results which may significantlydiffer from other fair value analysis perhaps even to the point of recordingimpairment.  The risk to earnings is whenthe underlying mortgages payoff significantly faster than the assumptions usedin the previously recorded amortization. Estimating future cash flows on the underlying mortgages is a difficultanalysis and requires judgment based on the best information available.  The Company looks at alternative assumptionsand projections when preparing a reasonable and supportable analysis.  Based on the Company’s quarterly analysis ofMSRs, there was no impairment to the MSRs at September 30, 2005.

 

*Retained Interest from Securitization* – TheCompany recorded an asset as a result of the automobile securitization.  See Note 4 of the “Notes to UnauditedConsolidated Financial Statements” which is included in Part I, Item I “FinancialStatements” of this Form 10-Q.  Thisasset is recorded based on present value concepts of future expected cashflows.  The assumptions used to calculatethe initial retained interest value and subsequent assumptions are based on thebest information available.  The value ofthe retained interest may change significantly if actual cash flows differ fromexpected cash flows.

 

20

----

 

*Self-Insurance*-The Company has a self-insured healthcare plan for its employees up to certainlimits.  To mitigate a portion of theserisks, the Company has a stop-loss insurance policy through a commercialinsurance carrier for coverage in excess of $60,000 per individual occurrencewith a maximum aggregate limitation of $1.0 million.  The estimate of self-insurance liability isbased upon known claims and an estimate of incurred, but not reported (“IBNR”)claims.  IBNR claims are estimated usinghistorical claims lag information received by a third party claimsadministrator.  Due to the uncertainty ofhealth claims, the approach includes a process that may differ significantlyfrom other methodologies and still produce an estimate that is in accordancewith GAAP.  Although management believesthat it uses the best information available to determine the accrual,unforeseen health claims could result in adjustments to the accrual.  These adjustments could significantly affectnet earnings if circumstances differ substantially from the assumptions used inestimating the accrual.

 

**Asset Quality and Potential Problem Loans andLeases**

 

Nonperforming assets (nonaccrual loans andleases, accruing loans and leases delinquent more than 90 days and foreclosedassets) increased to $8.6 million at September 30, 2005 from $7.0 millionat June 30, 2005, an increase of $1.6 million, or 23.5%.  Accruing loans and leases delinquent morethan 90 days increased $1.0 million to $2.6 million at September 30, 2005compared to $1.6 million at June 30, 2005. In addition, the ratio of nonperforming assets to total assets, which isone indicator of credit risk exposure, increased to 0.94% at September 30,2005 from 0.78% at June 30, 2005.

 

Nonaccruing loans and leases increased 10.8%,or $574,000, to $5.9 million at September 30, 2005 compared to $5.3million at June 30, 2005.  Includedin nonaccruing loans and leases at September 30, 2005 were four loanstotaling $261,000 secured by one- to four-family real estate, 11 loans totaling$4.2 million secured by commercial business, six leases totaling $171,000, 37consumer loans totaling $469,000 and three agriculture loans totaling $750,000.

 

The risk rating system in place is designedto identify and manage the nonperforming loans and leases.  Commercial and agricultural loans andequipment finance leases will have specific reserve allocations based on collateralvalues or based on the present value of expected cash flows if the loans andleases are deemed impaired.  Loans andleases that are not performing do not necessarily result in a loss.

 

As of September 30, 2005, the Companyhad $148,000 of foreclosed assets.  Thebalance of foreclosed assets at September 30, 2005 consisted of $1,000 ofsingle-family collateral owned, $33,000 in equipment finance leases and$114,000 of consumer collateral owned.

 

At September 30, 2005, the Company haddesignated $10.3 million of its assets as special mention and classified $1.8million of its assets that management has determined need to be closelymonitored because of possible credit problems of the borrowers or the cashflows of the secured properties.  At September 30,2005 the Company had $23.7 million in multi-family, commercial business,commercial real estate and agricultural participation loans purchased, of which$4.2 million were classified as of September 30, 2005.  These loans and leases were considered indetermining the adequacy of the allowance for loan and lease losses.  The allowance for loan and lease losses isestablished based on management’s evaluation of the risks probable in the loanand lease portfolio and changes in the nature and volume of loan and leaseactivity.  Such evaluation, whichincludes a review of all loans and leases for which full collectibility may notbe reasonably assured, considers the estimated fair market value of theunderlying collateral, present value of expected principal and interestpayments, economic conditions, historical loss experience and other factorsthat warrant recognition in providing for an adequate loan and lease lossallowance.

 

21

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Although the Company’smanagement believes that the September 30, 2005 recorded allowance forloan and lease losses was adequate to provide for probable losses on therelated loans and leases, there can be no assurance that the allowance existingat September 30, 2005 will be adequate in the future.

 

In accordance with the Company’sinternal classification of assets policy, management evaluates the loan andlease portfolio on a monthly basis to identify loss potential and determinesthe adequacy of the allowance for loan and lease losses quarterly.  Loans and leases are placed on nonaccrualstatus when the collection of principal and/or interest become doubtful.  Foreclosed assets include assets acquired insettlement of loans.  The following tablesets forth the amounts and categories of the Company’s nonperforming assets forthe periods indicated.

 
| ** **                                                                      | ** ** | **Nonperforming Assets As Of** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,**         | ** ** | **June 30,** | ** ** |
| ** **                                                                      | ** ** | **2005**                       | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | **(Dollars in Thousands)**     | ** ** |
| Nonaccruing loans and leases:                                                   |       |                           |       |   |   |
| One- to  four-family                                                            |       | $                              | 261        |   | $ | 263 |   |
| Commercial  real estate                                                         |       | —                         |       | 70 |   |
| Commercial  business                                                            |       | 4,245                          |       | 4,518 |   |
| Equipment  finance leases                                                       |       | 171                            |       | 130 |   |
| Consumer (1)                                                                    |       | 469                            |       | 341 |   |
| Agricultural                                                                    |       | 750                            |       | — |   |
| Total                                                                           |       | 5,896                          |       | 5,322 |   |
|                                                                            |       |                           |       |   |   |
| Accruing loans and leases delinquent more  than 90 days:                        |       |                           |       |   |   |
| One- to  four-family                                                            |       | 266                            |       | 98 |   |
| Commercial  real estate                                                         |       | 627                            |       | 292 |   |
| Commercial  business                                                            |       | 1,164                          |       | 1,052 |   |
| Equipment  finance leases                                                       |       | 202                            |       | 71 |   |
| Consumer (1)                                                                    |       | 2                              |       | — |   |
| Agricultural                                                                    |       | 367                            |       | 96 |   |
| Total                                                                           |       | 2,628                          |       | 1,609 |   |
|                                                                            |       |                           |       |   |   |
| Foreclosed assets: (2)                                                          |       |                           |       |   |   |
| One- to  four-family                                                            |       | 1                              |       | 39 |   |
| Equipment  finance leases                                                       |       | 33                             |       | — |   |
| Consumer (1)                                                                    |       | 114                            |       | 50 |   |
| Total                                                                           |       | 148                            |       | 89 |   |
|                                                                            |       |                           |       |   |   |
| Total nonperforming assets                                                      |       | $                              | 8,672      |   | $ | 7,020 |   |
|                                                                            |       |                           |       |   |   |
| Ratio of nonperforming assets to total  assets                                  |       | 0.94                           | %          | 0.78 | % |
|                                                                            |       |                           |       |   |   |
| Ratio of nonperforming loans and leases to  total loans and leases (3) (4) |       | 1.23                           | %          | 1.01 | % |

 

----

(1) Includesmobile home loans.

(2) Totalforeclosed assets do not include land or other real estate owned held for sale.

(3) Nonperformingloans and leases include both nonaccruing and accruing loans and leases delinquentmore than 90 days.

(4) Totalloans and leases include loans held for sale.

 

22

----

 

The following table sets forth information with respectto activity in the Company’s allowance for loan and lease losses during theperiods indicated.

 
| ** **                                                                                               | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                                                                               | ** ** | **(Dollars in Thousands)**                | ** ** |
|                                                                                                     |       |                                      |       |   |   |
| Balance at  beginning of period                                                                          |       | $                                         | 5,076      |   | $ | 3,605 |   |
| Charge-offs:                                                                                             |       |                                      |       |   |   |
| One- to  four-family                                                                                     |       | (1                                        | )          | — |   |
| Commercial  business                                                                                     |       | (2                                        | )          | (18 | ) |
| Equipment  finance leases                                                                                |       | (6                                        | )          | (4 | ) |
| Consumer (1)                                                                                             |       | (267                                      | )          | (282 | ) |
| Agriculture                                                                                              |       | —                                    |       | (14 | ) |
| Total  charge-offs                                                                                       |       | (276                                      | )          | (318 | ) |
|                                                                                                     |       |                                      |       |   |   |
| Recoveries:                                                                                              |       |                                      |       |   |   |
| One- to  four-family                                                                                     |       | 1                                         |       | — |   |
| Commercial  real estate                                                                                  |       | —                                    |       | — |   |
| Commercial  business                                                                                     |       | —                                    |       | 2 |   |
| Equipment  finance leases                                                                                |       | 6                                         |       | 1 |   |
| Consumer (1)                                                                                             |       | 52                                        |       | 51 |   |
| Agriculture                                                                                              |       | —                                    |       | 69 |   |
| Total  recoveries                                                                                        |       | 59                                        |       | 123 |   |
|                                                                                                     |       |                                      |       |   |   |
| Net  (charge-offs)                                                                                       |       | (217                                      | )          | (195 | ) |
|                                                                                                     |       |                                      |       |   |   |
| Additions  charged to operations                                                                         |       | 462                                       |       | 179 |   |
|                                                                                                     |       |                                      |       |   |   |
| Balance at  end of period                                                                                |       | $                                         | 5,321      |   | $ | 3,589 |   |
|                                                                                                     |       |                                      |       |   |   |
| Ratio of net  (charge-offs) during the period to average loans and leases outstanding  during the period |       | (0.03                                     | )%         | (0.03 | )% |
|                                                                                                     |       |                                      |       |   |   |
| Ratio of  allowance for loan and lease losses to total loans and leases at end of  period (2)            |       | 0.77                                      | %          | 0.53 | % |
|                                                                                                     |       |                                      |       |   |   |
| Ratio of  allowance for loan and lease losses to nonperforming loans and leases at end  of period (3)    |       | 62.42                                     | %          | 155.77 | % |

 

----

(1) Includesmobile home loans.

(2) Totalloans and leases include loans held for sale.

(3) Nonperformingloans and leases include both nonaccruing and accruing loans and leases delinquentmore than 90 days.

 

23

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The distribution of the Company’s allowancefor loan and lease losses and impaired loss summary as required by FASBStatement No. 114, “Accounting by Creditors for Impairment of a Loan” aresummarized in the following tables.  Thecombination of FASB 5 and FASB 114 calculations comprise the Company’sallowance for loan and lease losses.

 
| ** **               | ** ** | **FASB 5**                     | ** ** | **FASB 114**              | ** ** | **FASB 5**       | ** ** | **FASB 114**      | ** ** |
|--------------------------|------------|--------------------------------|------------|---------------------------|------------|------------------|------------|-------------------|------------|
| ** **               | ** ** | **Allowance**                  | ** ** | **Impaired Loan**         | ** ** | **Allowance**    | ** ** | **Impaired Loan** | ** ** |
| ** **               | ** ** | **for Loan and**               | ** ** | **Valuation**             | ** ** | **for Loan and** | ** ** | **Valuation**     | ** ** |
| ** **               | ** ** | **Lease Losses**               | ** ** | **Allowance**             | ** ** | **Lease Losses** | ** ** | **Allowance**     | ** ** |
| **Loan Type**            | ** ** | **At September 30, 2005** | ** ** | **At June 30, 2005** | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)**     | ** ** |
|                     |       |                           |       |                      |       |             |       |              |       |
| One- to four-family      |       | $                              | 187        |                      | $          | —           |       | $                 | 186        |   | $ | — |   |
| Commercial real estate   |       | 247                            |       | —                    |       | 200              |       | —            |       |
| Multi-family real estate |       | 68                             |       | —                    |       | 61               |       | —            |       |
| Commercial business      |       | 751                            |       | 1,750                     |       | 844              |       | 1,750             |       |
| Equipment finance leases |       | 430                            |       | —                    |       | 359              |       | —            |       |
| Consumer (1)             |       | 1,472                          |       | —                    |       | 1,343            |       | —            |       |
| Agricultural             |       | 416                            |       | —                    |       | 333              |       | —            |       |
|                     |       |                           |       |                      |       |             |       |              |       |
| Total                    |       | $                              | 3,571      |                      | $          | 1,750            |       | $                 | 3,326      |   | $ | 1,750 |   |

 

----

(1) Includes mobile home loans.

 

**FASB 114 Impaired Loan Summary**

 
| ** **          | ** ** | ** **                     | ** ** | ** **                 | ** ** | **Impaired**  | ** ** | ** **    | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|---------------------|------------|--------------------------------|------------|----------------------------|------------|---------------|------------|---------------|------------|-------------|------------|---------------|------------|
| ** **          | ** ** | **Number**                     | ** ** | ** **                 | ** ** | **Loan**      | ** ** | **Number**    | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| ** **          | ** ** | **of Loan**                    | ** ** | **Loan**                   | ** ** | **Valuation** | ** ** | **of Loan**   | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| ** **          | ** ** | **Customers**                  | ** ** | **Balance**                | ** ** | **Allowance** | ** ** | **Customers** | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan Type**       | ** ** | **At September 30, 2005** | ** ** | **At June 30, 2005**  | ** ** |
| ** **          | ** ** | **(Dollars in Thousands)**     | ** ** | **(Dollars in Thousands)** | ** ** |
|                |       |                           |       |                       |       |          |       |          |       |        |       |          |       |
| Commercial business |       | 4                              |       | $                          | 4,175      |          | $          | 1,750         |       | 4           |       | $             | 4,152      |   | $ | 1,750 |   |
| Total               |       | 4                              |       | $                          | 4,175      |          | $          | 1,750         |       | 4           |       | $             | 4,152      |   | 1,750 |   |
|                     |            |                                |            |                            |            |               |            |               |            |             |            |               |            |  |  |  |  |

 

24

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The allowance for loan and lease losses was$5.3 million at September 30, 2005 as compared to $3.6 million at September 30,2004.  The ratio of the allowance forloan and lease losses to total loans and leases was 0.77% at September 30,2005 compared to 0.53% at September 30, 2004.  The Company’s management has considerednonperforming loans and leases and potential problem loans and leases inestablishing the allowance for loan and lease losses.  The Company continues to monitor itsallowance for probable loan and lease losses and make future additions orreductions in light of the level of loans and leases in its portfolio and aseconomic conditions dictate.  Thecurrent level of the allowance for loan and lease losses is a result ofmanagement’s assessment of the risks within the portfolio based on theinformation revealed in credit reporting processes. The Company utilizes arisk-rating system on all commercial business, agricultural, construction andmulti-family and commercial real estate loans, including purchased loans.  A periodic credit review is performed on alltypes of loans and leases to establish the necessary reserve based on theestimated risk within the portfolio. This assessment of risk takes into accountthe composition of the loan and lease portfolio, historical loss experience foreach loan and lease category, previous loan and lease experience, concentrationsof credit, current economic conditions and other factors that in management’sjudgment deserve recognition.

 

Real estate propertiesacquired through foreclosure are recorded at the lower of cost or fair value(less a deduction for disposition costs). Valuations are periodically updated by management and a specificprovision for losses on such properties is established by a charge tooperations if the carrying values of the properties exceed their estimated netrealizable values.

 

Althoughmanagement believes that it uses the best information available to determinethe allowances, unforeseen market conditions could result in adjustments andnet earnings being significantly affected if circumstances differ substantiallyfrom the assumptions used in making the final determinations.  Future additions to the Company’s allowancesresult from periodic loan, property and collateral reviews and thus cannot bepredicted in advance.

 

25

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**Comparison of the Three MonthsEnded September 30, 2005 and September 30, 2004**

 

*General*.  The Company’s net income was $1.0 million, or$0.29 for both basic and diluted earnings per share for the three months ended September 30,2005, a $437,000 decrease in earnings compared to $1.5 million, or $0.41 forboth basic and diluted earnings per share for the same period in the priorfiscal year.  For the three months ended September 30,2005, the return on average equity was 7.59%, a 32.0% decrease compared to11.16% for the same period in the prior fiscal year.  For the three months ended September 30,2005, the return on average assets was 0.45%, a 34.8% decrease compared to0.69% for the same period in the prior fiscal year.  As discussed in more detail below, thedecreases were due to a variety of key factors, including a decrease in netinterest income of $205,000 and increases in provision for losses on loans andleases of $283,000 and noninterest expense of $343,000 offset by an increase innoninterest income of $187,000 and a decrease in income tax expense of$207,000.

 

*Interest,Dividend and Loan Fee Income.* Interest, dividend and loan fee income was $12.5 million for the threemonths ended September 30, 2005 as compared to $10.7 million for the sameperiod in the prior fiscal year, an increase of $1.8 million or 16.7%.  A $1.1 million increase in interest, dividendand loan fee income was the result of an increase in the average yield on loansand leases receivable from 5.82% for the three months ended September 30,2004 to 6.45% for the three months ended September 30, 2005 and a $306,000increase in interest, dividend and loan fee income was due to a 3.1% increasein the average volume of loans and leases receivable. The average yield ontotal interest-earning assets was 5.92% for the three months ended September 30,2005 as compared to 5.40% for the same period in the prior fiscal year.

 

*Interest Expense.*  Interest expense was $6.1 million for thethree months ended September 30, 2005 as compared to $4.2 million for thesame period in the prior fiscal year, an increase of $2.0 million or47.9%.  A $1.4 million increase ininterest expense was the result of an increase in average yield oninterest-bearing deposits from 1.91% for the three months ended September 30,2004 to 2.83% for the three months ended September 30, 2005.  A $170,000 increase in interest expense wasthe result of a 16.9% increase in the average balance of FHLB advances andother borrowings and a $153,000 increase in interest expense was a result ofthe average yield on FHLB advances and other borrowings increasing from 3.75%for the three months ended September 30, 2004 to 4.24% for the threemonths ended September 30, 2005.  Anincrease of $1.7 million in interest expense was the result of an increase in theaverage yield on interest bearing liabilities from 2.32% for the three monthsended September 30, 2004 to 3.23% for the three months ended September 30,2005.

 

*Net Interest Income.*The Company’s net interest income for the three months ended September 30,2005 decreased $205,000, or 3.2%, to $6.3 million compared to $6.5 million forthe same period in the prior fiscal year. The decrease in net interest income was due primarily to an increase inthe average yield on interest bearing liabilities for the three months ended September 30,2005 compared to the same period in the prior fiscal year offset by an increasein the average yield on interest earning assets for the three months ended September 30,2005 compared to the same period in the prior fiscal year.  The Company’s net interest margin was 3.01%for the first quarter of Fiscal 2006 as compared to 3.30% for the same periodin the prior fiscal year.

 

*Provision for Losses on Loans and Leases.*The allowance for loan and leaselosses is maintained at a level which is considered by management to beadequate to absorb probable losses on existing loans and leases that may becomeuncollectible, based on an evaluation of the collectibility of loans and leasesand prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in thenature and volume of the loan and lease portfolio, overall portfolio quality,review of specific problem loans and leases, and current economic conditionsthat may affect the borrower’s ability to pay. The allowance for loan and lease losses is established through aprovision for losses on loans and leases charged to expense.

 

26

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During the three months ended September 30,2005, the Company recorded a provision for losses on loans and leases of$462,000 compared to $179,000 for the three months ended September 30,2004, an increase of $283,000.  See “AssetQuality” for further discussion.

 

*Noninterest Income.*  Noninterest income was $2.4 million for thethree months ended September 30, 2005 as compared to $2.2 million for thesame period in the prior fiscal year, an increase of $187,000 or 8.5%.  The increase in noninterest income was dueprimarily to increases in net gain on sale of loans of $153,000, fees ondeposits of $56,000 and trust income of $36,000 offset by a decrease in loanservicing income of $60,000.

 

Net gain on sale of loans was $255,000 forthe three months ended September 30, 2005 as compared to $102,000 for thesame period in the prior fiscal year, an increase of $153,000 or 150.0%.  The increase was primarily due to an increasein residential mortgage loan production of 45.3% in dollar volume for the threemonths ended September 30, 2005 as compared to the same period in theprior fiscal year.

 

Fees on depositsincreased $56,000 primarily due to an increase in fees collected onpoint-of-sale purchases by customers. The remaining increase in fees on deposits is comprised of various otherdeposit fee income.

 

Trust income increased $36,000primarily due to assets under management increasing from $87.7 million to$103.7 million.

 

Loan servicing income decreased $60,000 from$372,000 for the three months ended September 30, 2004 to $312,000 for thethree months ended September 30, 2005 primarily due to a decrease in thenumber of loans serviced by the Bank.

 

*Noninterest Expense.*  Noninterest expense was $6.7 million for thethree months ended September 30, 2005 as compared to $6.3 million for thethree months ended September 30, 2004. The increase in noninterest expense was primarily due to increases incompensation and employee benefits $305,000 and other noninterest expense of$41,000.

 

Compensation and employee benefits increased $305,000, or 7.6%, to $4.3million for the three months ended September 30, 2005 as compared to $4.0million for the three months ended September 30, 2004.  Net healthcare costs, inclusive of healthclaims and administration fees offset by stop loss and employee reimbursementunder the Company’s self-insured health plan were $419,000 for the three monthsended September 30, 2005, an increase of $38,000, or 9.1% compared to theprior fiscal year.  In addition,compensation and employee benefits increased $49,000 for training and tuitionexpenses with the remainder of the increase being primarily due to meritincreases, bonuses and additional staffing over the prior year.

 

Other noninterest expense increased $41,000for the three months ended September 30, 2005 compared to the same periodin the prior fiscal year primarily due to increases in computer service expenseand freight and courier expense.

 

*Income tax expense.*  The Company’s income tax expense for thethree months ended September 30, 2005 decreased $207,000 or 27.0% to$561,000 compared to $768,000 for the same period in the prior fiscalyear.  The effective tax rate was 35.4%and 34.5% for the three months ended September 30, 2005 and September 30,2004, respectively.  The increase in theeffective tax rate for the quarter was the result of an increase in theexpected effective tax rate for Fiscal 2005 due to permanent tax differences.

 

27

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**Liquidity and Capital Resources**

 

The Bank’s primary sources of funds areearnings, in-market deposits, FHLB advances and other borrowings, repayments ofloan principal, mortgage-backed securities and callable agency securities and,to a lesser extent, sales of mortgage loans, sales and maturities ofsecurities, out-of-market deposits and short-term investments.  While scheduled loan payments and maturingsecurities are relatively predictable, deposit flows and loan and securityprepayments are more influenced by interest rates, general economic conditionsand competition. The Bank attempts to price its deposits to meet its asset/liabilityobjectives consistent with local market conditions.  Excess balances are invested in overnightfunds.

 

Liquidity management is both a daily andlong-term responsibility of management. The Bank adjusts its investments in liquid assets based upon management’sassessment of (i) expected loan demand, (ii) projected loan sales, (iii) expecteddeposit flows, (iv) yields available on interest-bearing deposits, and (v) theobjectives of its asset/liability management program.  Excess liquidity is invested generally ininterest-bearing overnight deposits and other short-term government and agencyobligations.

 

The Bank anticipates that it will havesufficient funds available to meet current loan commitments.  At September 30, 2005, the Bank hadoutstanding commitments to originate residential mortgage loans of $28.1million, commercial real estate loans of $7.4 million and commercial businessloans of $1.9 million.  In addition, theBank had outstanding commitments to sell residential mortgage loans of $25.1million and consumer student loans of $1.9 million.  Commitments by the Bank to originate loansare not necessarily executed by the customer. The Bank monitors the ratio of commitments to funding for use inliquidity management.  At September 30,2005, the Bank had no commitments to purchase or sell securities available forsale.

 

The growth in indirectlending has provided securitization opportunities in the capital markets.  On January 31, 2003, the Bank soldapproximately $40.1 million principal of indirect and $9.9 million principal ofdirect automobile receivables in a securitization transaction.  The proceeds were used in part to continue toservice the demand of the Bank’s dealer network.  The securitization is a source of funds at arate lower than other sources of funds, which reduces the Bank’s capitalrequirements and the credit risk from the loans sold.  See Note 4 of the “Notes to ConsolidatedFinancial Statements” which is included in Part I, Item 1 “FinancialStatements” of this Form 10-Q for additional information on the consumerautomobile securitization.

 

Although in-marketdeposits are the Bank’s primary source of funds, the Bank’s policy has been toutilize borrowings where the funds can be invested in either loans orsecurities at a positive rate of return or to use the funds for short-termliquidity purposes.  The Bank currentlyhas two unsecured lines of federal funds totaling $25.0 million withcorrespondent banks.  There were no fundsdrawn on either line of credit at September 30, 2005.  Additionally, as of September 30, 2005,the Bank had $40.0 million in out-of-market certificates of deposit and$701,000 in out-of-market money market accounts.  The Bank may also seek other sources ofcontingent liquidity including additional federal funds purchased lines withcorrespondent banks and lines of credit with the Federal Reserve Bank.

 

The Company uses itscapital resources to pay dividends to its stockholders, to repurchase Companystock pursuant to Board of Directors approved plans, to support organic growth,to make acquisitions, to service its debt obligations and to provide fundingfor investment into the Bank of Tier 1 (core) capital.

 

The Company currentlyhas in effect a stock buyback program in which up to 10% of the common stock ofthe Company outstanding on May 1, 2005 may be acquired through April 30,2006.  As of September 30, 2005, atotal of 47,300 shares of common stock have been purchased pursuant to thecurrent program, all of which were purchased during May and June 2005.  See Part II, Item 2 “Unregistered Salesof Equity Securities and Use of Proceeds” of this Form 10-Q.

 

28

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Savings institutionsinsured by the Federal Deposit Insurance Corporation are required by the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 to meet threeregulatory capital requirements.  If arequirement is not met, regulatory authorities may take legal or administrativeactions, including restrictions on growth or operations or, in extreme cases,seizure.  Institutions not in compliancemay apply for an exemption from the requirements and submit a recapitalizationplan.  Under these capital requirements,at September 30, 2005, the Bank met all current capital requirements.

 

The minimum OTS Tier 1 (core) capitalrequirement for well-capitalized institutions is 5.00% of total adjusted assetsfor thrifts.  The Bank had Tier 1 (core)capital of 8.23% at September 30, 2005. The minimum OTS total risk-based capital requirement for well-capitalizedinstitutions is 10.00% of risk-weighted assets. The Bank had total risk-based capital of 10.66% at September 30,2005.

 

**Off-Balance Sheet Financing Arrangements**

 

During the fiscal year ended June 30,2003, the Bank securitized and sold consumer automobile loans in the amount of$50.0 million through HFSC and Automobile Securitization Trust.  The outstanding balance of the securitizedautomobile loans was $5.0 million at September 30, 2005.  As part of the sales transaction, the Bankretains servicing responsibilities and a retained interest in the receivables,which is subordinated to third party investors’ interests.  The receivables were sold without legalrecourse.  The sale provided the Bankwith an additional source of liquidity at interest rates more favorable than itcould receive through other forms of financing. It also assisted in reducing capital requirements and credit risk to theBank, in addition to giving the Bank access to the national capitalmarkets.  See Note 4 of the “Notes toConsolidated Financial Statements” which is included in Part I, Item 1 “FinancialStatements” of this Form 10-Q for further detail.

 

**Impact of Inflation and Changing Prices**

 

The unauditedconsolidated financial statements and notes thereto presented in this QuarterlyReport on Form 10-Q have been prepared in accordance with GAAP, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars without considering the change in the relative purchasingpower of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Bank’soperations. Unlike most industrial companies, nearly all the assets andliabilities of the Bank are monetary in nature. As a result, interest rates have a greater impact on the Bank’sperformance than do the effects of general levels of inflation.  Interest rates do not necessarily move in thesame direction or to the same extent as the prices of goods and services.

 

**Recent Accounting Pronouncements**

 

In December 2005, FASB issued SFAS No. 123R, “Share-BasedPayment”, which requires all companies to measure compensation costs for allshare-based payments (including stock options) at fair value.  The Company adopted SFAS No. 123Reffective as of July 1, 2005.

 

SFAS No. 123R provides two alternativesfor adoption: (1) a “modified prospective” method in which compensationcosts is recognized for all awards granted subsequent to the effective date ofthis statement as well as for the unvested portion of awards outstanding as ofthe effective date and (2) a “modified retrospective” method which followsthe approach in the “modified prospective” method, but also permits entities torestate prior periods to reflect compensation cost calculated under SFAS No. 123for pro forma amounts disclosure.  TheCompany adopted the Black-Scholes option-pricing model and the modifiedprospective method.

 

In May 2005, FASB issued SFAS No. 154, “Accounting Changesand Error Corrections”, which requires that a voluntary change in accountingprinciple be applied retrospectively with all prior period financial statementspresented, unless it is impracticable to do so. The new standard is effective for accounting changes and correction oferrors made in fiscal years beginning after December 15, 2005.  The Company has not determined the effect theadoption of SFAS No. 154 will have on its consolidated financialstatements.

 

29

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**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

 

The Company’s net income is largely dependenton its net interest income.  Net interestincome is susceptible to interest rate risk to the degree that interest-bearingliabilities with short- and medium-term maturities mature or reprice more rapidlythan its interest-earning assets.  Wheninterest-bearing liabilities mature or reprice more quickly thaninterest-earning assets in a given period, a significant increase in marketrates of interest could adversely affect net interest income.  Similarly, when interest-earning assetsmature or reprice more quickly than interest-bearing liabilities, fallinginterest rates could result in a decrease in net income.

 

In an attempt to manageits exposure to change in interest rates, management monitors the Company’sinterest rate risk.  The Company’sAsset-Liability Committee meets periodically to review the Company’s interestrate risk position and profitability, and to recommend adjustments forconsideration by executive management. Management also reviews the Bank’ssecurities portfolio, formulates investment strategies, and oversees the timingand implementation of transactions to assure attainment of the Board ‘sobjectives in the most effective manner. In managing market risk and the asset/liability mix, the Bank has placedits emphasis on developing a portfolio in which, to the extent practicable,assets and liabilities reprice within similar periods.  Notwithstanding the Company’s interest raterisk management activities, the potential for changing interest rates is anuncertainty that can have an adverse effect on net income.  The Company does not currently engage intrading activities or use derivative instruments to control interest rate riskalthough it may in the future, if necessary, to manage interest rate risk.

 

In adjusting the Company’s asset/liabilityposition, management attempts to manage the Company’s interest rate risk whileenhancing net interest margins.  Attimes, depending on the level of general interest rates, the relationshipbetween long and short-term interest rates, market conditions and competitivefactors, management may determine to increase the Company’s interest rate riskposition somewhat in order to increase its net interest margin.

 

As set forthbelow, depending upon the volatility of the rate change, the change in asset orliability mix of the Company or other factors may produce a decrease in netinterest margin in an upward moving rate environment even as the NPV estimateindicates an increase in net value.  Theconverse situation can also be expected. One approach used to quantify interest rate risk is theNPV analysis.  In essence, this analysiscalculates the difference between the present value of the liabilities and thepresent value of expected cash flows from assets and off-balance sheetcontracts.  The following tables setforth, at June 30, 2005 (the most recent report available) and September 30,2004, an analysis of the Company’s interest rate risk as measured by theestimated changes in NPV resulting from instantaneous and sustained parallelshifts in the yield curve (+ 300 or –100 basis points, measured in 100 basispoint increments).  Due to the abnormallylow prevailing interest rate environment, -200 and –300 NPV were not estimatedby the OTS.  Management does not believethat the Company has experienced any material changes in its market riskposition from that disclosed in the Company’s Annual Report on Form 10-Kfor the fiscal year ended June 30, 2005 or that the Company’s primarymarket risk exposures and how those exposures were managed during the threemonths ended September 30, 2005 changed significantly when compared to June 30,2005.

 

30

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The data in thefollowing tables is based on assumptions utilized by the OTS in assessinginterest rate risk of thrift institutions and published in “Selected Asset andLiability Price Tables as of June 30, 2005” and “Selected Asset andLiability Price Tables as of September 30, 2004”.  Even if interest rates change in thedesignated amounts, there can be no assurance that the Company’s assets andliabilities would perform as set forth below.

 

| **June 30, 2005**     | ** ** |
|----------------------------|------------|
| **Change in**              | ** ** | **Estimated  NPV** | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Interest Rates**         | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **(Dollars in thousands)** | ** ** |
| Basis Points               |       |   |   |   |   |   |   |
| +300                       |       |   | $ | 93,517 |   | $ | (10,726 | ) | (10 | )% |
| +200                       |       |   | 99,208 |   | (5,035 | ) | (5 | ) |
| +100                       |       |   | 102,459 |   | (1,784 | ) | (2 | ) |
| —                     |       |   | 104,243 |   | — |   | — |   |
| -100                       |       |   | 101,818 |   | (2,425 | ) | (2 | ) |
| -100                       |       |   | 94,213 |   | (10,031 | ) | (10 | ) |
|                            |            |  |  |  |  |  |  |  |  |  |

 

| **September 30, 2004** | ** ** |
|-----------------------------|------------|
| **Change in**               | ** ** | **Estimated  NPV** | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Interest Rates**          | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **(Dollars in thousands)**  | ** ** |
| Basis Points                |       |   |   |   |   |   |   |
| +300                        |       |   | $ | 101,515 |   | $ | (9,951 | ) | (9 | )% |
| +200                        |       |   | 106,605 |   | (4,861 | ) | (4 | ) |
| +100                        |       |   | 110,164 |   | (1,301 | ) | (1 | ) |
| —                      |       |   | 111,465 |   | — |   | — |   |
| -100                        |       |   | 108,310 |   | (3,156 | ) | (3 | ) |
|                             |            |  |  |  |  |  |  |  |  |  |

 

In managing market risk and theasset/liability mix, the Bank has placed its emphasis on developing a portfolioin which, to the extent practicable, assets and liabilities reprice withinsimilar periods. The effect of this policy will generally be to reduce the Bank’ssensitivity to interest rate changes. The goal of this policy is to provide a relatively consistent level ofnet interest income in varying interest rate cycles and to minimize the potentialfor significant fluctuations from period to period.

 

**Item 4.  Controls andProcedures**

 

The Company’s management has evaluated, under thesupervision and with the participation of the Company’s Chairman, President andChief Executive Officer and the Company’s Executive Vice President, ChiefFinancial Officer and Treasurer, the effectiveness of the design and operationof the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e),and have concluded that, as of the end of the period covered by this QuarterlyReport, the Company’s disclosure controls and procedures are effective forgathering, analyzing and disclosing information the Company is required todisclose in its periodic reports filed under the Exchange Act.  There were no significant changes in theCompany’s internal control over financial reporting identified in the abovereferenced evaluation that materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

31

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**PART II - OTHER INFORMATION**

 

**Item 1.****                                   LegalProceedings**

 

TheCompany, the Bank and their subsidiaries are involved as plaintiff or defendantin various legal actions arising in the normal course of their businesses.  While the ultimate outcome of theseproceedings cannot be predicted with certainty, it is the opinion ofmanagement, after consultation with counsel representing the Company and/or theBank in the proceedings, that the resolution of these proceedings are notlikely to have a material effect on the Company’s consolidated financialposition or results of operations.  TheCompany and its direct and indirect subsidiaries are not aware of any legalactions or proceedings outside of the normal course of business.

 

**Item 2.****                                   UnregisteredSales of Equity Securities and Use of Proceeds**

 

The followingtable sets forth the purchases by the Company of its common stock during thequarterly period ended September 30, 2005.

 
| ** **                  | ** ** | **Total**     | ** ** | ** **     | ** ** | **Total Number**             | ** ** | **Maximum Number of**        | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **Number**    | ** ** | **Average**    | ** ** | **of Shares Purchased**      | ** ** | **Shares that May Yet** | ** ** |
| ** **                  | ** ** | **of Shares** | ** ** | **Price Paid** | ** ** | **as Part of Publicly** | ** ** | **Be Purchased Under**       | ** ** |
| **Period**                  | ** ** | **Purchased** | ** ** | **per Share**  | ** ** | **Announced Programs**       | ** ** | **the Current Program**      | ** ** |
| July 1 - 31, 2005      |       | 0             |       | $              | 0.00       |                         | 0          |                         | 303,614    |   |
| August 1 - 31, 2005    |       | 0             |       | $              | 0.00       |                         | 0          |                         | 303,614    |   |
| September 1 - 30, 2005 |       | 0             |       | $              | 0.00       |                         | 0          |                         | 303,614    |   |
|                        |       |          |       |           |       |                         |       |                         |       |
| 1st Quarter  Total          |       | 0             |       | $              | 0.00       |                         | 0          |                         |       |   |

 

The Companycurrently has in effect stock buyback program, which was publicly announced on April 25,2005 and pursuant to which up to 10% of the common stock of the Company thatwas outstanding on May 1, 2005, which equals 350,914 shares, may beacquired through April 30, 2006.  Asof September 30, 2005, a total of 47,300 shares of common stock have beenpurchased pursuant to the program, all of which were purchased in the openmarket during the May and June 2005.

 

**Item 3.****                                   Defaultsupon Senior Securities**

 

None

 

**Item 4.****                                   Submissionof Matters to a Vote of Security Holders**

 

None

 

**Item 5.****                                   OtherInformation**

 

None

 

32

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**Item 6.****                                   Exhibits**

 
| **Regulation S-K Exhibit  Number** | ** ** | **Document**                                                                                                                                                                                                                 |
|------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                               |       |                                                                                                                                                                                                                         |
| 10.1                               |       | Home  Federal Bank Short-Term Incentive Plan (incorporated herein by reference to  the Current Report on Form 8-K filed with the Securities and Exchange  Commission on August 1, 2005).                           |
| 10.2                               |       | Home  Federal Bank Third Amended and Restated Long-Term Incentive Plan  (incorporated herein by reference to the Current Report on Form 8-K  filed with the Securities and Exchange Commission on August 1, 2005). |
| 10.3                               |       | Form of  Stock Option Agreement (incorporated herein by reference to the Current  Report on Form 8-K filed with the Securities and Exchange Commission on September 30,  2005).                               |
| 10.4                               |       | Form of  Restricted Stock Agreement (incorporated herein by reference to the Current  Report on Form 8-K filed with the Securities and Exchange Commission on September 30,  2005).                           |
| 31.1                               |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                                                                                            |
| 31.2                               |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
| 32.1                               |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                            |
| 32.2                               |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002                                                                            |

 

33

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**HFFINANCIAL CORP.**

 

**FORM 10-Q**

**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   |   |   | HF Financial  Corp. |   |
|--------|--------|--------|---------------------|--------|
|   |   |   |                |
|   |   |   | (Registrant)        |

 

 
| Date:  | November 10,  2005 |                                |   | By: | /s/ Curtis  L. Hage |
|--------|-------------------------|-------------------------------------|--------|-----|---------------------|
|   |                    | Curtis L. Hage, Chairman, President |
|   |                    | And Chief Executive Officer         |
|   |                    | (Principal Executive Officer)       |

 

 
| Date:  | November 10,  2005 |                                                                                                                                |   | By: | /s/ Darrel  L. Posegate |
|--------|-------------------------|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----|-------------------------|
|   |                    | Darrel L. Posegate, Executive Vice  President,  Chief Financial Officer and Treasurer  (Principal Financial and Accounting Officer) |

 

34

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**Indexto Exhibits**

 
| **Exhibit Number** | ** ** | ** **                                                                                                                                        |
|-------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                              |
| 31.1                    |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                 |
| 31.2                    |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1                    |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                 |
| 32.2                    |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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