**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

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**FORM 10-Q**

 

**ý****          ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period ended September 30,2003**

 

**Commission File Number: 0-19972**

 

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**HF FINANCIAL CORP.**

(Exact name of registrant as specified in itscharter.)

 

| **Delaware**                                                    |   | **46-0418532**                           |
|-----------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification  Number) |
|                                                            |   |                                     |
| **225 South Main Avenue,  Sioux Falls, SD**                     |   | **57104**                                |
| (Address of principal executive office)                         |   | (ZIP Code)                               |

 

**(605) 333-7556**

(Registrant’s telephone number, includingarea code)

 

 

Indicate by check mark whether the registrant  (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  Yes  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer(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 12, 2003there were 3,260,241 issued and outstanding shares of the Registrant’s CommonStock, with $.01 par value.

 

 

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**HF FINANCIAL CORP.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **PART I**  |
|-------------|
|        |
| Item 1.     | Financial Statements (Unaudited): |   |
|        |   |   |
|        | Consolidated  Statements of Financial Condition As of September 30, 2003 and June 30, 2003 |   |
|        |   |   |
|        | Consolidated Statements of Income for the  Three Months Ended September 30, 2003 and 2002 |   |
|        |   |   |
|        | Consolidated  Statements of Cash Flows for the Three Months Ended September 30, 2003 and  2002 |   |
|        |   |   |
|        | 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** |
|        |   |   |
| Item  1.    | Legal  Proceedings |   |
|        |   |   |
| Item  2.    | Changes  in 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 and Reports on Form 8-K |   |
|        |   |   |
| Form 10-Q   | Signature Page |   |

 

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**HF FINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFFINANCIAL CONDITION**

**(Dollars in Thousands)**

 
|                                                                                                                                                      |   | **September 30, 2003** |    | **June 30, 2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|---------|-------------------|--------|
|                                                                                                                                                      |   | **(Unaudited)**        |    | **(Audited)**     |   |
| **ASSETS**                                                                                                                                                |   |                   |    |              |   |
| Cash and cash equivalents                                                                                                                                 |   | $                      | 32,172  |              | $      | 44,214 |   |
| Securities available for sale                                                                                                                             |   | 77,753                 |    | 88,527            |   |
| Federal Home Loan Bank stock                                                                                                                              |   | 4,631                  |    | 7,025             |   |
| Loans held for sale                                                                                                                                       |   | 14,542                 |    | 15,984            |   |
|                                                                                                                                                      |   |                   |    |              |   |
| Loans and leases receivable                                                                                                                               |   | 608,866                |    | 599,259           |   |
| Allowance for loan and lease losses                                                                                                                       |   | (3,998                 | )       | (3,842            | )      |
| Net loans and leases receivable                                                                                                                           |   | 604,868                |    | 595,417           |   |
|                                                                                                                                                      |   |                   |    |              |   |
| Accrued interest receivable                                                                                                                               |   | 4,671                  |    | 4,298             |   |
| Office properties and equipment, net of  accumulated depreciation                                                                                         |   | 12,930                 |    | 13,138            |   |
| Foreclosed real estate and other properties                                                                                                               |   | 1,739                  |    | 1,812             |   |
| Cash value of life insurance                                                                                                                              |   | 11,671                 |    | 11,432            |   |
| Servicing rights                                                                                                                                          |   | 4,151                  |    | 4,003             |   |
| Goodwill, net                                                                                                                                             |   | 4,951                  |    | 5,020             |   |
| Intangible asset                                                                                                                                          |   | —                 |    | 175               |   |
| Other assets                                                                                                                                              |   | 9,680                  |    | 9,438             |   |
| Total assets                                                                                                                                              |   | $                      | 783,759 |              | $      | 800,483 |   |
|                                                                                                                                                      |   |                   |    |              |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                             |   |                   |    |              |   |
| **LIABILITIES**                                                                                                                                           |   |                   |    |              |   |
| Deposits                                                                                                                                                  |   | $                      | 603,770 |              | $      | 621,381 |   |
| Advances from Federal Home Loan Bank and other  borrowings                                                                                                |   | 80,061                 |    | 89,819            |   |
| Company obligated mandatorily redeemable  preferred securities of subsidiary trusts that solely hold subordinated  debentures                             |   | 27,000                 |    | 20,000            |   |
| Advances by borrowers for taxes and insurance                                                                                                             |   | 13,121                 |    | 7,901             |   |
| Accrued expenses and other liabilities                                                                                                                    |   | 9,336                  |    | 12,024            |   |
| Total liabilities                                                                                                                                         |   | 733,288                |    | 751,125           |   |
|                                                                                                                                                      |   |                   |    |              |   |
| **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, 4,968,293 and 4,930,391 shares issued at September 30, 2003 and  June 30, 2003, respectively |   | 50                     |    | 49                |   |
| Common stock subscribed for but not issued 21,395  shares                                                                                                 |   | —                 |    | 382               |   |
| Additional paid-in capital                                                                                                                                |   | 17,131                 |    | 16,527            |   |
| Retained earnings, substantially restricted                                                                                                               |   | 58,909                 |    | 57,967            |   |
| Deferred compensation                                                                                                                                     |   | (706                   | )       | (733              | )      |
| Accumulated other comprehensive income (loss),  net of related deferred tax effect                                                                        |   | (814                   | )       | (735              | )      |
| Less cost of treasury stock, 1,708,946 shares                                                                                                             |   | (24,099                | )       | (24,099           | )      |
| Total stockholders’ equity                                                                                                                           |   | 50,471                 |    | 49,358            |   |
| Total liabilities and stockholders’ equity                                                                                                           |   | $                      | 783,759 |              | $      | 800,483 |   |

 

*See accompanying notes tounaudited consolidated financial statements.*

 

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**HFFINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFINCOME**

**(Dollarsin Thousands, Except Per Share Data)**

 
|                                                                        |   | **Three Months Ended September 30,** |   |
|-----------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                        |   | **2003**                             |   | **2002** |   |
|                                                                        |   | **(Unaudited)**                      |   | **(Unaudited)** |   |
| **Continuing operations:**                                                  |   |                                 |   |   |   |
| Interest and dividend income:                                               |   |                                 |   |   |   |
| Loans and leases receivable                                                 |   | $                                    | 9,386  |   | $ | 10,501 |   |
| Investment securities and interest-bearing  deposits                        |   | 678                                  |   | 1,005 |   |
|                                                                        |   | 10,064                               |   | 11,506 |   |
| Interest expense:                                                           |   |                                 |   |   |   |
| Deposits                                                                    |   | 2,596                                |   | 3,388 |   |
| Advances from Federal Home Loan Bank and other  borrowings                  |   | 1,319                                |   | 1,383 |   |
|                                                                        |   | 3,915                                |   | 4,771 |   |
| **Net interest income**                                                     |   | 6,149                                |   | 6,735 |   |
| Provision for losses on loans and leases                                    |   | 437                                  |   | 1,034 |   |
| **Net interest income after  provision for losses on loans and leases**     |   | 5,712                                |   | 5,701 |   |
| Noninterest income:                                                         |   |                                 |   |   |   |
| Fees on deposits                                                            |   | 1,072                                |   | 1,083 |   |
| Loan fees and service charges                                               |   | 676                                  |   | 478 |   |
| Gain on sale of loans, net                                                  |   | 568                                  |   | 222 |   |
| Loan servicing income                                                       |   | 419                                  |   | 404 |   |
| Gain on sale of securities, net                                             |   | —                               |   | 350 |   |
| Other                                                                       |   | 797                                  |   | 532 |   |
|                                                                        |   | 3,532                                |   | 3,069 |   |
| Noninterest expense:                                                        |   |                                 |   |   |   |
| Compensation and employee benefits                                          |   | 4,808                                |   | 4,104 |   |
| Occupancy and equipment                                                     |   | 820                                  |   | 821 |   |
| Other                                                                       |   | 1,608                                |   | 1,514 |   |
|                                                                        |   | 7,236                                |   | 6,439 |   |
| **Income from continuing  operations before income taxes**                  |   | 2,008                                |   | 2,331 |   |
| Income tax expense                                                          |   | 686                                  |   | 880 |   |
| **Income from continuing  operations**                                      |   | 1,322                                |   | 1,451 |   |
|                                                                        |   |                                 |   |   |   |
| **Discontinued operations:**                                                |   |                                 |   |   |   |
| Income from operations of discontinued segment,  net of income taxes of $45 |   | —                               |   | 88 |   |
| (Loss) on discontinued segment, net of income  taxes of $(15)               |   | —                               |   | (29 | ) |
| **Income from discontinued  operations**                                    |   | —                               |   | 59 |   |
| **Net Income**                                                              |   | $                                    | 1,322  |   | $ | 1,510 |   |
| **Comprehensive income**                                                    |   | $                                    | 1,243  |   | $ | 1,235 |   |
| **Cash dividends paid per share**                                           |   | $                                    | 0.1175 |   | $ | 0.1150 |   |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

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|                                |   | **Three Months Ended September 30,** |   |
|-------------------------------------|--------|--------------------------------------|--------|
|                                |   | **2003**                             |   | **2002** |   |
|                                |   | **(Unaudited)**                      |   | **(Unaudited)** |   |
|                                |   |                                 |   |   |   |
| **Basic earnings per share:**       |   |                                 |   |   |   |
| Income from continuing operations   |   | $                                    | 0.41   |   | $ | 0.43 |   |
| Income from discontinued operations |   | —                               |   | 0.02 |   |
| Net income                          |   | $                                    | 0.41   |   | $ | 0.45 |   |
|                                |   |                                 |   |   |   |
| **Diluted earnings per share:**     |   |                                 |   |   |   |
| Income from continuing operations   |   | $                                    | 0.40   |   | $ | 0.43 |   |
| Income from discontinued operations |   | —                               |   | 0.02 |   |
| Net income                          |   | $                                    | 0.40   |   | $ | 0.45 |   |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

3

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**HFFINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(Dollars in Thousands)**

**(Unaudited)**

 
|                                                                                          |   | **Three Months Ended September 30,** |   |
|-----------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                          |   | **2003**                             |   | **2002** |   |
| **Cash flows from operating  activities**                                                     |   |                                 |   |   |   |
| Net income                                                                                    |   | $                                    | 1,322  |   | $ | 1,510 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities:  |   |                                 |   |   |   |
| Provision for losses on loans and leases                                                      |   | 437                                  |   | 1,034 |   |
| Depreciation                                                                                  |   | 413                                  |   | 400 |   |
| Amortization of discounts and premiums on  securities and other                               |   | 444                                  |   | 312 |   |
| Stock based compensation                                                                      |   | 139                                  |   | 101 |   |
| Loans originated for resale                                                                   |   | (61,562                              | )      | (24,219 | ) |
| Proceeds from the sale of loans                                                               |   | 63,572                               |   | 17,696 |   |
| (Gain) on sale of loans, net                                                                  |   | (568                                 | )      | (222 | ) |
| Realized (gain) on sale of securities, net                                                    |   | —                               |   | (350 | ) |
| Losses and provision for losses on sales of  foreclosed real estate and other properties, net |   | 30                                   |   | 33 |   |
| Loss on disposal of office properties and  equipment, net                                     |   | —                               |   | 21 |   |
| Change in other assets and liabilities                                                        |   | (2,961                               | )      | (52 | ) |
| Net cash provided by (used in) operating  activities                                          |   | 1,266                                |   | (3,736 | ) |
|                                                                                          |   |                                 |   |   |   |
| **Cash flows from investing  activities**                                                     |   |                                 |   |   |   |
| Loans and leases purchased                                                                    |   | (131                                 | )      | (172 | ) |
| Loans and leases originated and held                                                          |   | (38,125                              | )      | (76,639 | ) |
| Principal collected on loans and leases                                                       |   | 28,357                               |   | 49,224 |   |
| Securities available for sale:                                                                |   |                                 |   |   |   |
| Sales and maturities and repayments                                                           |   | 10,691                               |   | 20,229 |   |
| Purchases                                                                                     |   | (750                                 | )      | (31,157 | ) |
| Purchase of Federal Home Loan Bank stock                                                      |   | (256                                 | )      | (449 | ) |
| Redemption of Federal Home Loan Bank stock                                                    |   | 2,650                                |   | — |   |
| Proceeds from sale of office properties and  equipment                                        |   | —                               |   | 8 |   |
| Purchase of office properties and equipment                                                   |   | (200                                 | )      | (89 | ) |
| Purchase of servicing rights                                                                  |   | (214                                 | )      | (120 | ) |
| Proceeds from sale of foreclosed real estate and  other properties, net                       |   | 246                                  |   | 163 |   |
| Net cash provided by (used in) investing  activities                                          |   | 2,268                                |   | (39,002 | ) |
|                                                                                               |        |                                      |        |  |  |  |  |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

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|                                                                   |   | **Three Months Ended September 30,** |    |
|------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                   |   | **2003**                             |    | **2002** |   |
|                                                                   |   |                                 |    |   |   |
| **Cash flows from financing  activities**                              |   |                                 |    |   |   |
| Net (decrease) in deposit accounts                                     |   | $                                    | (17,611 | ) | $ | (22,561 | ) |
| Proceeds of advances from Federal Home Loan Bank  and other borrowings |   | 11,000                               |    | 240,500 |   |
| Payments on advances from Federal Home Loan Bank  and other borrowings |   | (20,758                              | )       | (189,444 | ) |
| Payment of debt issue costs                                            |   | (158                                 | )       | (150 | ) |
| Proceeds from issuance of preferred securities                         |   | 7,000                                |    | 5,000 |   |
| Increase in advances by borrowers                                      |   | 5,220                                |    | 4,109 |   |
| Purchase of treasury stock                                             |   | —                               |    | (64 | ) |
| Proceeds from issuance of common stock                                 |   | 111                                  |    | — |   |
| Cash dividends paid                                                    |   | (380                                 | )       | (384 | ) |
| Net cash provided by (used in) financing  activities                   |   | (15,576                              | )       | 37,006 |   |
|                                                                   |   |                                 |    |   |   |
| (Decrease) in cash and cash equivalents                                |   | (12,042                              | )       | (5,732 | ) |
|                                                                   |   |                                 |    |   |   |
| Cash and cash equivalents                                              |   |                                 |    |   |   |
| Beginning                                                              |   | 44,214                               |    | 27,546 |   |
| Ending                                                                 |   | $                                    | 32,172  |   | $ | 21,814 |   |
|                                                                   |   |                                 |    |   |   |
| Supplemental Disclosures of Cash Flows  Information                    |   |                                 |    |   |   |
| Cash payments for interest                                             |   | $                                    | 6,603   |   | $ | 4,964 |   |
| Cash payments for income and franchise taxes, net                      |   | 134                                  |    | 81 |   |
|                                                                   |   |                                 |    |   |   |
| Supplemental Schedule of Noncash Investing and  Financing Activities   |   |                                 |    |   |   |
| Other investments reclassified as cash and cash  equivalents           |   | $                                    | 98      |   | $ | — |   |
| Other investments reclassified as other assets                         |   | 95                                   |    | — |   |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

5

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**HF FINANCIAL CORP. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

For The Three MonthsEnded September 30, 2003 and 2002

(Unaudited)

 

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

 

*Basis of presentation:*

 

The consolidated financial information of HF Financial Corp. (the“Company”) and its wholly-owned subsidiaries included in this Form 10-Q isunaudited.  However, in the opinion ofmanagement, adjustments (consisting of normal recurring adjustments) necessaryfor a fair presentation for the interim periods have been included.  Results for any interim period are notnecessarily indicative of results to be expected for the year.  The accounting and reporting policies of theCompany and its subsidiaries conform to accounting principles generallyaccepted in the United States of America (“GAAP”) and to general practicewithin the industry.

 

The interim consolidated financial statements include the accounts ofthe Company, its wholly-owned subsidiaries, HomeFirst Mortgage Corp. (the“Mortgage Corp.”), HF Card Services, LLC (“HF Card”), HF Financial Group, Inc.(“HF Group”), HF Financial Capital Trust I (“Trust I”), HF Financial CapitalTrust II (“Trust II”), HF Financial Capital Trust III (“Trust III”), HF FinancialCapital Trust IV (“Trust IV”), Home Federal Bank (the “Bank”) and the Bank’swholly-owned subsidiaries, Hometown Insurors, Inc. (“Hometown”), Mid AmericaCapital Services, Inc. (“Mid America Leasing”), Home Federal SecuritizationCorp. (“HFSC”), Mid-America Service Corporation and PMD, Inc.  Trust IV was formed on September 25,2003.  See Note 5.  All intercompany balances and transactionshave been eliminated in consolidation.

 

Stock-based compensation:  The Company accounts for stock-based compensationin accordance with Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees”,*andrelated interpretations.  Accordingly,no stock-based employee compensation cost has been recognized for grants underthe fixed stock option plans, as all options granted under those plans had anexercise price equal to the market value of the underlying common stock on thedate of grant.  These stock-basedcompensation plans are described more fully in the Company’s Annual Report onForm 10-K for the fiscal year ended June 30, 2003, under Note 18 of “Notes toConsolidated Financial Statements.”

 

The followingtable illustrates the effect on net income and earnings per share if theCompany had applied the fair value recognition provisions of FinancialAccounting Standards Board (“FASB”) Statement No. 123, “*Accounting for Stock-Based Compensation”,*tostock-based employee compensation.

 

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|                                                                                                                                         |   | **Three Months Ended September 30,**               |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|--------|
|                                                                                                                                         |   | **2003**                                           |   | **2002** |   |
|                                                                                                                                         |   | **(Dollars in Thousands, Except  Per Share Data)** |   |
|                                                                                                                                         |   |                                               |   |   |   |
| Net income, as reported                                                                                                                      |   | $                                                  | 1,322  |   | $ | 1,510 |   |
| Deduct total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |   | (36                                                | )      | (34 | ) |
| Pro forma net income                                                                                                                         |   | $                                                  | 1,286  |   | $ | 1,476 |   |
|                                                                                                                                         |   |                                               |   |   |   |
| Basic earnings per share:                                                                                                                    |   |                                               |   |   |   |
| As reported                                                                                                                                  |   | $                                                  | 0.41   |   | $ | 0.45 |   |
| Pro forma                                                                                                                                    |   | 0.40                                               |   | 0.44 |   |
|                                                                                                                                         |   |                                               |   |   |   |
| Diluted earnings per share:                                                                                                                  |   |                                               |   |   |   |
| As reported                                                                                                                                  |   | $                                                  | 0.40   |   | $ | 0.45 |   |
| Pro forma                                                                                                                                    |   | 0.39                                               |   | 0.44 |   |

 

**NOTE 2.****                REGULATORY CAPITAL**

 

Thefollowing table sets forth the Bank’s compliance with its capital requirementsat September 30, 2003:

 

|                   |   | **Amount**                 |   | **Percent** |   |
|------------------------|--------|----------------------------|--------|-------------|--------|
|                   |   | **(Dollars in Thousands)** |   |
| Tier I (core) capital: |   |                       |   |        |   |
| Required               |   | $                          | 31,057 |        | 4.00   | % |
| Actual                 |   | 66,896                     |   | 8.62        |   |
| Excess                 |   | 35,839                     |   | 4.62        |   |
|                   |   |                       |   |        |   |
| Risk-based capital:    |   |                       |   |        |   |
| Required               |   | $                          | 51,276 |        | 8.00   | % |
| Actual                 |   | 66,676                     |   | 10.40       |   |
| Excess                 |   | 15,400                     |   | 2.40        |   |

 

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

 

Basicearnings per share is computed by dividing incomeavailable to common stockholders (the numerator) by the weighted-average numberof common shares outstanding  (thedenominator) during the period.  Sharesissued during the period and shares reacquired during the period are weightedfor the portion of the period that they were outstanding. The weighted averagenumber of common shares outstanding for the three month period ended September30, 2003 and 2002 was 3,236,338 and 3,335,189, respectively.

 

Dilutive earnings per share is similar to the computation of basicearnings per share except that the denominator is increased to include thenumber of additional common shares that would have been outstanding if thedilutive options outstanding had been exercised. The weighted average number ofcommon and dilutive potential common shares outstanding for

 

7

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the three month period ended September 30, 2003 and 2002 was 3,338,431and 3,364,660, respectively

 

**NOTE 4.****          FORMATION OF HFSECURITIZATION CORP. AND CONSUMER LOAN SECURITIZATION**

 

On January 31, 2003, the Bank securitized and sold motor vehicleinstallment loans with principal balances totaling $50.0 million for a gain of$308,000 through HFSC and Home Federal Automobile Securitization Trust 2003-A(“Automobile Securitization Trust”).  Aspart of the sales transaction, the Bank retains servicingresponsibilities.  In addition, the Bankretains the rights to cash flows remaining after investors in the AutomobileSecuritization Trust have received their contractual payments and has pledged a$2.4 million reserve fund to the Automobile Securitization Trust.  These retained interests are subordinated toinvestors’ interests.  The investors andAutomobile Securitization Trust have no recourse to the Bank’s other assets forfailure of debtors to pay when due.

 

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.

 

Key economic assumptions used and the sensitivity of fair value of theretained interest as of September 30, 2003 are as follows:

 
|                                       |   | **Retained  Interest** |   | **Servicing  Rights** |   |
|--------------------------------------------|--------|------------------------|--------|-----------------------|--------|
|                                       |   |                   |   |                  |   |
| Fair Value                                 |   | $                      | 3,457  |                  | $      | 154 |   |
| Weighted average life (in years)           |   | 3.15                   |   | 3.15                  |   |
| Prepayment speed (ABS annual rate):        |   | 21.60                  | %      | 21.60                 | %      |
| Impact on fair value of 10% adverse change |   | $                      | (48    | )                     | $      | (11 | ) |
| Impact on fair value of 20% adverse change |   | (91                    | )      | (22                   | )      |
| Credit losses (annual rate):               |   | 0.63                   | %      | 0.63                  | %      |
| Impact on fair value of 10% adverse change |   | $                      | (32    | )                     | $      | — |   |
| Impact on fair value of 20% adverse change |   | (43                    | )      | —                |   |
| Discount rate:                             |   | 11.91                  | %      | 10.00                 | %      |
| Impact on fair value of 10% adverse change |   | $                      | (54    | )                     | $      | (1 | ) |
| Impact on fair value of 20% adverse change |   | (97                    | )      | (2                    | )      |

 

These sensitivities are hypothetical and should be used withcaution.  Changes in fair value based ona 10.0% variation in assumptions generally cannot be extrapolated because therelationship of the change in assumption to the change in fair value may not belinear.  Also, in this table, the effectof a variation in a particular assumption on the fair value of the retainedinterest is calculated without changing any other assumption.  In reality, changes in one factor may resultin changes in another (i.e., increases in market interest rates may result inlower prepayments and increased credit losses), which might magnify orcounteract the sensitivities.

 

8

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Static pool losses are calculated by summing the actual and projectedfuture credit losses and dividing the total by the original balance of the poolof loans.  The expected static poollosses of the loans securitized in 2003 is 0.55%.

 

**NOTE5.****          COMPANY OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OFSUBSIDIARY TRUST HOLDING SOLELY SUBORDINATED DEBENTURES**

 

On September25, 2003, the Company issued $7.0 million of Company Obligated MandatorilyRedeemable PreferredSecurities of Trust IV.  Trust IV existsfor the sole purpose of issuing trust preferred securities and investing theproceeds in subordinated debentures of the Company.  These subordinated debentures constitute the sole asset of TrustIV.  The securities provide forcumulative cash distributions calculated at a rate based on three-month LIBORplus 3.10% adjusted quarterly.  TheCompany may, at one or more times, defer interest payments on the capitalsecurities for up to 20 consecutive quarterly periods, but not beyond October8, 2033.  At the end of the deferralperiod, all accumulated and unpaid distributions will be paid.  The capital securities must be redeemed onOctober 8, 2033; however, the Company has the option to shorten the maturitydate to a date not earlier than October 8, 2008.  Holders of the capital securities have no voting rights, areunsecured, and rank junior in priority of the payment to all of the Company’sindebtedness and senior to the Company’s capital stock.

 

**NOTE 6.**                **SALE OF PROPERTY ANDCASUALTY BOOK OF BUSINESS**

 

The Company sold the property and casualtybook of business of Hometown to a third party as of July 31, 2003 for totalproceeds of $375,000 and recorded an after tax gain of $77,000.  The transaction had an immaterial impact onthe Company’s financial position and results of operations.

 

9

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**NOTE 7.****               ****SEGMENT REPORTING**

 

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” (includingleasing activities) and “other”.  The“banking” segment is conducted through the Bank and Mid America Leasing and the“other” segment is composed of smaller nonreportable segments, the Company andinter-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, 2003**                    |   | **Banking**                |    | **Other** |   | **Total** |   |
|---------------------------------------------------------------|--------|----------------------------|---------|-----------|--------|-----------|--------|
|                                                          |   | **(Dollars in Thousands)** |    |
|                                                          |   |                       |    |      |   |      |   |
| Net interest income                                           |   | $                          | 6,455   |      | $      | (306      | )      | $ | 6,149 |   |
| Intersegment interest income                                  |   | (206                       | )       | 206       |   | —    |   |
| Provision for losses on loans and leases                      |   | (437                       | )       | —    |   | (437      | )      |
| Noninterest income                                            |   | 3,486                      |    | 46        |   | 3,532     |   |
| Intersegment noninterest income                               |   | (88                        | )       | 88        |   | —    |   |
| Noninterest expense                                           |   | (6,952                     | )       | (284      | )      | (7,236    | )      |
| Intersegment noninterest expense                              |   | 2                          |    | (2        | )      | —    |   |
| Income (loss) from continuing operations before  income taxes |   | $                          | 2,260   |      | $      | (252      | )      | $ | 2,008 |   |
|                                                          |   |                       |    |      |   |      |   |
| Total assets at September 30, 2003                            |   | $                          | 780,747 |      | $      | 3,012     |   | $ | 783,759 |   |

 
| **Three  Months Ended September 30, 2002**                    |   | **Banking**                |    | **Other** |   | **Total** |   |
|---------------------------------------------------------------|--------|----------------------------|---------|-----------|--------|-----------|--------|
|                                                          |   | **(Dollars in Thousands)** |    |
|                                                          |   |                       |    |      |   |      |   |
| Net interest income                                           |   | $                          | 6,955   |      | $      | (220      | )      | $ | 6,735 |   |
| Intersegment interest income                                  |   | (241                       | )       | 241       |   | —    |   |
| Provision for losses on loans and leases                      |   | (1,034                     | )       | —    |   | (1,034    | )      |
| Noninterest income                                            |   | 2,930                      |    | 139       |   | 3,069     |   |
| Intersegment noninterest income                               |   | (90                        | )       | 90        |   | —    |   |
| Noninterest expense                                           |   | (6,110                     | )       | (329      | )      | (6,439    | )      |
| Intersegment noninterest expense                              |   | 1                          |    | (1        | )      | —    |   |
| Income (loss) from continuing operations before  income taxes |   | $                          | 2,411   |      | $      | (80       | )      | $ | 2,331 |   |
|                                                          |   |                       |    |      |   |      |   |
| Total assets at September 30, 2002                            |   | $                          | 758,944 |      | $      | 3,531     |   | $ | 762,475 |   |

 

10

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL****CONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

The Company is a financial services provider and, as such, has inherentrisks that must be managed in order to achieve net income.  Primary risks that affect net income includecredit risk, liquidity risk, operational risk, regulatory compliance risk andreputation risk.  The Company’s netincome is derived by managing net interest margin, the ability to collect feesfrom services provided, by controlling the costs of delivering services and themanagement of loan and lease losses. The primary source of revenues comes from the net interest margin, whichrepresents the difference between income on interest-earning assets (i.e. loansand investment securities) and expense on interest-bearing liabilities (i.e.deposits and borrowed funding).  The netinterest margin is affected by regulatory, economic and competitive factorsthat influence 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.

 

**Forward-LookingStatements**

 

ThisForm 10-Q and other reports issued by the Company, including reports filed withthe Securities and Exchange Commission, contain “forward-looking statements”that deal with future results, expectations, plans and performance.  In addition, the Company’s management maymake forward-looking statements orally to the media, securities analysts,investors or others.  Theseforward-looking statements might include one or more of the following:

 

*      Projectionsof income, loss, revenues, earnings or losses per share, dividends, capitalexpenditures, capital structure, tax benefit or other financial items.

*      Descriptionsof plans or objectives of management for future operations, products orservices and transactions.

*      Forecastsof future economic performance.

*      Descriptionsof assumptions 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 similarmeaning, or future 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,possible legislative changes and adverse economic, business and competitivedevelopments, such as shrinking interest margins; deposit outflows; reduceddemand for financial services and loan products; changes in accounting policiesor guidelines, 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 to successfully enter into a definitive agreement for andclose anticipated transactions; technological, computer-related or operational difficulties;adverse changes in securities markets; results of litigation; or othersignificant uncertainties.

 

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

 

11

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**FinancialCondition Data**

 

At September 30, 2003, the Company had totalassets of $783.8 million, a decrease of $16.7 million from the level at June30, 2003.  The decrease in assets wasdue primarily to decreases in cash and cash equivalents of $12.0 million,securities available for sale of $10.8 million, Federal Home Loan Bank (“FHLB”)stock of $2.4 million and loans held for sale of $1.4 million offset by anincrease in net loans and leases receivable of $9.5 million.  The decrease in liabilities of $17.8 millionwas due to decreases in deposits of $17.6 million, advances from the FHLB andother borrowings of $9.8 million and accrued expenses and other liabilities of$2.7 million offset by an increase in the liability for company obligatedmandatorily redeemable preferred securities of $7.0 million and advances byborrowers for taxes and insurance of $5.2 million from the levels at June 30,2003.  In addition, stockholders’ equityincreased to $50.5 million at September 30, 2003 from $49.4 million at June 30,2003 primarily due to net income of $1.3 million offset by cash dividends paidof $379,000.

 

The decrease in cash and cash equivalents of $12.0 million was dueprimarily to decreased liquidity. Federal funds sold decreased $8.0 million in part due to not renewingmaturing advances with the FHLB.  See“Liquidity and Capital Resources.”

 

The decrease in securities available for sale of $10.8 million wasprimarily the result of sales, maturities and repayments of $10.7 millionexceeding purchases of $750,000. Included in the $10.7 million of sales, maturities and repayments wasapproximately $8.8 million of mortgage-backed securities principalrepayments.  Approximately 78% of themortgage-backed securities principal payments were variable-rate.  Variable-rate mortgage-backed securitiescomprise 58.4% of the Company’s securities available for sale portfolio.  The purchases consisted of tax-exemptmunicipal bonds.

 

The net decrease in FHLB stock of $2.4 million was a result of theCompany’s redemption of $2.7 million of stock, through the Bank, due to a FHLBcapital structure change effective July 1, 2003.

 

The decrease in loans held for sale of $1.4 million was primarilyrelated to a $1.8 million decrease in mortgage loan closings during September2003 as compared to June 2003.

 

The increase in net loans and leases receivable of $9.5 million was dueprimarily to an increase in purchases and originations over sales, amortizationand repayments of principal.  Consumerindirect automobile loans increased $7.8 million over the levels at June 30,2003.  Residential mortgage loanproduction increased 72.6% in dollar volume for the three months endedSeptember 30, 2003 as compared to the same period in the prior fiscal year.

 

The $17.6 milliondecrease in deposits was primarily due to decreases in demand accounts of $9.4million, savings accounts of $7.7 million and in-market certificates ofdeposits of $5.5 million offset by increases in money market accounts of $3.1million and out-of-market certificates of deposit of $1.8 million.  Of the $9.4 million decrease in demandaccounts, a $13.2 million decrease was attributable to a decline in public fundmoney and of the $7.7 million decrease in savings, a $8.5 million decrease wasattributable to a decline in public fund money.

 

Advances from the FHLBand other borrowings decreased $9.8 million primarily due to the Company’s  repayment on two short-term notes with FirstTennessee Bank, NA totaling $4.0 million and maturing advances with the FHLB inthe amount of $4.9 million.

 

12

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Accrued expenses andother liabilities decreased $2.7 million primarily due to the payment ofaccrued compensation expenses of $749,000, treasury, tax and loan obligationsof $1.2 million and collections due on loans sold to third parties of $1.0million.

 

The liability forcompany obligated mandatorily redeemable preferred securities increased $7.0million due to the Company issuing additional trust preferred securitiesthrough Trust IV.  See Note 5.

 

The $5.2 million increase in advances by borrowers for taxes andinsurance was due primarily to the receipt of escrow payments in excess ofamounts paid out.  The major escrowpayments are primarily paid semiannually in April and October.

 

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

 
|                               |   | **At  September 30, 2003**  |       | **At June  30, 2003**                    |   |
|------------------------------------|--------|-----------------------------|------------|------------------------------------------|--------|
|                               |   | **Amount**                  |       | **Percent  of  Loans in  Each Category** |   | **Amount** |   | **Percent  of  Loans in  Each Category** |   |
|                               |   | **(Dollars  in Thousands)** | ** ** |
|                               |   |                        |       |                                     |   |   |   |   |   |
| One-to  four-family (1)            |   | $                           | 84,725     |                                     | 13.91  | % | $ | 83,722 |   | 13.97 | % |
| Commercial  real estate            |   | 93,089                      |       | 15.29                                    | %      | 93,192 |   | 15.55 | % |
| Multi-family  real estate          |   | 48,342                      |       | 7.94                                     | %      | 49,171 |   | 8.21 | % |
| Commercial  business               |   | 111,725                     |       | 18.35                                    | %      | 113,406 |   | 18.93 | % |
| Equipment  finance leases          |   | 22,163                      |       | 3.64                                     | %      | 23,070 |   | 3.85 | % |
| Consumer                           |   | 181,782                     |       | 29.86                                    | %      | 171,774 |   | 28.66 | % |
| Agricultural                       |   | 61,655                      |       | 10.13                                    | %      | 58,095 |   | 9.69 | % |
| Construction  and development      |   | 4,024                       |       | 0.66                                     | %      | 5,357 |   | 0.89 | % |
| Mobile  homes                      |   | 1,361                       |       | 0.22                                     | %      | 1,472 |   | 0.25 | % |
| Total  Loans and Leases Receivable |   | $                           | 608,866    |                                     | 100.00 | % | $ | 599,259 |   | 100.00 | % |

 

----

(1) Excludes $14,542 and $15,984 loans held forsale at September 30, 2003 and June 30, 2003, respectively.

 

 
|                                   |   | **At  September 30, 2003**  |       | **At June  30, 2003**                       |       |
|----------------------------------------|--------|-----------------------------|------------|---------------------------------------------|------------|
|                                   |   | **Amount**                  | ** ** | **Percent  of  Deposits in  Each Category** | ** ** | **Amount** |   | **Percent  of  Deposits in  Each Category** | ** ** |
|                                   |   | **(Dollars  in Thousands)** |       |
|                                   |   |                        |       |                                        |       |   |   |   |   |
| Noninterest  bearing checking accounts |   | $                           | 64,542     |                                        | 10.69      | % | $ | 77,004 |   | 12.39 | % |
| Interest  bearing accounts             |   | 46,785                      |       | 7.75                                        | %          | 43,699 |   | 7.03 | % |
| Money  market accounts                 |   | 181,226                     |       | 30.02                                       | %          | 178,113 |   | 28.66 | % |
| Savings  accounts                      |   | 46,798                      |       | 7.75                                        | %          | 54,462 |   | 8.77 | % |
| Certificates  of deposit               |   | 264,419                     |       | 43.79                                       | %          | 268,103 |   | 43.15 | % |
| Total  Deposits                        |   | $                           | 603,770    |                                        | 100.00     | % | $ | 621,381 |   | 100.00 | % |

 

13

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**Analysis of NetInterest Income**

 

Net interest income represents the difference between income oninterest-earning assets and expense on interest-bearing liabilities.  Net interest income depends upon the volumeof interest-earning assets and interest-bearing liabilities and the interestrates 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.  All average balances are monthly average balances and include thebalances of nonaccruing loans.  Theyields and costs for the three months ended September 30, 2003 and 2002 includefees which are considered adjustments to yield.  Balances related to discontinued credit card loan operations havebeen reclassified to non-interest earning assets for all periods presented.

 

 

|                                                                                                                          |   | **THREE MONTHS ENDED SEPTEMBER 30,** |    |
|-------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                                                                          |   | **2003**                             |    | **2002** |   |
|                                                                                                                          |   | **Average  Outstanding  Balance**    |    | **Interest  Earned/  Paid** |   | **Yield/  Rate** |   | **Average  Outstanding  Balance** |   | **Interest  Earned/  Paid** |   | **Yield/  Rate** |   |
|                                                                                                                          |   | **(Dollars in Thousands)**           |    |
| Interest-earning  assets:                                                                                                     |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Loans  and leases receivable (1)                                                                                              |   | $                                    | 623,533 |   | $ | 9,386 |   | 5.97 | % | $ | 581,730 |   | $ | 10,501 |   | 7.16 | % |
| Investment  securities (2) (3)                                                                                                |   | 94,486                               |    | 643 |   | 2.70 | % | 88,109 |   | 957 |   | 4.31 | % |
| FHLB  stock                                                                                                                   |   | 4,680                                |    | 35 |   | 2.97 | % | 6,363 |   | 48 |   | 2.99 | % |
|                                                                                                                          |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                                                                                                |   | 722,699                              |    | $ | 10,064 |   | 5.52 | % | 676,202 |   | $ | 11,506 |   | 6.75 | % |
| Noninterest-earning  assets                                                                                                   |   | 61,676                               |    |   |   |   |   | 47,510 |   |   |   |   |   |
| Total  assets                                                                                                                 |   | $                                    | 784,375 |   |   |   |   |   | $ | 723,712 |   |   |   |   |   |
|                                                                                                                          |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                                                                                                |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                                                                     |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Checking  and money market                                                                                                    |   | $                                    | 224,138 |   | $ | 631 |   | 1.12 | % | $ | 189,719 |   | $ | 739 |   | 1.55 | % |
| Savings                                                                                                                       |   | 47,183                               |    | 70 |   | 0.59 | % | 40,752 |   | 101 |   | 0.98 | % |
| Certificates  of deposit                                                                                                      |   | 264,447                              |    | 1,895 |   | 2.84 | % | 253,892 |   | 2,548 |   | 3.98 | % |
| Total  interest-bearing deposits                                                                                              |   | 535,768                              |    | 2,596 |   | 1.92 | % | 484,363 |   | 3,388 |   | 2.78 | % |
| FHLB  advances and other borrowings                                                                                           |   | 85,774                               |    | 1,014 |   | 4.69 | % | 104,371 |   | 1,169 |   | 4.44 | % |
| Company  obligated mandatorily redeemable preferred securities of subsidiary trusts  that solely hold subordinated debentures |   | 22,333                               |    | 305 |   | 5.42 | % | 14,176 |   | 214 |   | 5.99 | % |
| Total  interest-bearing liabilities                                                                                           |   | 643,875                              |    | 3,915 |   | 2.41 | % | 602,910 |   | 4,771 |   | 3.14 | % |
| Noninterest-bearing  deposits                                                                                                 |   | 69,924                               |    |   |   |   |   | 52,909 |   |   |   |   |   |
| Other  liabilities                                                                                                            |   | 20,813                               |    |   |   |   |   | 18,633 |   |   |   |   |   |
| Total  liabilities                                                                                                            |   | 734,612                              |    |   |   |   |   | 674,452 |   |   |   |   |   |
| Equity                                                                                                                        |   | 49,763                               |    |   |   |   |   | 49,260 |   |   |   |   |   |
| Total  liabilities and equity                                                                                                 |   | $                                    | 784,375 |   |   |   |   |   | $ | 723,712 |   |   |   |   |   |
|                                                                                                                          |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Net  interest income; interest rate spread (4)                                                                                |   |                                 |    | $ | 6,149 |   | 3.11 | % |   |   | $ | 6,735 |   | 3.61 | % |
|                                                                                                                          |   |                                 |    |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin (4) (5)                                                                                                  |   |                                 |    |   |   | 3.38 | % |   |   |   |   | 3.95 | % |

 

----

(1) Includes interest on accruing loans and leasespast due 90 days or more.

(2) Includes federal funds sold.

(3) Yields do not reflect the tax exempt nature ofmunicipal securities.

(4) Percentages for the three months endedSeptember 30, 2003 and September 30, 2002 have been annualized.

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

 

14

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**Rate/Volume Analysisof Net Interest Income**

 

Thefollowing schedule presents the dollar amount of changes in interest income andinterest expense for major components of interest-earning assets andinterest-bearing liabilities.  Itdistinguishes between the increases and decreases due to fluctuatingoutstanding balances that are due to the levels and volatility of interestrates.  For each category ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (i.e., changes involume multiplied by old rate) and (ii) changes in rate (i.e., changes in ratemultiplied by old volume).  For purposesof this table, changes attributable to both rate and volume, which cannot besegregated, have been allocated proportionately to the change due to volume andthe change due to rate.

 
|                                                                                                                          |   | **Three Months Ended September 30,  2003 vs 2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|--------|
|                                                                                                                          |   | **Increase  (Decrease)  Due to  Volume**           |   | **Increase  (Decrease)  Due to  Rate** |   | **Total  Increase  (Decrease)** |   |
|                                                                                                                          |   | **(Dollars in Thousands)**                         |   |
| Interest-earning  assets:                                                                                                     |   |                                               |   |   |   |   |   |
| Loans  and leases receivable (1)                                                                                              |   | $                                                  | 755    |   | $ | (1,870 | ) | $ | (1,115 | ) |
| Other  investment securities                                                                                                  |   | 69                                                 |   | (383 | ) | (314 | ) |
| FHLB  stock                                                                                                                   |   | (13                                                | )      | — |   | (13 | ) |
|                                                                                                                          |   |                                               |   |   |   |   |   |
| Total  interest-earning assets                                                                                                |   | $                                                  | 811    |   | $ | (2,253 | ) | $ | (1,442 | ) |
|                                                                                                                          |   |                                               |   |   |   |   |   |
| Interest-bearing  liabilities:                                                                                                |   |                                               |   |   |   |   |   |
| Deposits:                                                                                                                     |   |                                               |   |   |   |   |   |
| Checking  and money market                                                                                                    |   | $                                                  | 134    |   | $ | (242 | ) | $ | (108 | ) |
| Savings                                                                                                                       |   | 16                                                 |   | (47 | ) | (31 | ) |
| Certificates  of deposit                                                                                                      |   | 106                                                |   | (759 | ) | (653 | ) |
| Total  deposits                                                                                                               |   | 256                                                |   | (1,048 | ) | (792 | ) |
| FHLB  advances and other borrowings                                                                                           |   | (208                                               | )      | 53 |   | (155 | ) |
| Company  obligated mandatorily redeemable preferred securities of subsidiary trusts  that solely hold subordinated debentures |   | 123                                                |   | (32 | ) | 91 |   |
|                                                                                                                          |   |                                               |   |   |   |   |   |
| Total  interest-bearing liabilities                                                                                           |   | $                                                  | 171    |   | $ | (1,027 | ) | $ | (856 | ) |
|                                                                                                                          |   |                                               |   |   |   |   |   |
| Net  interest income                                                                                                          |   |                                               |   |   |   | $ | (586 | ) |

 

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

 

15

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**Application ofCritical 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 andLease Losses – GAAP requires the Company to set aside reserves or maintain anallowance against probable loan and lease losses in the loan and leaseportfolio.  Management must develop a consistentand systematic approach to estimate the appropriate balances that will coverthe probable losses.  Due to theuncertainty of future events, the approach includes a process that may differsignificantly from other methodologies and still produce an estimate that is inaccordance with GAAP.

 

The allowance is compiled by utilizing the Company’s loan risk ratingsystem which is structured to identify weaknesses in the loan portfolio.  The risk rating system has evolved to aprocess whereby management believes the system will properly identify thecredit risk associated with the loan portfolio.  Due to the stratification of loans for the allowance calculation,the estimate of the allowance for loan and lease losses could change materiallyif the loan risk rating system would not properly identify the strength of alarge or a few large loan 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.

 

The Company implemented a formal risk-rating system for classifyingleases in the first half of fiscal 2003.

 

Mortgage Servicing Rights (“MSR”) – The Company records a servicingasset for contractually separated servicing from the underlying mortgageloans.   The asset is initially recordedat fair value and represents an intangible asset backed by an income streamfrom the serviced assets.  The asset isamortized in proportion to and over the period of estimated net servicingincome.

 

At each balance sheet date, the MSRs need tobe analyzed for impairment which occurs when the fair value of the MSRs islower than 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 portfolio, the Company estimates the fairvalue of the MSRs using present value of future cash flow analysis.  If the analysis produces a fair value thatis greater than or equal to the amortized book value of the MSRs, no impairmentis recognized.  If the fair value isless than the book value, an expense for the difference is charged to earningsby initiating a MSR valuation account. If the Company determines this impairment is temporary, any futurechanges in fair value are recorded as a change in earnings and thevaluation.  If the Company determinesthe impairment to be permanent, the valuation is written off against the MSRswhich results in a new amortized balance.

 

Due to the substantial decline in interestrates over the last several quarters, 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

 

16

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is when the underlyingmortgages payoff significantly faster than the previously recordedamortization.  Estimating future cashflows on the underlying mortgages is a difficult analysis and requires judgmentbased on the best information available. The Company looks at alternative assumptions and projections whenpreparing a reasonable and supportable analysis.  Based on the Company’s analysis of MSRs at quarter-end, there isno impairment to the MSRs.

 

Retained Interest from Securitization – The Company recorded an asset asa result of the automobile securitization. See Note 4.  This asset isrecorded based on present value concepts of future expected cash flows.  The assumptions used to calculate theinitial retained interest value and subsequent assumptions are based the bestinformation available.  The value of theretained interest may change significantly if actual cash flows differ from expectedcash flows.

 

**Asset Quality andPotential Problem Loans**

 

Whena borrower fails to make a required payment on real estate secured loans within10 to 15 days after the payment is due, the Bank generally institutescollection procedures by issuing a late notice.  The customer is contacted again when the payment is 30 days pastdue.  In the case of consumer loans, theborrower is sent a notice when a loan is 10 days past due and is contacted bytelephone when a loan is 30 days past due. In most cases, delinquencies are cured promptly; however, if a loan hasbeen delinquent for more than 30 days, the Bank attempts additional written aswell as verbal contacts and, if necessary, personal contact with the borrowerin order to determine the reason for the delinquency and to effect a cure, and,where appropriate, reviews the condition of the property and the financialcircumstances of the borrower.  Basedupon the results of any such investigation, the Bank may: (i) accept arepayment program which under appropriate circumstances could involve an extensionin the case of consumer loans for the arrearage from the borrower, (ii) seekevidence, in the form of a listing contract, of efforts by the borrower to sellthe property if the borrower has stated that he is attempting to sell, or (iii)initiate foreclosure proceedings. When a loan payment is delinquent for 90days, the Bank generally will initiate foreclosure proceedings unlessmanagement is satisfied the credit problem is correctable.

 

Loans aregenerally classified as nonaccrual when there are reasonable doubts as to thecollectibility of principal and/or interest and/or when payment becomes 90 dayspast due, except loans which are well secured and in the process ofcollection.  Interest collections onnonaccrual loans, for which the ultimate collectibility of principal isuncertain, are applied as principal reductions.

 

Nonperformingassets (nonaccrual loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets) decreased to $4.8 million at September 30,2003 from $6.2 million at June 30, 2003, a decrease of $1.4 million, or22.6%.  In addition, the ratio ofnonperforming assets to total assets, which is one indicator of credit riskexposure, decreased to 0.62% at September 30, 2003 as compared to 0.77% at June30, 2003.  The decrease in the ratio ofnonperforming assets to total assets at September 30, 2003 as compared to June30, 2003 was due to the decrease in nonperforming assets of $1.4 million.  In addition, asset quality continues toimprove in part due to significant impaired loan credit resolution and theCompany’s conservative underwriting on new loan production.

 

Nonaccruingloans and leases decreased 20.5% or $900,000 to $3.5 million at September 30,2003 compared to $4.4 million at June 30, 2003.  Included in nonaccruing loans and leases at September 30, 2003were four loans totaling $228,000 secured by one- to four-family real estate,three loans totaling $278,000 secured by commercial real estate, ten commercialbusiness loans totaling $244,000, four equipment finance leases totaling$11,000, two agricultural loans totaling $1.9 million, forty consumer loanstotaling $821,000 and five mobile home loans totaling $37,000.

 

17

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The Company’s nonperforming loans and leases, which representnonaccrual and past due 90 days and still accruing, have decreased $1.2 millionor 20.7% from the levels at June 30, 2003. The risk rating system in place is designed to identify and manage thenonperforming loans and leases.  Commercial and agricultural loans and equipment finance leaseswill have specific reserve allocations based on collateral values or based onthe present value of expected cash flows if the loans and leases are deemedimpaired.  Loans and leases that are notperforming do not necessarily result in a loss.

 

As ofSeptember 30, 2003, the Company had $261,000 of foreclosed assets.  The balance of foreclosed assets atSeptember 30, 2003 consisted of $122,000 in consumer collateral and $139,000 insingle-family residences.  The Companydid not have any foreclosed assets secured by mobile home loans at September30, 2003.

 

At September30, 2003, the Company had criticized $3.3million of its assets as special mention and classified $11.7 million of itsassets that management has determined need to be closely monitoredbecause of possible credit problems of the borrowers or the cash flows of thesecured properties.  At September 30,the Company had $49.4 million in multi-family, commercial real estate andagricultural participation loans purchased, of which $2.1 million or 4.3%, wereincluded in the Company’s $11.7 million of classified assets.  Other potential problem loans and leases areincluded in criticized and classified assets. Criticized and classified loans and leases were considered indetermining the adequacy of the allowance for loan and lease losses.  The allowance for  loan and lease losses is established based on management’sevaluation of the risks probable in the loan and lease portfolio and changes inthe nature and volume of loan and lease activity.  Such evaluation, which includes a review of all loans and leasesfor which full collectability may not be reasonably assured, considers theestimated fair market value of the underlying collateral, present value ofexpected principal and interest payments, economic conditions, historical lossexperience and other factors that warrant recognition in providing for anadequate loan and lease loss allowance.

 

Although the Company’s management believes that the September 30, 2003recorded allowance for loan and lease losses was adequate to provide forprobable losses on the related loans and leases, there can be no assurance thatthe allowance existing at September 30, 2003 will be adequate in the future.

 

18

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Inaccordance with the Company’s internal classification of assets policy,management evaluates the loan and lease portfolio on a monthly basis toidentify loss potential and determines the adequacy of the allowance for loanand lease losses quarterly.  Loans areplaced on nonaccrual status when the collection of principal and/or interestbecome doubtful.  Foreclosed assetsinclude assets acquired in settlement of loans.  The following table sets forth the amounts and categories of theCompany’s nonperforming assets from continuing operations for the periodsindicated.

 
|                                                                   |   | **Nonperforming Assets As Of** |   |
|------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                   |   | **September 30,  2003**        |   | **June 30,  2003** |   |
|                                                                   |   | **(Dollars in Thousands)**     |   |
| Nonaccruing  loans and leases:                                         |   |                           |   |   |   |
| One-  to four-family                                                   |   | $                              | 228    |   | $ | 103 |   |
| Commercial  real estate                                                |   | 278                            |   | 310 |   |
| Commercial  business                                                   |   | 244                            |   | 472 |   |
| Equipment  finance leases                                              |   | 11                             |   | 30 |   |
| Consumer                                                               |   | 821                            |   | 875 |   |
| Agriculture                                                            |   | 1,853                          |   | 2,541 |   |
| Mobile  homes                                                          |   | 37                             |   | 34 |   |
| Total                                                                  |   | 3,472                          |   | 4,365 |   |
|                                                                   |   |                           |   |   |   |
| Accruing  loans and leases delinquent more than 90 days:               |   |                           |   |   |   |
| One-  to four-family                                                   |   | —                         |   | 330 |   |
| Commercial  real estate                                                |   | 42                             |   | 42 |   |
| Commercial  business                                                   |   | 308                            |   | 779 |   |
| Equipment  finance leases                                              |   | 569                            |   | 313 |   |
| Consumer                                                               |   | 11                             |   | 2 |   |
| Agriculture                                                            |   | 182                            |   | — |   |
| Total                                                                  |   | 1,112                          |   | 1,466 |   |
|                                                                   |   |                           |   |   |   |
| Foreclosed  assets: (1)                                                |   |                           |   |   |   |
| One-  to four-family                                                   |   | 139                            |   | 258 |   |
| Consumer                                                               |   | 122                            |   | 77 |   |
| Total                                                                  |   | 261                            |   | 335 |   |
|                                                                   |   |                           |   |   |   |
| Total  nonperforming assets                                            |   | $                              | 4,845  |   | $ | 6,166 |   |
|                                                                   |   |                           |   |   |   |
| Ratio  of nonperforming assets to total assets                         |   | 0.62                           | %      | 0.77 | % |
|                                                                   |   |                           |   |   |   |
| Ratio  of nonperforming loans and leases to total loans and leases (2) |   | 0.74                           | %      | 0.95 | % |

 

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(1) Total foreclosed assets do not include land orother real estate owned held for sale.

(2) Nonperforming loans and leases includeboth nonaccruing and accruing loans and leases delinquent more than 90 days.

 

19

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The following table sets forth information with respectto activity in the Company’s allowance for loan and lease losses fromcontinuing operations during the periods indicated.  Balances related to discontinued credit card loan operations havebeen eliminated for all periods presented.

 
|                                                                                                     |   | **Three Months Ended September 30,** |   |
|----------------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                                     |   | **2003**                             |   | **2002** |   |
|                                                                                                     |   | **(Dollars in Thousands)**           |   |
|                                                                                                     |   |                                 |   |   |   |
| Balance  at beginning of period                                                                          |   | $                                    | 3,842  |   | $ | 4,461 |   |
| Charge-offs:                                                                                             |   |                                 |   |   |   |
| One-  to four-family                                                                                     |   | (6                                   | )      | — |   |
| Commercial  business                                                                                     |   | (72                                  | )      | (53 | ) |
| Equipment  finance leases                                                                                |   | (7                                   | )      | (54 | ) |
| Consumer                                                                                                 |   | (258                                 | )      | (272 | ) |
| Mobile  homes                                                                                            |   | —                               |   | (18 | ) |
| Total  charge-offs                                                                                       |   | (343                                 | )      | (397 | ) |
|                                                                                                     |   |                                 |   |   |   |
| Recoveries:                                                                                              |   |                                 |   |   |   |
| One-  to four-family                                                                                     |   | 4                                    |   | — |   |
| Commercial  business                                                                                     |   | 1                                    |   | — |   |
| Equipment  finance leases                                                                                |   | 12                                   |   | 6 |   |
| Consumer                                                                                                 |   | 42                                   |   | 96 |   |
| Mobile  homes                                                                                            |   | 3                                    |   | 2 |   |
| Total  recoveries                                                                                        |   | 62                                   |   | 104 |   |
|                                                                                                     |   |                                 |   |   |   |
| Net  (charge-offs)                                                                                       |   | (281                                 | )      | (293 | ) |
|                                                                                                     |   |                                 |   |   |   |
| Additions  charged to operations                                                                         |   | 437                                  |   | 1,034 |   |
|                                                                                                     |   |                                 |   |   |   |
| Balance  at end of period                                                                                |   | $                                    | 3,998  |   | $ | 5,202 |   |
|                                                                                                     |   |                                 |   |   |   |
| Ratio  of net (charge-offs) during the period to average loans and leases  outstanding during the period |   | (0.05                                | )%     | (0.05 | )% |
|                                                                                                     |   |                                 |   |   |   |
| Ratio  of allowance for loan and lease losses to total loans and leases at end of  period                |   | 0.64                                 | %      | 0.86 | % |
|                                                                                                     |   |                                 |   |   |   |
| Ratio  of allowance for loan and lease losses to nonperforming loans and leases at  end of period (1)    |   | 87.22                                | %      | 46.31 | % |

 

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(1) Nonperforming loans and leases include bothnonaccruing and accruing loans and leases delinquent more than 90 days.

 

20

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Thedistribution of the Company’s allowance for loan and lease losses and impairedloss summary at the dates indicated are summarized in the followingtables.  The combination of FASB 5 andFASB 114 calculations comprise the Company’s allowance for loan and leaselosses.

 
|                      |   | **FASB 5  Allowance  for loan and  lease losses** |   | **FASB 114  Impaired Loan  Valuation  Allowance** |   | **FASB 5  Allowance  for loan and  lease losses** |   | **FASB 114  Impaired Loan  Valuation  Allowance** |   |
|---------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
| **Loan Type**             |   | **At September 30, 2003**                         |   | **At June 30, 2003**                              |   |
|                      |   | **(Dollars in Thousands)**                        |   |                                              |   |                                              |   |
|                      |   |                                              |   |                                              |   |                                              |   |                                              |   |
| One-  to four-family      |   | $                                                 | 22     |                                              | $      | —                                            |   | $                                                 | 28     |   | $ | — |   |
| Commercial  real estate   |   | 109                                               |   | —                                            |   | 130                                               |   | —                                            |   |
| Multi-family  real estate |   | 98                                                |   | —                                            |   | 111                                               |   | —                                            |   |
| Commercial  business      |   | 710                                               |   | 116                                               |   | 652                                               |   | 132                                               |   |
| Equipment  finance leases |   | 256                                               |   | —                                            |   | 250                                               |   | —                                            |   |
| Consumer                  |   | 1,622                                             |   | —                                            |   | 1,538                                             |   | —                                            |   |
| Agricultural              |   | 309                                               |   | 723                                               |   | 230                                               |   | 714                                               |   |
| Mobile  homes             |   | 33                                                |   | —                                            |   | 57                                                |   | —                                            |   |
| Total                     |   | $                                                 | 3,159  |                                              | $      | 839                                               |   | $                                                 | 2,996  |   | $ | 846 |   |

 

 

**FASB 114 Impaired Loan Summary**

 

 
|                     |   | **Number  of Loan  Customers** |       | **Loan  Balance** |   | **Impaired Loan  Valuation  Allowance** |   |
|--------------------------|--------|--------------------------------|------------|-------------------|--------|-----------------------------------------|--------|
| **Loan Type**            |   | **At September 30, 2003**      |       |
|                     |   | **(Dollars in Thousands)**     | ** ** |
|                     |   |                           |       |              |   |                                    |   |   |   |
| Commercial  business     |   | 6                              |       | $                 | 169    |                                    | $      | 116 |   |
| Other  agriculture loans |   | 1                              |       | 1,853             |   | 723                                     |   |
| Total                    |   | 7                              |       | $                 | 2,022  |                                    | $      | 839 |   |

 

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|                     |   | **Number  of Loan  Customers** |       | **Loan  Balance** |       | **Impaired Loan  Valuation  Allowance** |       |
|--------------------------|--------|--------------------------------|------------|-------------------|------------|-----------------------------------------|------------|
| **Loan Type**            |   | **At June 30, 2003**           |       |
|                     |   |                           | ** ** |              | ** ** |                                    | ** ** |
| Commercial  business     |   | 8                              |       | $                 | 354        |                                    | $          | 132 |   |
| Agriculture  real estate |   | 1                              |       | 27                |       | —                                  |       |
| Other  agriculture loans |   | 3                              |       | 2,293             |       | 714                                     |       |
| Total                    |   | 12                             |       | $                 | 2,674      |                                    | $          | 846 |   |

 

 

The allowance for loan and lease losses was $4.0 million at September30, 2003 as compared to $5.2 million at September 30, 2002.  The ratio of the allowance for loan andlease losses to total loans and leases was 0.64% at September 30, 2003 comparedto 0.86% at September 30, 2002, a decrease of 25.6%.  The Company’s management has considered nonperforming loans and leasesand potential problem loans and leases in establishing the allowance for loanand lease losses.  The Company continuesto monitor its allowance for probable loan and lease losses and make futureadditions or reductions in light of the level of loans and leases in itsportfolio and as economic conditions dictate. The current level of the allowance forloan and lease losses is a result of management’s assessment of the riskswithin the portfolio based on the information revealed in credit reporting processes.The Company utilizes a risk-rating system on all commercial business,agricultural, construction and multi-family and commercial real estate loans,including purchased loans.  A periodiccredit review is performed on all types of loans and leases to establish thenecessary reserve based on the estimated risk within the portfolio. Thisassessment of risk takes into account the composition of the loan and leaseportfolio, historical loss experience for each loan and lease category,previous loan and lease experience, concentrations of credit, current economicconditions and other factors that in management’s judgment deserve recognition.Office of Thrift Supervision (“OTS”) regulators have reviewed the Company’smethodology for determining allowance requirements on the Company’s loan andlease portfolio and have made no required recommendations for increases in theallowances during the three months ended September 30, 2003.

 

Realestate properties acquired throughforeclosure are recorded at the lower of cost or fair value (less a deductionfor disposition costs).  Valuations areperiodically updated by management and a specific provision for losses on suchproperties is established by a charge to operations if the carrying values ofthe properties exceed their estimated net realizable 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.

 

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**Comparison of the Three Months Ended September 30, 2003 andSeptember 30, 2002**

 

**Continued Operations:**

 

*General*. The Company’s net income from continuing operations was $1.3 million or$0.41 and $0.40 for basic and diluted earnings per share, respectively, for thethree months ended September 30, 2003, a $200,000 decrease in earnings comparedto $1.5 million or $0.43 for both basic and diluted earnings per share for thesame period in the prior fiscal year. For the three months ended September 30, 2003, the return on averageequity from continuing operations was 10.63%, a 9.8% decrease compared to11.78% for the same period in the prior fiscal year.  For the three months ended September 30, 2003, the return onaverage assets from continuing operations was 0.67%, a 16.3% decrease comparedto 0.80% 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 $586,000 and an increase in noninterest expense of $797,000offset by decreases in the provision for losses on loans and leases of $597,000and income tax expense of $194,000 and an increase in noninterest income of$463,000.

 

*Interestand Dividend Income.*  Interestand dividend income was $10.1 million for the three months ended September 30,2003 as compared to $11.5 million for the same period in the prior fiscal year,a decrease of $1.4 million or 12.2%.  A$2.3 million decrease in interest and dividend income was the result of a 18.2%decrease in the average yield on interest-earning assets.  The average yield on interest-earning assetswas 5.52% for the three months ended September 30, 2003 as compared to 6.75%for the same period in the prior fiscal year. For the three months ended September 30, 2003, the average yield onloans and leases receivable was 5.97%, a decrease of 16.6% from 7.16% for thesame period in the prior fiscal year. The overall decrease in interest and dividend income was primarily dueto repricing of loans and investments that generally reflected the decline innational interest rates.  From June 30,2001 to September 30, 2003, the prime rate dropped from 6.75% to 4.00%.  Average volume increases of $41.8 million inloans and leases receivable contributed to a $755,000 increase in interest anddividend income for the three months ended September 30, 2003 as compared tothe same period in the prior fiscal year.  As of June 30, 2003 and September 30, 2003,  the Bank statedit had exceeded the 20% Home Owners’ Loan Act (“HOLA”) limitation forcommercial loans. This calculation was based on information provided in OTSfilings.  The Bank has reviewed its options with the OTS and has beeninformed by the OTS that it can designate loans under HOLA as real estate ifthe Bank substantially relies upon a security interest in real estate given bythe borrower as a condition of making the loan.  The Bank is in theprocess of reviewing the loans classified as commercial with real estate securityin order to determine if reclassification is possible.  Based uponpreliminary findings, the Bank anticipates the HOLA percentage for commercialloans will be back in compliance with the 20% limitation following certainreclassifications.  The Bank will finalize and submit its findings to theOTS.

 

*Interest Expense.*  Interest expense was $3.9 million for thethree months ended September 30, 2003 as compared to $4.8 million for the sameperiod in the prior fiscal year, a decrease of $856,000 or 17.8%.  A $1.0 million decrease in interest expensewas the result of a 23.2% decrease in the average rate paid on interest-bearingliabilities.  The average rate oninterest-bearing liabilities was 2.41% for the three months ended September 30,2003 as compared to 3.14% for the same period in the prior fiscal year.  For the three months ended September 30,2003, the average rate paid on interest-bearing deposits was 1.92%, a decreaseof 30.9% from 2.78% for the same period in the prior fiscal

 

23

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year.  Average volume decrease on FHLB advances and other borrowings of$18.6 million also contributed to a $208,000 decrease in interest expense forthe three months ended September 30, 2003 as compared to the same period in theprior fiscal year.  Average volumeincreases of $51.4 million in interest-bearing deposits and $8.2 million incompany obligated mandatorily redeemable preferred securities of subsidiarytrusts contributed to an increase of $256,000 and $123,000, respectively, forthe three months ended September 30, 2003 as compared to the same period in theprior fiscal year.

 

*Net Interest Income.*The Company’s net interest income from continuing operations for the threemonths ended September 30, 2003 decreased $586,000, or 8.7%, to $6.1 millioncompared to $6.7 million for the same period in the prior fiscal year.  The decrease in net interest income was dueprimarily to a decreasing net interest margin as national rates continued toremain low over the prior year.  TheCompany’s net interest margin was 3.38% for the first quarter of fiscal 2004 ascompared to 3.95% for the same period in the prior fiscal year.

 

*Provision for Losses on Loans.*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 collectability of loans and priorloan loss experience.  The evaluationtakes into consideration such factors as changes in the nature and volume ofthe loan and lease portfolio, overall portfolio quality, review of specificproblem loans and leases, and current economic conditions that may affect theborrower’s ability to pay.  Theallowance for loan and lease losses is established through a provision forlosses on loans and leases charged to expense.

 

During thethree months ended September 30, 2003, the Company recorded a provision forlosses on loans and leases of $437,000 compared to $1.0 million for the threemonths ended September 30, 2002, an decrease of $597,000.  See “Asset Quality” for further discussion.

 

*Noninterest Income.*  Noninterest income was $3.5 million for thethree months ended September 30, 2003 as compared to $3.1 million for the threemonths ended September 30, 2002, an increase of $463,000  or 14.9%. The increase in noninterest income was due primarily to increases in netgain on sale of loans of $346,000, loan fees and service charges of $198,000and other noninterest income of $265,000 offset by a decrease in net gain onsale of securities of  $350,000.

 

Net gain onsale of loans increased 155.9% to $568,000 for the three months ended September30, 2003 as compared to $222,000 for the same period in the prior fiscal yearprimarily due to an increase in the amount of residential mortgage loans soldinto the secondary market during the first quarter of fiscal 2004 as comparedto the same period in the prior fiscal year. Residential mortgage loan production increased 72.6% in dollar volumefor the three months ended September 30, 2003 as compared to the same period inthe prior fiscal year.  As is the casewith the industry, residential mortgage loan pipelines decreased back to morehistorical levels at September 30, 2003 and will be reflected in the secondquarter of fiscal 2004.

 

Loan fees andservice charges increased 41.4% to $676,000 for the three months endedSeptember 30, 2003 as compared to $478,000 for same period in the prior fiscalyear.  Residential mortgage loanproduction increase as discussed above attributed to the increase over the sameperiod in the prior fiscal year.

 

Othernoninterest income increased 49.8% to $797,000 for the three months endedSeptember 30, 2003 as compared to $532,000 for the same period in the priorfiscal year due to income in the amount of $121,000 recorded on the retainedinterest obtained through the securitization of automobile loans during thethird quarter of fiscal 2003.  See Note4.  In addition, the Bank recorded anincrease of $79,000 in other noninterest income for bank owned life insurance(“BOLI”) as compared to the same period in the prior fiscal year.  Also included in

 

24

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noninterest income for thethree months ended September 30, 2003 is $116,000 net gain on the sale of theCompany’s property and casualty book of business.

 

Net gain onsale of securities decreased $350,000 for the three months ended September 30,2003 as compared to the same period in the prior fiscal year due to no salesoccurring during the first quarter of fiscal 2004.

 

*Noninterest Expense.*  Noninterest expense was $7.2 million for the three months endedSeptember 30, 2003 as compared to $6.4 million for the three months endedSeptember 30, 2002, an increase of $797,000 or 12.5%.  The increase in noninterest expense was due primarily toincreases in compensation and employee benefits of $704,000 and other expensesof $94,000.

 

Compensationand employee benefits increased 17.1% to $4.8 million for the three months endedSeptember 30, 2003 as compared to $4.1 million for the same period in the priorfiscal year primarily due to increases in employee base compensation of$229,000, variable compensation (performance incentives) of $32,000 andincreased health claims, net of stop loss, of $342,000.  The Company has had a self-insured healthplan for nine years.

* *

*Income tax expense.*  The Company’s income tax expense for thethree months ended September 30, 2003 decreased $194,000 or 22.0% to $686,000compared to $880,000 for the same period in the prior fiscal year.  The decrease was primarily due to areduction in the Company’s effective tax rate due to changes in permanent taxdifferences.   The effective tax ratewas 34.2% and 37.8% for the three months ended September 30, 2003 and September30, 2002, respectively.

 

**DiscontinuedOperations:**

 

*Incomefrom discontinued operations. *Income fromdiscontinued operations decreased $59,000 for the three months ended September30, 2003 compared to the same period in the prior fiscal year primarily due tothe sale of the credit card loan portfolio on January 31, 2003.  There was no activity from the discontinuedoperations during the first quarter of fiscal 2004.

 

**Liquidity and CapitalResources**

 

The Bank’sprimary sources of funds are earnings, in-market deposits, FHLB advances andother borrowings,  repayments of loanprincipal, mortgage-backed securities and callable agency securities and, to alesser extent, sales of mortgage loans, sales and maturities of securities,mortgage-backed securities, out-of-market deposits and short-terminvestments.  While scheduled loanpayments and maturing securities are relatively predictable, deposit flows andloan prepayments are more influenced by interest rates, general economicconditions and competition. The Bank attempts to price its deposits to meet itsasset/liability objectives consistent with local market conditions.  Excess balances are invested in overnightfunds.

 

Liquiditymanagement is both a daily and long-term responsibility of management.  The Bank adjusts its investments in liquidassets based upon management’s assessment of (i) expected loan demand, (ii)projected loan sales, (iii) expected deposit flows, (iv) yields available oninterest-bearing deposits, and (v) the objectives of its asset/liabilitymanagement program. Excess liquidity is invested generally in interest-bearingovernight deposits and other short-term government and agency obligations.  At September 30, 2003, the Bank had $16.0million invested in federal funds sold. During the three months ended September 30, 2003, the Bank decreased itsborrowings with the FHLB by $5.2 million.

 

25

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The Bankanticipates that it will have sufficient funds available to meet current loancommitments.  At September 30, 2003, theBank had outstanding commitments to originate and purchase mortgage andcommercial loans of $87.4 million and to sell mortgage loans of $25.0 million.  Commitments by the Bank to originate loansare not necessarily executed by the customer. The Bank monitors the ratio of commitments to fundings for use inliquidity management.  At September 30,2003, the Bank had no outstanding commitments to purchase or sell securitiesavailable for sale.

 

Althoughin-market deposits are the Bank’s primary source of funds, the Bank’s policyhas been to utilize borrowings where the funds can be invested in either loansor securities at a positive rate of return or to use the funds for short-termliquidity purposes.  The Bank currentlyhas two $10.0 million unsecured lines of federal funds with correspondentbanks.  There were no funds drawn oneither line of credit at September 30, 2003. Also, the Bank has implemented arrangements to acquire out-of- marketcertificates of deposit and money market accounts as an additional source offunding.  As of September 30, 2003, theBank had $37.5 million in out-of-market certificates of deposit and $15.0  million in out-of-market money marketaccounts.  The Bank may also seek othersources of contingent liquidity including additional federal funds purchasedlines with correspondent banks and lines of credit with the Federal ReserveBank.

 

The Company issued trustpreferred securities during the first quarter of fiscal 2004 in order to increaseits liquidity and payoff two unsecured notes with First Tennessee Bank, NAtotaling $4.5 million.   See Note 5.

 

The Company uses itscapital resources to pay dividends to its stockholders, to repurchase Companystock in the market pursuant to Board of Directors’ approved plans, to supportorganic growth, to make acquisitions, to service its debt obligations and toprovide funding for investment into the Bank of tier 1 (core) capital.

 

The Company currentlyhas in effect a stock buy back program in which up to 10% of the common stockof the Company outstanding on May 1, 2003 may be acquired through April 30,2004.  A total of 48,600 shares ofcommon stock have been purchased pursuant to the current program, with noshares purchased during the three months ended September 30, 2003.

 

Savingsinstitutions insured by the Federal Deposit Insurance Corporation are requiredby the Financial Institutions Reform, Recovery and Enforcement Act of 1989(“FIRREA”) to meet three regulatory capital requirements.  If a requirement is not met, regulatoryauthorities may take legal or administrative actions, including restrictions ongrowth or operations or, in extreme cases, seizure.  Institutions not in compliance may apply for an exemption fromthe requirements and submit a recapitalization plan.  Under these capital requirements, at September 30, 2003, the Bankmet all current capital requirements.

 

The OTS hasadopted capital requirement for savings institutions comparable to therequirement for national banks.  The minimumOTS core capital requirement for well capitalized institutions is 4.00% oftotal adjusted assets for thrifts.  TheBank had tier 1 (core) capital of 8.62% at September 30, 2003.  The minimum OTS risk-based capitalrequirement for well capitalized institutions is 8.00% of risk-weightedassets.  The Bank had risk-based capitalof 10.40% at September 30, 2003.

 

**Off-Balance SheetFinancing Arrangements**

 

During fiscal2003, the Bank securitized and sold consumer automobile loans in the amount of$50.0 million through HFSC and Automobile Securitization Trust.  As a result of this securitizationtransaction, the Bank had sold automobile loans in the amount of $29.8 millionat September 30,

 

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2003.  As part of the sales transaction, the Bank retains servicingresponsibilities and a retained interest in the receivables which issubordinated to third party investors’ interests.  The receivables were sold without legal recourse to third partyconduits.  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 riskto the Bank, in addition to giving the Bank  access to the national capital markets.  See Note 4 for further detail.

 

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**Impact of Inflationand Changing Prices**

 

TheConsolidated Financial Statements and Notes thereto presented in this Form 10-Qhave been prepared in accordance with GAAP, which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering the change in the relative purchasing power of money over time dueto inflation.  The impact of inflationis reflected in the increased cost of the Bank’s operations. Unlike mostindustrial companies, nearly all the assets and liabilities of the Bank aremonetary in nature.  As a result,interest rates have a greater impact on the Bank’s performance than do theeffects of general levels of inflation. Interest rates do not necessarily move in the same direction or to thesame extent as the prices of goods and services.

 

**Recent AccountingPronouncements**

 

In March 2003, the FASB started a project to addressissues related to stock-based compensation (“SBC”).  The objective of the project is to cooperate with theInternational Accounting Standards Board to achieve convergence to one single,high-quality global accounting standard on SBC.   The FASB has discussed several issues relating to SBCarrangements, but continues to deliberate on other SBC issues.

 

TheCompany accounts for stock-based compensation in accordance with APB OpinionNo. 25, “*Accounting for Stock Issued toEmployees”*, and related interpretations.  No stock-based employee compensation cost has been recognized forgrants under the Company’s fixed stock option plans, as all options grantedunder those plans had an exercise price equal to the market value of theunderlying common stock on the date of grant.

 

The Company continues to monitor the progressof the FASB regarding its SBC project and will continue applying the guidanceof APB Opinion No. 25.  The Company willreevaluate its accounting policy on SBC upon the FASB’s issuance of an exposuredraft and final accounting standard regarding SBC as a result of its currentSBC project.

 

In January 2003, theFASB issued Interpretation No. 46 *“Consolidationof Variable Interest Entities.”* This Interpretation was issued in an effort to expand upon andstrengthen existing accounting guidance that addresses when a company shouldinclude in its financial statements the assets, liabilities and activities ofanother entity.  In general, a variableinterest entity is a corporation, partnership, trust, or any other legalstructure used for business purposes that either (i) does not have equityinvestors with voting rights or (ii) has equity investors that do not providesufficient financial resources for the entity to support its activities.  A variable interest entity often holdsfinancial assets, including loans or receivables, real estate or otherproperty.  To further assist financialstatement users in assessing a company’s risks, the Interpretation also requiresdisclosures about variable interest entities that the Company is not requiredto consolidate but in which it has a significant variable interest.  The consolidation requirements ofInterpretation No. 46 apply immediately to period interest entities createdafter January 31, 2003.  The consolidationrequirements for older entities were effective at the beginning of the firstinterim period beginning after June 15, 2003, however, on October 8, 2003 theFASB deferred the implementation date of Interpretation No. 46 until the firstperiod ending after December 15, 2003. Management does not believe the full adoption of Interpretation No. 46will have a material effect on the Company’s financial position, liquidity orresults of operation, however, interpretations of this standard and its applicationto various transaction types and structures are evolving.

 

In April 2003, FASBissued SFAS Statement No. 149, *“Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.”*  This Statement improves financial reportingby

 

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requiring that contracts withcomparable characteristics be accounted for similarly.  In particular, this Statement (i) clarifiesunder what circumstances a contract with an initial net investment meets thecharacteristics of a derivative discussed in paragraph 6(b) of Statement 133,(ii) clarifies when a derivative contains a financing component, (iii) amendsthe definition of an underlying to conform it to language used in FASBInterpretation No. 45, *“Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others”* and (iv) amends certain other existingpronouncements.  The changes will resultin more consistent reporting on contracts and hedging relationships enteredinto or modified after June 30, 2003.  The adoption of this Statement did not have a material effect on theCompany’s financial position, liquidity or results of operations.

 

In May 2003,FASB issued SFAS Statement No. 150, *“Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”*.  This Statementestablishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances). This Statement iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003, except for mandatorily redeemable financialinstruments of nonpublic entities.  Theadoption of this Statement did not have a material effect on the Company’sfinancial position, liquidity or results of operations, however, managementcontinues to review guidance from the FASB and Federal Reserve.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Interest raterisk is the most significant market risk affecting the Company.  Other types of market risk, such as foreigncurrency exchange rate risk and commodity price risk, do not arise in thenormal course of the Company’s business activities.  The Bank, like other financial institutions, is subject tointerest rate risk to the extent that its interest-bearing liabilities withshort- and medium-term maturities mature or reprice more rapidly than itsinterest-earning assets.  The Companydoes not currently engage in trading activities or use derivative instrumentsto control interest rate risk although it may in the future, if necessary, tomanage interest rate risk.

 

Thecomposition of the Bank’s balance sheet results in maturity mismatches betweeninterest-earning assets and interest-bearing liabilities.  The scheduled maturities of the Bank’s fixedrate interest-earning assets are longer than the scheduled maturities of itsfixed rate interest-bearing liabilities. This mismatch exposes the Bank to interest rate risk.  In a rising rate scenario, as measured bythe OTS interest rate risk exposure simulation model, the estimated market orportfolio value (“PV”) of the Bank’s assets would decline in value to a greaterdegree than the change in the PV of the Bank’s liabilities, thereby reducingnet portfolio value (“NPV”), the estimated market value of its shareholders’equity.

 

As set forth below, depending upon the volatility of the rate change,the change in asset or liability mix of the Company or other factors mayproduce a decrease in net interest margin in an upward moving rate environmenteven as the NPV estimate indicates an increase in net value.  The converse 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, 2003 (the most recent report available) and September 30,2002, 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 theabnormally low prevailing interest rate environment, -200 and –300 NPV were notestimated by the OTS.  Management doesnot believe that the Company has experienced any material

 

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changes in its market riskposition from that disclosed in the Company’s Annual Report on Form 10-K forthe fiscal year ended June 30, 2003 or that the Company’s primary market riskexposures and how those exposures were managed during the three months endedSeptember 30, 2003 changed significantly when compared to June 30, 2003.

 

Thedata in the following tables is based on assumptions utilized by the OTS inassessing interest rate risk of thrift institutions and published in “SelectedAsset and Liability Price Tables as of June 30, 2003” and “Selected Asset andLiability Price Tables as of September 30, 2002”.  Even if interest rates change in the designated amounts, therecan be no assurance that the Company’s assets and liabilities would perform asset forth below.  Depending upon thevolatility of the rate change, the change in asset or liability mix of theCompany or other factors may produce a decrease in net interest margin in anincreasing rate environment even as the NPV estimate indicates an increase innet value.  The converse situation canalso be  expected.  In addition, a change in U.S. Treasury ratesin the designated amounts accompanied by a change in the shape of the Treasuryyield curve would cause significantly different changes to the NPV thanindicated below.

 

June 30, 2003

 

|                          |   | **Estimated**               |   | **Estimated  Increase  (Decrease) in NPV** |   |
|-------------------------------|--------|-----------------------------|--------|--------------------------------------------|--------|
| **Change in  Interest Rates** |   | **NPV  Amount**             |   | **Amount**                                 |   | **Percent** |   |
|                          |   | **(Dollars in thousands )** |   |                                       |   |
| Basis Points                  |   |                        |   |                                       |   |   |   |
|                          |   |                        |   |                                       |   |   |   |
| +300                          |   | $                           | 80,157 |                                       | $      | 2,306 |   | 3 | % |
| +200                          |   | 80,555                      |   | 2,703                                      |   | 3 |   |
| +100                          |   | 79,200                      |   | 1,348                                      |   | 2 |   |
| —                        |   | 77,852                      |   | —                                     |   | — |   |
| -100                          |   | 76,488                      |   | (1,364                                     | )      | (2 | ) |
|                               |        |                             |        |                                            |        |  |  |  |  |

 

 

September 30, 2002

 

|                          |   | **Estimated**               |       | **Estimated  Increase  (Decrease) in NPV** |       |
|-------------------------------|--------|-----------------------------|------------|--------------------------------------------|------------|
| **Change in  Interest Rates** |   | **NPV  Amount**             |       | **Amount**                                 |       | **Percent** |   |
|                          |   | **(Dollars in thousands )** | ** ** |                                       | ** ** |
| Basis Points                  |   |                        |       |                                       |       |
|                          |   |                        |       |                                       |       |   |   |
| +300                          |   | $                           | 80,477     |                                       | $          | 251 |   | 0 | % |
| +200                          |   | 82,380                      |       | 2,154                                      |       | 3 |   |
| +100                          |   | 82,416                      |       | 2,190                                      |       | 3 |   |
| —                        |   | 80,226                      |       | —                                     |       | — |   |
| -100                          |   | 78,370                      |       | (1,856                                     | )          | (2 | ) |
|                               |        |                             |            |                                            |            |  |  |  |  |

 

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In managing market risk and the asset/liability mix, the Bank hasplaced its emphasis on developing a portfolio in which, to the extentpracticable, assets and liabilities reprice within similar periods. The effectof this policy will generally be to reduce the Bank’s sensitivity to interestrate changes.  The goal of this policyis to provide a relatively consistent level of net interest income in varyinginterest rate cycles and to minimize the potential for significant fluctuationsfrom period to period.

 

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

Management, including the Company’s Chairman, President and ChiefExecutive Officer and the Executive Vice President, Chief Financial Officer andTreasurer, evaluated the effectiveness of the design and operation of theCompany’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) underthe Exchange Act) as of the end of the period covered by this report.  Based upon that evaluation, the Chairman,President and Chief Executive Officer and the Executive Vice President, ChiefFinancial Officer****andTreasurer concluded that the disclosure controls and procedures were effective,in all material respects, to ensure that information required to be disclosedin the reports the Company files and submits under the Exchange Act isrecorded, processed, summarized and reported as and when required.

 

There have been no significant changes in internal control overfinancial reporting or in other factors that could significantly affect theCompany’s internal control over financial reporting subsequent to September 30,2003.

 

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**PART II**

 

**Item1.****    Legal Proceedings**

 

The Company, Home Federaland its subsidiaries are involved as plaintiff or defendant in various legalactions 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 Home Federal and theCompany in the proceedings, that the resolution of these proceedings should nothave a material effect on the Company’s consolidated financial position orresults of operations.  The Company andits direct and indirect subsidiaries are not aware of any legal actions orproceedings outside of the normal course of business.

 

**Item 2.****    Changes in Securities andUse of Proceeds**

 

None

 

**Item 3.****    Defaults upon SeniorSecurities**

 

None

 

**Item 4.****    Submission of Matters to aVote of Security Holders**

 

None

 

**Item5.****    Other Information**

 

None

 

**Item 6.****    Exhibits and Reports onForm 8-K**

 

(a)   Exhibits

 
| **Regulation  S-K  Exhibit Number** |   | **Document**                                                                                                                                 |
|-------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                                |   | Guarantee Agreement dated September 25, 2003 by and  between HF Financial Corp. and Wilmington Trust Company                                 |
| 10.2                                |   | Indenture Agreement dated September 25, 2003 by and  between HF Financial Corp. and Wilmington Trust Company                                 |
| 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  Executive 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 Executive  Officer and Treasurer Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 |

 

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| (b)    |   | Reports on Form 8-K                                                                                                                                                                                                                                          |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                         |
|   |   | On  July 16, 2003, the Company filed Form 8-K, reporting under Item 9, “Regulation  FD Disclosure (Information Provided Under Item 12),” announcing the  resolution to an impaired loan.                                                           |
|   |   |                                                                                                                                                                                                                                                         |
|   |   | On July 29, 2003, the Company filed Form 8-K, reporting under Item  12, “Results of Operations and Financial Condition,” announcing results for  the fourth quarter and fiscal year ended June 30, 3003.                                           |
|   |   |                                                                                                                                                                                                                                                         |
|   |   | On August 18, 2003, the Company filed Form 8-K, reporting under Item  5, “Other Events,” announcing the sale of the Property and Casualty book of  business of Hometown Insurors, Inc. to Olson and Associates Insurors, Inc. of  Sioux Falls, SD. |
|   |   |                                                                                                                                                                                                                                                         |
|   |   | On September 30, 2003, the Company filed Form 8-K, reporting under  Item 5, “Other Events,” announcing the issue of $7.0 million of  Company Obligated Mandatorily Redeemable Preferred Securities of HF Financial Capital Trust IV.               |

 

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**HF FINANCIAL CORP.**

 

**FORM 10-QSIGNATURES**

 

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 13, 2003 |   |                                          | By:    | /s/ Curtis L. Hage |   |
|   |              |   | Curtis L. Hage, Chairman, President           |   |
|   |              |   | And Chief Executive Officer                   |   |
|   |              |   | (Duly Authorized Officer)                     |   |
|   |              |   |                                          |   |
| Date:  | November 13, 2003 |   |                                          | By:    | /s/ Darrel L. Posegate |   |
|   |              |   | Darrel L. Posegate, Executive Vice President, |   |
|   |              |   | Chief Financial Officer and Treasurer         |   |
|   |              |   | (Principal Financial and Accounting Officer)  |   |
|        |                   |        |                                               |        |  |  |  |

 

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