10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

Commission file number: 0-12668

Hills Bancorporation

Incorporated in Iowa I.R.S. Employer Identification
No. 42-1208067

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes     o No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

	SHARES OUTSTANDING
CLASS	At October 31, 2006
Common Stock, no par value	4,555,180

Page 1 of 36

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION

Page

Number

Item 1. Financial Statements

and December 31, 2005. 3

months ended September 30, 2006 and 2005. 4

three and nine months ended September 30, 2006 and 2005. 5

for nine months ended September 30, 2006 and 2005. 6

months ended September 30, 2006 and 2005. 7 - 8

Notes to consolidated financial statements 9 - 13

Item 2. Management's Discussion and Analysis of Financial Condition

and Results of Operations 14 - 27

Item 3. Quantitative and Qualitative Disclosures About Market Risk 28

Item 4. Controls and Procedures 29

Part II

OTHER INFORMATION

Item 1. Legal proceedings 30

Item 1A. Risk factors 30

Item 2. Unregistered sales of equity securities and use of proceeds 30

Item 3. Defaults upon senior securities 30

Item 4. Submission of matters to a vote of security holders 30

Item 5. Other information 30

Item 6. Exhibits 30

Signatures 31

Exhibits Index 32

Page 2 of 36

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

ASSETS	September 30, 2006 (Unaudited)				December 31, 2005
Cash and cash equivalents		$	28,543		$	29,956
Investment securities:
Available for sale at fair value (amortized cost September 30, 2006 $187,512;
December 31, 2005 $199,673)			185,447			196,786
Held to maturity at amortized cost (fair value September 30, 2006 $178; December 31, 2005 $225)			170			215
Stock of Federal Home Loan Bank			13,285			12,000
Loans held for sale			800			702
Loans, net			1,252,877			1,141,716
Property and equipment, net			22,416			22,265
Tax credit real estate			7,213			7,595
Accrued interest receivable			10,463			8,619
Deferred income taxes			7,602			6,819
Goodwill			2,500			2,500
Other assets			4,079			4,476
		$	1,535,395		$	1,433,649
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Noninterest-bearing deposits		$	136,102		$	146,799
Interest-bearing deposits			939,558			889,615
Total deposits		$	1,075,660		$	1,036,414
Short-term borrowings			62,788			34,537
Federal Home Loan Bank borrowings			248,129			223,161
Accrued interest payable			2,690			2,313
Other liabilities			7,459			7,111
		$	1,396,726		$	1,303,536
Redeemable Common Stock Held by Employee Stock
Ownership Plan (ESOP)		$	20,486		$	20,634
STOCKHOLDERS’ EQUITY
Capital stock, no par value; authorized 10,000,000 shares; issued
September 30, 2006 4,566,272 shares; December 31, 2005 4,563,637 shares		$	—		$	—
Paid in capital			12,150			11,970
Retained earnings			128,326			119,989
Accumulated other comprehensive income (loss)			(1,276	)		(1,783	)
Treasury stock at cost (September 30, 2006 11,092 shares;
December 31, 2005 1,400 shares)			(531	)		(63	)
		$	138,669		$	130,113
Less maximum cash obligation related to ESOP shares			20,486			20,634
		$	118,183		$	109,479
		$	1,535,395		$	1,433,649

See Notes to Consolidated Financial Statements.

Page 3 of 36

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Interest income:
Loans, including fees	$	20,780	$	17,152	$	58,860	$	48,545
Investment securities:
Taxable		1,113		1,148		3,403		3,607
Nontaxable		727		682		2,149		1,985
Federal funds sold		—		102		31		205
Total interest income	$	22,620	$	19,084	$	64,443	$	54,342
Interest expense:
Deposits	$	7,182	$	5,209	$	19,720	$	13,933
Short-term borrowings		907		131		2,107		438
FHLB borrowings		3,054		2,668		8,657		7,268
Total interest expense	$	11,143	$	8,008	$	30,484	$	21,639
Net interest income	$	11,477	$	11,076	$	33,959	$	32,703
Provision for loan losses		433		239		2,142		998
Net interest income after provision for loan losses	$	11,044	$	10,837	$	31,817	$	31,705
Other income:
Net gain on sale of loans	$	280	$	313	$	661	$	857
Net losses on sale of investment securities		—		—		—		(234	)
Trust fees		837		749		2,550		2,208
Service charges and fees		1,801		1,576		5,134		4,260
Rental revenue on tax credit real estate		190		171		592		559
Other noninterest income		648		600		2,046		1,782
	$	3,756	$	3,409	$	10,983	$	9,432
Other expenses:
Salaries and employee benefits	$	4,623	$	4,336	$	13,725	$	12,682
Occupancy		555		554		1,651		1,615
Furniture and equipment		892		869		2,505		2,554
Office supplies and postage		311		281		959		931
Advertising and business development		359		519		1,218		1,312
Outside services		1,185		1,287		3,597		3,538
Rental expenses on tax credit real estate		224		273		689		715
Other noninterest expense		367		382		968		921
	$	8,516	$	8,501	$	25,312	$	24,268
Income before income taxes	$	6,284	$	5,745	$	17,488	$	16,869
Federal and state income taxes		1,991		1,776		5,456		5,200
Net income	$	4,293	$	3,969	$	12,032	$	11,669
Earnings per share:
Basic	$	0.94	$	0.87	$	2.64	$	2.56
Diluted		0.93		0.86		2.62		2.55

See Notes to Consolidated Financial Statements.

Page 4 of 36

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Net income	$	4,293		$	3,969		$	12,032		$	11,669
Other comprehensive income (loss):
Unrealized holding gains (losses) arising during the period,	$	2,859		$	(1,705	)	$	822		$	(2,787	)
Income tax effect of unrealized gains (losses)		(1,094	)		631			(315	)		1,031
	$	1,765		$	(1,074	)	$	507		$	(1,756	)
Less: reclassification adjustment for losses included in
net income, net of income taxes		—			—			—			144
Other comprehensive income (loss)		1,765			(1,074	)		507			(1,612	)
Comprehensive income	$	6,058		$	2,895		$	12,539		$	10,057

See Notes to Consolidated Financial Statements.

Page 5 of 36

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

	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Maximum Cash Obligation Related To ESOP Shares			Treasury Stock			Total
Balance, December 31, 2005	$	11,970		$	119,989		$	(1,783	)	$	(20,634	)	$	(63	)	$	109,479
Issuance of 4,144 shares of
common stock		200			—			—			—			—			200
Forfeiture of 1,509 shares of
common stock		(56	)		—			—			—			—			(56	)
Shared-based compensation		36			—			—			—			—			36
Change related to ESOP shares		—			—			—			148			—			148
Net income		—			12,032			—			—			—			12,032
Cash dividends ($.81 per share)		—			(3,695	)		—			—			—			(3,695	)
Purchase of 9,692 shares of
common stock		—			—			—			—			(468	)		(468	)
Other comprehensive income (loss)		—			—			507			—			—			507
Balance, September 30, 2006	$	12,150		$	128,326		$	(1,276	)	$	(20,486	)	$	(531	)	$	118,183
Balance, December 31, 2004	$	11,364		$	108,199		$	576		$	(16,336	)	$	—		$	103,803
Issuance of 5,355 shares of
common stock		191			—			—			—			—			191
Forfeiture of 711 shares of
common stock		(22	)		—			—			—			—			(22	)
Change related to ESOP shares		—			—			—			(3,623	)		—			(3,623	)
Net income		—			11,669			—			—			—			11,669
Income tax benefit related to
stock-based compensation		8			—			—			—			—			8
Cash dividends ($.75 per share)		—			(3,413	)		—			—			—			(3,413	)
Purchase of 939 shares of
common stock		—			—			—			—			(42	)		(42	)
Other comprehensive income (loss)		—			—			(1,612	)		—			—			(1,612	)
Balance, September 30, 2005	$	11,541		$	116,455		$	(1,036	)	$	(19,959	)	$	(42	)	$	106,959

See Notes to Consolidated Financial Statements.

Page 6 of 36

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

	Nine Months Ended September 30,
	2006			2005
Cash Flows from Operating Activities
Net income	$	12,032		$	11,669
Adjustments to reconcile net income to net cash
and cash equivalents provided by operating activities:
Depreciation		1,755			1,883
Provision for loan losses		2,142			998
Net losses on sale of investment securities		—			234
Share-based compensation		36			—
Compensation expensed through issuance of common stock		200			163
Income tax benefits related to stock-based compensation		—			8
Forfeiture of common stock		(56	)		(22	)
Provision for deferred income taxes		(1,098	)		(541	)
Decrease in accrued interest receivable		(1,844	)		(1,255	)
Amortization of discount on investment securities, net		405			600
Increase (decrease) in other assets		398			(633	)
Increase in accrued interest and other liabilities		725			1,507
Loans originated for sale		(75,802	)		(88,270	)
Proceeds on sales of loans		76,365			90,329
Net gain on sales of loans		(661	)		(857	)
Net cash and cash equivalents provided by operating activities	$	14,597		$	15,813
Cash Flows from Investing Activities
Proceeds from maturities of investment securities:
Available for sale	$	25,531		$	43,910
Held to maturity		45			4,685
Proceeds from sales of investment securities available for sale		—			10,465
Purchases of investment securities available for sale		(15,061	)		(59,515	)
Loans made to customers, net of collections		(113,303	)		(102,864	)
Purchases of property and equipment		(1,906	)		(1,794	)
Investment in tax credit real estate, net		382			320
Net cash used in investing activities	$	(104,312	)	$	(104,793	)
Cash Flows from Financing Activities
Net increase in deposits	$	39,246		$	80,427
Net increase (decrease) in short-term borrowings		28,251			(13,596	)
Borrowings from FHLB		45,000			40,000
Payments on FHLB borrowings		(20,032	)		(131	)
Stock options exercised		—			28
Purchase of treasury stock		(468	)		(42	)
Dividends paid		(3,695	)		(3,413	)
Net cash provided by financing activities	$	88,302		$	103,273

(Continued)

Page 7 of 36

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

	Nine Months Ended September 30,
	2006			2005
(Decrease) increase in cash and cash equivalents	$	(1,413	)	$	14,293
Cash and cash equivalents:
Beginning of year		29,956			23,008
End of period	$	28,543		$	37,301
Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	19,343		$	13,613
Interest paid on other obligations		10,764			7,706
Income taxes paid		6,137			4,962
Noncash financing activities:
(Decrease) increase in maximum cash obligation
related to ESOP shares	$	(148	)	$	3,623

See Notes to Consolidated Financial Statements.

Page 8 of 36

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

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

Operating results for the nine month period ended September 30, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2005 filed with the Securities Exchange Commission on March 10, 2006.

Note 2. Earnings Per Share

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

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

	Three months ended September 30,					Nine months ended September 30,
	2006			2005		2006			2005
Common shares outstanding at the beginning of the period		4,559,883			4,549,656		4,562,237			4,549,656
Weighted average number of net shares issued (redeemed)		(2,119	)		3,740		(2,929	)		2,024
Weighted average shares outstanding (basic)		4,557,764			4,553,396		4,559,308			4,551,680
Weighted average of potential dilutive shares
attributable to stock options granted, computed under
the treasury stock method		27,650			19,682		27,806			20,844
Weighted average number of shares (diluted)		4,585,414			4,573,078		4,587,114			4,572,524
Net income (In Thousands)	$	4,293		$	3,969	$	12,032		$	11,669
Earnings per share:
Basic	$	0.94		$	0.87	$	2.64		$	2.56
Diluted	$	0.93		$	0.86	$	2.62		$	2.55

Page 9 of 36

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3. Recent Accounting Pronouncements

As of January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (FAS 123R) which requires companies to recognize in compensation expense the grant-date fair value of stock awards issued to employees and directors. The Company adopted FAS 123R using the modified prospective transition method. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect the impact of FAS 123R. As a result of applying FAS 123R, the Company recognized share-based compensation expense of $36,200 for the nine months ended September 30, 2006 (see Note 4.)

As of January 1, 2006, the Company has elected to use the guidance issued by the FASB in Position FAS No. 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards (“FSP FAS 123R-3”). FSP FAS 123R-3 provides a practical exception when a company transitions to the accounting requirements of FAS 123R. FAS 123R requires a company to calculate the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to adopting FAS 123R, termed the Additional Paid in Capital Pool (“APIC Pool”), assuming the company had been following the recognition provisions prescribed by FAS 123. The adoption of the FSP does not have an impact on the Company’s overall results of operations.

In March 2004, the Emerging Issues Task Force (EITF) revisited EITF Issue No. 03­1, The Meaning of Other­Than­Temporary Impairment and its Application of Certain Investments. Effective with reporting periods beginning after June 15, 2004, companies carrying certain types of debt and equity securities at amounts higher than the securities’ fair market values would have to use more detailed criteria to evaluate whether to record a loss and would have to disclose additional information about unrealized losses. The FASB subsequently issued a staff position deferring the effective date of the measurement and recognition provisions of the revised EITF No. 03­1 until further implementation issues may be resolved. On November 3, 2005, the FASB issued a Staff Position (FSP) that addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other­than­temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other­than­temporary impairments. The guidance in the FSP shall be applied to reporting periods beginning after December 15, 2005. Adoption of the new issuance did not have a material impact on the Company’s financial position and results of operations but the extent of any impact will vary due to the fact that the model, as issued, calls for many judgments and additional evidence gathering as such evidence exists at each securities valuation date.

In December 2004, the FASB issued FASB Statement No. 153, Exchanges of Nonmonetary Assets, which eliminates an exception in APB 29 for recognizing nonmonetary exchanges of similar productive assets at fair value and replaces it with an exception for recognizing exchanges of nonmonetary assets at fair value that do not have commercial substance. This Statement is effective for the Company for nonmonetary asset exchanges occurring on or after January 1, 2006. The adoption of this Statement did not have a significant effect on the Company’s financial statements.

In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections. Statement 154 establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting principle. The Company implemented the provisions of this statement as of January 1, 2006 and it did not have a significant effect on its financial statements.

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

Page 10 of 36

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3. Recent Accounting Pronouncements (continued)

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for years ending on or after November 15, 2006. The Company is currently evaluating the impact that SAB 108 will have on its consolidated financial statements.

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

Note 4. Employee Benefit Plans

The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 198,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Directors may exercise options immediately and officers’ rights under the plan vest over a five-year period from the date of the grant. Prior to January 1, 2006, the Company accounted for the stock options under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.

On January 1, 2006, the Company adopted FAS 123R, which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors. The Company adopted FAS 123R using the modified prospective transition method. The Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of FAS 123R. In accordance with the modified prospective transition method, the Consolidated Financial Statements for prior periods have not been restated.

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

	Options	Weighted-Average Exercise Price	Weighted-Average Remaining Contractual Term (years)	Aggregate Intrinsic Value (In Thousands)
Outstanding at September 30, 2006	62,619	$26.69	5.09	1,671
Options exercisable at September 30, 2006	44,019	25.27	4.53	1,112

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

Page 11 of 36

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Employee Benefit Plans (continued)

At September 30, 2006, 116,944 shares were available for issuance under the plan. No stock options were granted or exercised during the nine months ended September 30, 2006.

As of September 30, 2006, there was $44,800 in unrecognized compensation cost for stock options granted under the plan. As of March 31, 2006 and June 30, 2006, there was $70,000 and $52,600, respectively. This cost is expected to be recognized over a weighted-average period of 1.41 years.

The results for the first three quarters of 2006 are not directly comparable to the same period in 2005. Prior to the adoption of FAS 123R, the Company applied the existing accounting rules under APB Opinion No. 25, which provided that no compensation expense was charged for options granted at an exercise price equal to the market value of the underlying common stock on the date of the grant. If the fair value recognition provisions of FAS 123R had been applied to stock-based compensation for the three and nine months ended September 30, 2005, the Company’s pro forma net income and earnings per share would have been as follows:

	Three months ended September 30, 2005			Nine months ended September 30, 2005
Net income:
As reported	$	3,969		$	11,669
Deduct total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects		(21	)		(63	)
Pro forma	$	3,948		$	11,606
Basic earnings per share:
As reported	$	0.87		$	2.56
Pro forma	$	0.87		$	2.55
Diluted earnings per share:
As reported	$	0.86		$	2.55
Pro forma	$	0.86		$	2.54

Note 5. Stock Repurchase Program

In July of 2005, the Company’s Board of Directors approved a stock repurchase program pursuant to which the Company may repurchase 750,000 shares of its common stock from time to time through December 31, 2009. Pursuant to this authorization, the Company has purchased 11,092 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2006. Of these 11,092 shares, 5,715 shares were purchased during the quarter ended September 30, 2006, at an average price per share of $49.

Page 12 of 36

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Commitments and Contingencies

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at September 30, 2006 and December 31, 2005 is as follows:

	September 30, 2006		December 31, 2005
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	18,657	$	17,191
Credit card lines		27,896		24,934
Commercial, real estate and home construction		77,268		86,301
Commercial lines		74,936		61,510
Outstanding letters of credit		10,791		12,374

Page 13 of 36

HILLS BANCORPORATION

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

And Results of Operations

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

Special Note Regarding Forward Looking Statements

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

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

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

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

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

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

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

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

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

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

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

Page 14 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

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

• The economic impact of terrorist attacks and military actions.

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

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

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

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

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

Critical Accounting Policies

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual loans in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion and analysis should be read in conjunction with the Company's financial statements and the accompanying notes presented elsewhere herein, as well as the Management's Discussion and Analysis of Financial Condition and Results of Operation that is included. Although management believes the levels of the allowance as of September 30, 2006 and December 31, 2005 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Page 15 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Overview

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At September 30, 2006, the Bank has thirteen full service locations.

Net income for the nine-month period ended September 30, 2006 was $12.03 million compared to $11.67 million for the same nine months of 2005. Basic earnings per share increased to $2.64 for the nine months ended September 30, 2006 compared to $2.56 for the same period in 2005. Diluted earnings per share were $2.62 and $2.55 for the nine months ended September 30, 2006 and 2005, respectively. Return on average equity was 14.38% and return on average equity net of ESOP obligation was 12.14% for the nine months ended September 30, 2006, compared to 14.98% and 12.75%, respectively, for the same period in 2005. Return on average assets was 1.08% in 2006 compared to 1.16% in 2005. Dividends of $.81 per share were paid in January 2006 to 1,499 shareholders. The 2006 dividend was an 8.0% increase over the prior year’s dividend of $.75 per share.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earnings assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.35% compared to 3.58% in 2005. Despite this reduction in net interest margin, net interest income has increased due to the higher volume of earnings assets as of September 30, 2006 compared to the same period in 2005.

Highlights noted on the balance sheet as of September 30, 2006 for the Company included the following:

• Total assets are over $1.5 billion, at $1.535 billion.

• Net loans are $1.254 billion.

• Loan growth of $111.3 million since December 31, 2005.

• Deposit growth of $39.2 million since December 31, 2005.

• Short-term borrowings increased $28.3 million since December 31, 2005.

• Federal Home Loan Bank borrowings increased $25.0 million since December 31, 2005.

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

Page 16 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Financial Condition

Asset growth for the nine months ended September 30, 2006 was $101.7 million, which included a net loan increase of $111.3 million. Loans secured by real estate accounted for $90.1 million or 80.95% of the increase in loans. Commercial loans increased $24.7 million to $116.2 million as of September 30, 2006, an increase of 27.00% since December 31, 2005. The net loan increase was accomplished despite higher interest rates. Since December 31, 2005, the federal funds target rate has been raised by the Federal Reserve Open Market Committee from 4.25% to 5.25% with four increases of .25% each or a total of 1.00%. The upward movement of the federal funds target rate started on June 30, 2004 when the rate was 1.00% and has increased 17 times through September 30, 2006. The last increase was on June 29, 2006. The Federal Reserve Open Market Committee did not raise the target rate at its August, September or October, 2006 meetings. Interest rates on loans are generally affected by these increases since interest rates for the U.S. Treasury market normally increase when the Federal Reserve Board raises the federal funds target rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. Increases in interest rates may at some point materially reduce loan demand and slow the economy, but at the current interest rate levels, demand for loans remains good. The overall economy in the Company’s principal place of business, Johnson and Linn Counties, remains good with unemployment levels that remain low.

The tables below set forth the composition of the loan portfolio as of September 30, 2006 and December 31, 2005 (dollars in thousands), along with changes in the allowance for loan losses and non-performing loan information:

	September 30, 2006					December 31, 2005
	Amount		Percent			Amount		Percent
	(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	$	42,861		3.37	%	$	43,730		3.78	%
Commercial and financial		116,208		9.15			91,501		7.91
Real estate:
Construction		102,768		8.09			83,456		7.21
Mortgage		976,944		76.90			906,188		78.32
Loans to individuals		31,576		2.49			32,201		2.78
	$	1,270,357		100.00	%	$	1,157,076		100.00	%
Less allowance for loan losses		17,480					15,360
	$	1,252,877				$	1,141,716

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

Page 17 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
	(Amounts In Thousands)						(Amounts In Thousands)
Balance, beginning	$	17,100		$	14,370		$	15,360		$	13,790
Provision charged to expense		433			239			2,142			998
Recoveries		336			447			1,117			1,031
Loans charged off		(389	)		(446	)		(1,139	)		(1,209	)
Balance, ending	$	17,480		$	14,610		$	17,480		$	14,610

Non-performing loan information at September 30, 2006 and December 31, 2005, was as follows:

	September 30, 2006		December 31, 2005
	(Amounts in thousands)
Non-accrual loans	$	681	$	175
Accruing loans past due ninety days or more		3,201		1,910
Restructured loans		—		—
Non-performing loans (includes non-accrual loans)		14,666		16,602

Page 18 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

From December 31, 2005 to September 30, 2006, the balance of the investment securities held by the Company decreased by $11.34 million. The principal factor in this reduction was the maturity of various U.S. Government agency and municipal securities having a balance of approximately $11.76 million which were not replaced during the nine-month period. Partially offsetting the decrease was an increase in the market value of the remaining securities of $0.8 million. The carrying values of investment securities for September 30, 2006 and December 31, 2005 are summarized in the following table (dollars in thousands):

	September 30, 2006					December 31, 2005
	Amount		Percent			Amount		Percent
Securities available for sale
U.S. Government agencies
and corporations	$	102,237		55.13	%	$	117,482		59.70	%
State and political
subdivisions		83,210		44.87			79,304		40.30
Total securities
available for sale	$	185,447		100.00	%	$	196,786		100.00	%
Securities held to maturity
State and political
subdivisions	$	170		100.00	%	$	215		100.00	%

Deposit growth was $39.2 million in the first nine months of 2006 and repurchase agreements increased $11.1 million in the same period. These increases included $30.6 million of municipal deposits, $11.5 million of commercial deposits and $8.2 million of retail deposits. Short-term borrowings at December 31, 2005 included federal funds purchased of $6.8 million compared to $23.8 million as of September 30, 2006. The borrowings from the Federal Home Loan Bank (FHLB) decreased by $20 million with the maturity of two $10 million advances. One advance with an interest rate of 4.09% matured in June 2006. The second advance matured in July 2006 and had an interest rate of 5.22%. The Company borrowed an additional $45 million during the nine months ended September 30, 2006. Borrowings of $15 million were made in June, July and August of 2006 with interest rates of 4.69%, 4.66% and 4.46%, respectively. Each borrowing is for ten years and is callable in one year. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Dividends and Equity

In January 2006, Hills Bancorporation paid a dividend of $3,695,000 or $.81 per share, an 8.0% increase from the $.75 per share paid in January 2005. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity totaled $118.2 million as of September 30, 2006. Under risk-based capital rules, the total amount of risk based capital of the Company as of September 30, 2006, was 13.53% of risk-adjusted assets, and is substantially in excess of the required minimum of 8.00%. Risk-based capital was 13.80% as of September 30, 2005 and December 31, 2005. As of September 30, 2006, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s category.

Page 19 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2006 and 2005.

Net Income Overview

Net income increased $363,000 during the nine months ended September 30, 2006. Net income was $12,032,000 in 2006 and $11,669,000 in the comparable period in 2005, which represented an increase of approximately 3%. The changes in net income in 2006 from the first nine months of 2005 are as follows and are discussed in detail in the following review of operations:

• Net interest income increased by $1,256,000.

• The provision for loan losses increased by $1,144,000.

• Other income increased by $1,551,000.

• Other expenses increased by $1,044,000.

• Income taxes increased by $256,000.

For the nine-month periods ended September 30, 2006 and 2005, basic earnings per share were $2.64 and $2.56, respectively. Diluted earnings per share was $2.62 for the nine months ended September 30, 2006 and $2.55 for the same period in 2005.

Quarterly fluctuations in the Company’s net income continue to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average earnings assets. Net interest income of $34.0 million for the first nine months of 2006 was derived from the Company’s $1.409 billion of average earning assets and its net interest margin of 3.35%. Average earning assets in the nine months ending September 30, 2005 were $1.268 billion and the net interest margin was 3.58%. The margin compression was the result of the continued flattening of the yield curve and pricing pressure on short-term deposits. The overall net interest income increased due to the higher volume of earning assets in 2006 compared to 2005. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.25% would have resulted approximately in a $1,054,000 decrease in income before income taxes in the nine month period ending September 30, 2006. Similarly, an increase in the net interest margin of 10 basis points to 3.45% would have resulted in approximately a $1,054,000 increase in net interest income before taxes.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.254 billion at September 30, 2006. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which include non-accrual loans) and loans past due 90 days or more. The provision for loan losses was $2,142,000 in 2006 compared to $998,000 in 2005. The increase in the provision for loan losses is the result of growth in the overall loan portfolio and an increase in problem and watch loans of $5.8 million since December 31, 2005.

The amount of mortgage loans sold on the secondary market is the third factor that can cause fluctuations in net income. In the nine months ended September 30, 2006 and 2005, the net gain on sale of loans was $661,000 and $857,000, respectively. The sale of loans is influenced by the real estate market and interest rates.

Page 20 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2006 and 2005 (continued).

Net Interest Income

Net interest income is the excess of the interest and fees received on interest-earning assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the first nine months of 2006 was 3.35% compared to 3.58% in 2005 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the nine months ended in 2006 compared to the comparable period in 2005 are shown in the following table:

	Change in			Change in			Increase (Decrease) in Net Interest Income
	Average Balance			Average Rate			Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	158,706			0.32	%	$	7,416		$	2,910		$	10,326
Taxable securities		(15,464	)		0.20			(414	)		210			(204	)
Nontaxable securities		5,174			0.07			208			44			252
Federal funds sold		(7,668	)		0.96			(181	)		7			(174	)
	$	140,748					$	7,029		$	3,171		$	10,200
Interest expense:
Interest-bearing demand deposits	$	(4,611	)		0.27		$	23		$	(284	)	$	(261	)
Savings deposits		8,958			0.65			60			(1,431	)		(1,371	)
Time deposits		43,628			0.84			(1,012	)		(3,143	)		(4,155	)
Short-term borrowings		36,473			2.25			(692	)		(977	)		(1,669	)
FHLB borrowings		44,351			(0.21	)		(1,748	)		359			(1,389	)
	$	128,799					$	(3,369	)	$	(5,476	)	$	(8,845	)
Change in net interest income							$	3,660		$	(2,305	)	$	1,355

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2006			2005
Yield on average interest-earning assets		6.23	%		5.85	%
Rate on average interest-bearing liabilities		3.37			2.68
Net interest spread		2.86	%		3.17	%
Effect of noninterest-bearing funds		0.49			0.41
Net interest margin (tax equivalent interest income
divided by average interest-earning assets)		3.35	%		3.58	%

Page 21 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2006 and 2005 (continued).

Provision for Loan Losses

The provision for loan losses was $2,142,000 in 2006 compared to $998,000 in 2005, an increase of $1,144,000. The provision adjustment is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which include non-accrual loans) and loans past due ninety days or more.

The provision for loan losses increased in the first nine months of 2006 as a result of the growth in the overall loan portfolio and an increase in problem and watch loans of $5.8 million. In contrast, in the nine months ended September 30, 2005, the watch and problem loans decreased by $5.5 million. While loan growth was substantial in both periods, $111.3 million in 2006 and $100.7 million in 2005, the provision expense was offset in 2005 by the improvement in the quality of the loan portfolio. The increase in the provision expense for 2006 is reflective of a point in time and not any group or type of loans for which estimated losses were higher than expected.

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the nine months ended September 30, 2006 and 2005, recoveries were $1,117,000 and $1,031,000, respectively; and charge-offs were $1,139,000 in 2006 and $1,209,000 in 2005. The allowance for loan losses totaled $17,480,000 at September 30, 2006 compared to $15,360,000 at December 31, 2005. The allowance represented 1.38% and 1.33% of outstanding loans at September 30, 2006 and December 31, 2005, respectively. The methodology used in 2006 is consistent with 2005.

Net Gain on Sale of Loans

Net gain on sale of loans for the nine months ended September 30, 2006 was $661,000 compared to $857,000 for the comparable period ended September 30, 2005. The number of loans sold in 2006 was approximately 87% of the volume in 2005.

Other Income

Other income, other than the net gain on sale of loans discussed above, increased by $1,747,000 for the nine months ended September 30, 2006. Investment securities losses of $234,000 were recorded in 2005; there were no security sales recorded in 2006. Trust fees increased $342,000 in 2006 as a result of assets under management increasing from $743.8 million as of September 30, 2005 to $823.7 million as of September 30, 2006. Service charges and fees were up $874,000 from 2005 to 2006. $680,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and Point of Sale (POS) pin interchange fees increased during the same period by $246,000 due to volume of activity. Other noninterest income increased $264,000 as of September 30, 2006 compared to 2005. Included in this increase was a one-time $79,000 sales tax refund received in the second quarter of 2006 and a $53,000 rebate received in May 2006 related to the Bank’s participation in a credit card program.

Page 22 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2006 and 2005 (continued).

Other Expenses

Other expenses increased $1,044,000 in 2006 to $25,312,000 from the same period in 2005. This increase of 4.30% included $1,043,000 in salaries and benefits. Direct salary expense was up $722,000, or 7.60%, due to annual pay adjustments and an increase of 5 employees since December 31, 2005. Medical expense for employees' health insurance increased $248,000 due to a premium increase of 12% for 2006 and a $105,000 reduction in medical expense in 2005 due primarily to a change in the Company’s medical plan from a self-insured plan to a full-premium plan. Employee compensation expense, which includes expense related to the officers’ deferred compensation plan, decreased $81,000 in 2006. In the first nine months of 2005, the appraised value of the Company’s common stock increased $8 per share to $45. The appraised value increased $2.50 to $49 during the same period in 2006. Beginning effective June 30, 2005 and as a result of the Company’s program to repurchase up to a total of 750,000 shares of the Company’s common stock, the Company obtains a quarterly independent appraisal of the shares of stock.

Occupancy expense increased $36,000 with property tax and utilities expenses increasing $25,000 and $15,000, respectively, in the first nine months of 2006 as compared to the same period in 2005. In 2006, furniture and equipment expense included $1,312,000 in depreciation compared to $1,445,000 in 2005, a decrease of $133,000. This decrease is partially offset by an increase in equipment and software maintenance contracts of $59,000 to $791,000.

Advertising and business development expenses decreased $94,000 as of September 30, 2006 compared to the same period in 2005. In 2005, the expenses included a $50,000 contribution to the American Red Cross to assist the victims of Hurricane Katrina. Also, expenses related to the Company’s credit card incentive program were $43,500 more in the first nine months of 2005 as compared to the same period in 2006.

Outside services increased $59,000 from 2005 to $3.6 million in 2006. Outside services include professional fees, courier services and ATM fees and processing charges for the merchant credit card program, retail credit cards and other data processing services. The credit card, merchant card and debit card processing charges increased $83,000 due to the increase in the volume of activity. Professional fees decreased $77,000 from 2005 to $1,043,000 as of September 30, 2006. The 2005 expenses included $140,000 in consulting fees for a new fee income strategy which are not included in 2006 expenses. This decline is offset by the increase in attorney’s fees of $47,000 for the nine months ended September 30, 2006 as compared to the same period in 2005. Fees to an outside consultant were up $30,000 in 2006 as the result of the sales tax audit that resulted in the $79,000 sales tax refund discussed above and expanded information security testing.

Income Taxes

Federal and state income tax expenses were $5,456,000 and $5,200,000 for the nine months ended September 30, 2006 and 2005, respectively. Income taxes as a percentage of income before taxes were 31.20% in 2006 and 30.83% in 2005. The amount of tax credits in 2006 was $420,000 compared to $507,000 in 2005, as a result of one tax credit property ending its ten-year term for the credits.

Page 23 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2006 and 2005.

Net Income

Net income increased to $4,293,000 for the three months ended September 30, 2006 from $3,969,000 for the same period in 2005, an increase of 8.16%. Earnings per share, both basic and diluted, increased for the three months ended September 30, 2006 compared to the same period in 2005. For the three-month period ended September 30, 2006, basic earnings per share was $0.94 and diluted earnings per share was $0.93. For the three months ended September 30, 2005, basic earnings per share was $0.87 and diluted earnings per share was $0.86. Return on average equity was 14.88% and return on average equity net of ESOP obligation was 12.66% for the three months ended September 30, 2006, compared to 14.87% and 12.66%, respectively, for the same period in 2005. Return on average assets was 1.13% in 2006 compared to 1.15% in 2005.

Net Interest Income

Net interest income increased for the three month period ended September 30, 2006 by $401,000 from the similar period in 2005. The net interest margin in 2006 was 3.28% compared to 3.49% in 2005. The decrease is primarily due to an increase in rates on core deposit accounts, including insured money market accounts and short-term certificates of deposits. These rates were increased due to the upward movement of the federal fund rates. Rates paid on repurchase agreements and federal funds borrowed also increased. The increase in the volume of interest-earning assets accounted for a significant portion of the net interest income improvement. Net interest income changes on a tax-equivalent basis for the three months ended September 30, 2006 and 2005 are as follows:

	Change in			Change in			Increase (Decrease) in Net Interest Income
	Average Balance			Average Rate			Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	161,676			0.34	%	$	2,573		$	1,065		$	3,638
Taxable securities		(19,036	)		0.39			(177	)		142			(35	)
Nontaxable securities		4,877			0.01			65			4			69
Federal funds sold		(11,794	)		1.72			(102	)		—			(102	)
	$	135,723					$	2,359		$	1,211		$	3,570
Interest expense:
Interest-bearing demand deposits	$	(4,323	)		0.27		$	9		$	(94	)	$	(85	)
Savings deposits		10,638			0.64			39			(509	)		(470	)
Time deposits		32,995			0.88			(269	)		(1,149	)		(1,418	)
Short-term borrowings		53,307			2.42			(233	)		(543	)		(776	)
FHLB borrowings		32,926			(0.06	)		(423	)		37			(386	)
	$	125,543					$	(877	)	$	(2,258	)	$	(3,135	)
Change in net interest income							$	1,482		$	(1,047	)	$	435

Page 24 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2006 and 2005.

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2006			2005
Yield on average interest-earning assets		6.33	%		5.91
Rate on average interest-bearing liabilities		3.56			2.84
Net interest spread		2.77	%		3.07
Effect of noninterest-bearing funds		0.51			0.42
Net interest margin (tax equivalent interest income
divided by average interest-earning assets)		3.28	%		3.49

Provision for Loan Losses

The provision for loan losses was $433,000 for the quarter ended September 30, 2006 compared to $239,000 for the comparable quarter in 2005, an increase of $194,000. As discussed in connection with the results of operations for the nine months, the allowance for loan losses was increased due to management’s analysis of the outstanding loans at September 30, 2006. The provision for loan losses increased in the third quarter of 2006 as a result of the growth in the overall loan portfolio and an increase in loans classified as potential watch, watch and problem loans of $6.1 million. In contrast, in the three months ended September 30, 2005, the provision expense decreased by $363,000. Management’s analysis of outstanding loans as of September 30, 2005 indicated that the level of problem or watch loans considered in computing the provision adjustments had increased only $232,000 since June 30, 2005. In addition, net recoveries of loans were $1,000. These factors made a provision of $239,000 appropriate for the third quarter of 2005.

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the three months ended September 30, 2006 and 2005, recoveries were $336,000 and $447,000, respectively; and charge-offs were $389,000 in 2006 and $446,000 in 2005. The allowance for loan losses totaled $17,480,000 at September 30, 2006 compared to $14,610,000 at September 30, 2005. The allowance represented 1.38% and 1.31% of outstanding loans at September 30, 2006 and September 30, 2005, respectively.

Other Income

Total other income was $3,756,000 and $3,409,000 for the three months ended September 30, 2006 and 2005. For the reason explained in the preceding discussion of the nine month results, net gain on sale of loans was substantially less in 2006 as compared to 2005. Net gain on sale of loans decreased by $33,000 in the quarter ended September 30, 2006 as compared to the same quarter in 2005. The Trust Department fees for 2006 were $88,000 higher than 2005 due to the growth of assets under management. Service charges and fees were up $225,000 in the three months ended September 30, 2006. $139,000 of this increase was the result of new fee income strategies implemented in September 2005. Debit card and Point of Sale (POS) pin interchange fees increased $94,000 during the same period due to the volume of activity.

Page 25 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2006 and 2005 (continued).

Other Expenses

Total expenses for the 2006 quarter compared to the 2005 quarter increased $15,000 to $8,516,000. Salaries and employee benefits increased $287,000 for the quarter ended September 30, 2006 compared to 2005. Direct salary expense was up $234,000, or 7.22%, due to annual pay adjustments. The decrease of $172,000 in compensation expense related to the officers’ deferred compensation plan is explained above in the discussion of operations for the nine months ended September 30, 2006. The increase in medical insurance expense of $172,000 is also discussed above.

In the third quarter of 2006, furniture and equipment expense included $437,000 of depreciation compared to $482,000 in 2005, a decrease of $45,000. This decrease is offset by an increase in equipment and software maintenance contracts of $41,000 to a total of $303,000 in 2006. This increase is due to purchases in 2006 and the resulting maintenance agreements.

Advertising and business development expenses decreased $160,000 in comparing the quarters. The decrease is due to several factors including the types of office promotions conducted by the retail areas of the bank. Also, as discussed in the nine month operations section above, the third quarter 2005 expenses included a $50,000 contribution to the American Red Cross and higher expenses related to the Company’s credit card incentive program. Expenses for the credit card program were $26,000 in the third quarter of 2006 compared to $81,000 in the same period of 2005, a decrease of $55,000.

Outside services decreased $102,000 from 2005 to $1,185,000 for the quarter ended September 30, 2006. As a result of an increase in the volume of activity, credit card, merchant card and debit card processing charges increased $36,000. Professional fees decreased $157,000 from 2005. Third quarter 2005 expenses included the $140,000 in consulting fees discussed above.

Income Taxes

Income tax expense as a percentage of income before taxes increased to 31.68% in 2006 from 30.91% in 2005. Income tax expense is $215,000 more in 2006 compared to 2005 primarily due to the $539,000 increase in income before income taxes. The amount of tax credits in the third quarter of 2006 was $140,000 compared to $169,000 in 2005.

Page 26 of 36

HILLS BANCORPORATION

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

And Results of Operations (continued)

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. There were no federal funds sold as of September 30, 2006 or December 31, 2005. Investment securities available for sale comprised 12.08% of the Company’s total assets at September 30, 2006, compared to 13.73% at December 31, 2005.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of September 30, 2006, the Company had borrowed $248.1 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. This includes three new advances in 2006 for a total of $45 million. Also, two $10 million advances matured in 2006. These advances were used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $193 million at September 30, 2006.

As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and has lines of credit with two banks totaling $98 million. Those two lines of credit require the pledging of investment securities when drawn upon. The Company’s short-term borrowings at December 31, 2005 included federal funds purchased of $6.8 million compared to $23.8 million as of September 30, 2006. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at September 30, 2006.

Contractual Obligations

As of September 30, 2006, there had been no material changes in the Company’s contractual obligations from those disclosed in its Annual Report in Form 10-K for the year ended December 31, 2005.

Page 27 of 36

HILLS BANCORPORATION

Item 3. Quantitative and Qualitative Disclosures

About Market Risk

Market Risk Management

The Company's primary market risk exposure is to changes in interest rates. The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense. In the absence of other factors, the Company's overall yield on interest-earning assets will increase, as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Conversely, the Company's yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.

Asset/Liability Management

The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.

In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company's operations, management has implemented an asset/liability program designed to mitigate the Company's interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

The Bank model indicates that interest income should decline as interest rates increase, while net interest income should increase as interest rates decline. Generally, during periods of increasing interest rates, the Company's interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company's interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company's net interest income.

Page 28 of 36

HILLS BANCORPORATION

Item 4. Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Exchange Act of 1934 Rule 13a-15(f). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the first nine months of 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

Page 29 of 36

HILLS BANCORPORATION

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

No material legal proceedings are pending.

Item 1A. Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended September 30, 2006:

Period	Total number of shares purchased		Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs		Maximum number of shares that may yet be purchased under the plans or programs (1)
July 1 to July 31		1,974	$	49.00		7,351		742,649
August 1 to August 31		2,680		49.00		10,031		739,969
September 1 to September 30		1,061		49.00		11,092		738,908
Total		5,715	$	49.00		11,092		738,908

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization, which was publicly announced on August 9, 2005, will expire on December 31, 2009. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

Item 3. Defaults upon Senior Securities

Hills Bancorporation has no senior securities.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the quarter ended September 30, 2006.

Item 5. Other Information

None

Item 6. Exhibits and Reports on Form 8-K

Exhibits

31 Certifications under Section 302 of the Sarbanes-Oxley Act of 2002

32 Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

Page 30 of 36

SIGNATURES

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

      HILLS BANCORPORATION

Date: 11/7/06	By: /s/ Dwight O. Seegmiller
	Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date: 11/7/06	By: /s/ James G. Pratt
	James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

Page 31 of 36

HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED SEPTEMBER 30, 2006

Exhibit Number		Description	Page Number In The Sequential Numbering System September 30, 2006 Form 10-Q
	31.1	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002		33 of 36
	31.2	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002		34 of 36
	32.1	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002		35 of 36
	32.2	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002		36 of 36

Page 32 of 36

EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Dwight O. Seegmiller, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Hills Bancorporation;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: 11/7/06	By: /s/ Dwight O. Seegmiller
	Dwight O. Seegmiller, Director, President and Chief Executive Officer

Page 33 of 36

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, James G. Pratt, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Hills Bancorporation;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: 11/7/06	By: /s/ James G. Pratt
	James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

Page 34 of 36

EX-32.1

EXHIBIT 32.1

SECTION 906 CERTIFICATION BY DWIGHT O. SEEGMILLER

In connection with the quarterly report of Hills Bancorporation (the “Company”) on Form 10-Q for the quarter ended September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Dwight O. Seegmiller, Director, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002, that:

1.The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

2.The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: 11/7/06	By: /s/ Dwight O. Seegmiller
	Dwight O. Seegmiller, Director, President and Chief Executive Officer

Page 35 of 36

EX-32.2

EXHIBIT 32.2

SECTION 906 CERTIFICATION BY JAMES G. PRATT

In connection with the quarterly report of Hills Bancorporation (the “Company”) on Form 10-Q for the quarter ended September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James G. Pratt, Treasurer and Chief Accounting Officer of the Company, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002, that:

1.The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

2.The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: 11/7/06	By: /s/ James G. Pratt
	James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

Page 36 of 36