-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IF5kKPKMPjwOB7IL4EQ32Q7eJlNyhgKNSDUIqsx8VptJ1/U1Iarbrr38nhDmY+uY TO/vScTGErTBsrt3tWtCqA== 0000920112-98-000006.txt : 19980401 0000920112-98-000006.hdr.sgml : 19980401 ACCESSION NUMBER: 0000920112-98-000006 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: HEARTLAND FINANCIAL USA INC CENTRAL INDEX KEY: 0000920112 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 421405748 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-24724 FILM NUMBER: 98581639 BUSINESS ADDRESS: STREET 1: 1398 CENTRAL AVE CITY: DUBUQUE STATE: IA ZIP: 52001 BUSINESS PHONE: 3195892000 MAIL ADDRESS: STREET 1: 1398 CENTRAL AVE CITY: DUBUQUE STATE: IA ZIP: 52001 10-K 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission File Number: 0-24724 HEARTLAND FINANCIAL USA, INC. (Exact name of Registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 42-1405748 (I.R.S. Employer identification number) 1398 Central Avenue, Dubuque, Iowa) (52001 (Address of principal executive offices Zip Code) 319) 589-2100 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(g) of the Act: None (Title of Exchange Class) None (Name of Each Exchange on which Registered) Common Stock $1.00 par value (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (X) The index to exhibits follows the signature page. As of March 23, 1998, the Registrant had issued and outstanding 4,728,107 shares of the Registrant's Common Stock. The aggregate market value of the voting stock held by non-affiliates of the Registrant as of March 23, 1998, was $83,221,271.* Such figures include 424,010 shares of the Registrant's Common Stock held in a fiduciary capacity by the Trust Department of the Dubuque Bank & Trust Company, a wholly-owned subsidiary of the Registrant. *Based on the last reported price of an actual transaction in Registrant's Common Stock on March 17, 1998, and reports of beneficial ownership filed by directors and executive officers of Registrant and by beneficial owners of more than 5% of the outstanding shares of Common Stock of Registrant; however, such determination of shares owned by affiliates does not constitute an admission of affiliate status or beneficial interest in shares of Registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the 1998 Annual Meeting of Stockholders are incorporated by reference into Part III. HEARTLAND FINANCIAL USA, INC. Form 10-K Annual Report Table of Contents Part I Item 1. Business A. General Description B. Recent Developments C. Market Areas D. Competition E. Employees F. Accounting Standards G. Supervision and Regulation H. Governmental Monetary Policy and Economic Conditions Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 8. Financial Statements and Supplementary Data Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Part III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions Part IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K PART I. ITEM 1. BUSINESS A. GENERAL DESCRIPTION Heartland Financial USA, Inc. ("Heartland"), reincorporated in the state of Delaware in 1993, is a multi-bank holding company registered under the Bank Holding Company Act of 1956, as amended ("BHCA"). Heartland has four wholly-owned bank subsidiaries which are located in Dubuque, Iowa, Cottage Grove, Wisconsin and Galena and Rockford, Illinois and one wholly-owned federal savings bank subsidiary which is located in Keokuk, Iowa (collectively, the "Bank Subsidiaries"). All five Bank Subsidiaries are members of the Federal Deposit Insurance Corporation ("FDIC"). Dubuque Bank and Trust Company ("DB&T") is chartered under the laws of the State of Iowa and has two wholly-owned subsidiaries: DB&T Insurance, Inc. ("DB&T Insurance"), a multi-line insurance agency and DB&T Community Development Corp. ("DB&T Development"), majority owner of a senior housing project. Galena State Bank and Trust Company, Galena, Illinois, ("GSB") and Riverside Community Bank, Rockford,Illinois, ("RCB") are chartered under the laws of the State of Illinois. First Community Bank, FSB ("FCB") is organized under the laws of the United States. FCB has one wholly-owned subsidiary, KFS Services, Inc. Wisconsin Community Bank, previously Cottage Grove State Bank, ("WCB") is chartered under the laws of the State of Wisconsin and has one subsidiary, DBT Investment Corporation ("DBT Investment"), an investment management company. The Bank Subsidiaries operate 17 banking locations in Iowa, Illinois and Wisconsin. Heartland has three wholly-owned non-bank subsidiaries. Citizens Finance Co. ("Citizens") is a consumer finance company. ULTEA, Inc. ("Ultea") is a fleet leasing company headquartered in Madison, Wisconsin. Keokuk Bancshares, Inc. ("Keokuk") is an investment management company. During the fourth quarter of 1997, Heartland entered into an agreement with a group of New Mexico business leaders to establish a new bank in Albuquerque, New Mexico. Pending regulatory approval, the new bank will begin operations in the second quarter of 1998 and will be organized under the laws of the state of New Mexico. Heartland will own 80% of the proposed organization. The Bank Subsidiaries provide full service retail banking within Dubuque and Lee Counties in Iowa, within Jo Daviess, Hancock and Winnebago Counties in Illinois and within Dane County in Wisconsin. Deposit products include checking and other demand deposit accounts, NOW accounts, savings accounts, money market accounts, certificates of deposit, individual retirement accounts and other time deposits. The deposits in the Bank Subsidiaries are insured by the FDIC to the full extent permitted by law. Loans include commercial and industrial, agricultural, real estate mortgage, consumer, home equity, credit cards and lines of credit. Other products and services include VISA debit cards, automatic teller machines, safe deposit boxes and trust services. The principal service of the Bank Subsidiaries consists of making loans to businesses and individuals. These loans are made at the offices of the Bank Subsidiaries. The Bank Subsidiaries also engage in activities that are closely related to banking, including investment brokerage. Although each of the subsidiaries of Heartland operates under the direction of its own Board of Directors, Heartland has standard operating policies regarding asset/liability management, liquidity management, investment management, lending policies and deposit structure management. Heartland has historically centralized certain operations where economies of scale can be achieved. Operating Strategy Corporate policy, strategy and goals are established by the Board of Directors of Heartland (the "Heartland Board"). Pursuant to Heartland's philosophy, operational and administrative policies for the Bank Subsidiaries are also established by the Heartland Board. Within this framework, each of the Bank Subsidiaries focuses on providing personalized services and quality products to its customers to meet the needs of the communities which it serves. Heartland operates its banking subsidiaries as traditional community banks with conveniently located facilities and professional, highly motivated staffs which are active in the communities in which they are located. Heartland focuses on long- term relationships with customers and provides individualized quality service. In addition, within credit and rate of return parameters, Heartland attempts to ensure that each of the Bank Subsidiaries meets the credit needs of its communities and invests in local municipal obligations. Heartland uses a variety of marketing strategies to attract and retain customers, with a particular emphasis on a strong sales culture within the Bank Subsidiaries and an outside officer calling program. Many of Heartland's sales employees work on a salary plus commission basis, thus providing them with a strong incentive to aggressively market Heartland's financial products. Officers of each of the Bank Subsidiaries also regularly call on customers and potential customers of the institutions to maintain and develop deposit and other special service relationships, including cash management, employee benefit plan administration, and trust services. Heartland has an internal data processing division and has attempted to remain at the forefront of the banking industry in new technological innovations. Heartland believes that retaining control of its data processing leads to decreased operating costs and more effective service to its customers. Accordingly, during 1997, all Bank Subsidiaries converted to the Fiserv Comprehensive Banking System program, a national leader in bank software technology. To provide a high level of customer service and to manage effectively its growth, acquisition and operating strategies, Heartland also focuses on continued improvement of the internal operating systems of the Bank Subsidiaries. Acquisition and Expansion Strategy Heartland seeks to diversify both its market area and asset base while increasing profitability through acquisitions and expansion. Heartland's goal is to expand through the acquisition of established financial service organizations, primarily commercial banks or thrifts, to the extent suitable candidates can be identified and acceptable business terms negotiated. Heartland's acquisition strategy is focused on traditional community banks and thrifts located in stable and growing areas of Iowa, Wisconsin, Minnesota and Illinois. Heartland intends to look beyond these geographic areas for acquisition opportunities as evidenced by the proposed de novo bank in Albuquerque, New Mexico. In addition to price and terms, other factors considered by Heartland in determining the desirability of an acquisition candidate include financial condition, earnings potential, quality of management, market area and competitive environment. The Heartland Board may in the future consider establishing branches, loan production offices or other business facilities as a means of expanding its presence in current or new market areas. The Heartland Board may also investigate expansion into other lines of business closely related to banking if it believes these lines could be profitable without undue risk to Heartland and if Heartland can be competitive. Heartland does not currently have any definitive understandings or agreements for any acquisitions material to Heartland. However, Heartland will continue to look for further expansion opportunities. Lending Activities General The Bank Subsidiaries provide a range of commercial and retail lending services to corporations, partnerships and individuals. These credit activities include agricultural, commercial, residential real estate and installment loans, as well as loan participations and lines of credit. The Bank Subsidiaries aggressively market their services to qualified lending customers. Lending officers actively solicit the business of new companies entering their market areas as well as long-standing members of the Bank Subsidiaries' respective business communities. Through professional service and competitive pricing, the Bank Subsidiaries have been successful in attracting new lending customers. Heartland also actively pursues consumer lending opportunities. With convenient locations, advertising and customer communications, the Bank Subsidiaries have been successful in capitalizing on the credit needs of their market areas. Commercial Loans The Bank Subsidiaries have a strong commercial loan base and DB&T, in particular, continues to be a premier commercial lender in the tri-state area of northeast Iowa, northwest Illinois and southwest Wisconsin. The Bank Subsidiaries' areas of emphasis include, but are not limited to, loans to wholesalers, hotel and real estate developers, manufacturers, building contractors, business services companies and retailers. The Bank Subsidiaries provide a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment and real estate. Loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower. Terms of commercial business loans generally range from one to five years. The majority of the Bank Subsidiaries' commercial business loans have floating interest rates or reprice within one year. DB&T has also generated loans which are guaranteed by the U.S. Small Business Administration and has been certified as one of that agency's Preferred Lenders. Management believes that making these guaranteed loans helps its local communities as well as provides Heartland with a source of income and solid future lending relationships as such businesses grow and prosper. DB&T is also currently one of the state of Iowa's top lenders in the "Linked Investment for Tomorrow" program. This state-sponsored program offers interest rate reductions to businesses opened by minorities and those in rural areas. The primary repayment risk for commercial loans is the failure of the business due to economic or financial factors. In most cases, the Bank Subsidiaries have collateralized these loans and/or taken personal guarantees to help assure repayment. As the credit portfolios of the Bank Subsidiaries have continued to grow, several changes have been made in their lending departments resulting in an overall increase in these departments' skill levels. Loan review personnel and commercial lenders interact with their respective Boards of Directors each month. Heartland also utilizes an internal loan review function to analyze credits of the Bank Subsidiaries. Management has attempted to identify problem loans at an early date and to aggressively seek a resolution of these situations. The result has been a significantly below average level of problem loans compared to the Heartland Banks' industry peer groups in recent years. Agricultural Loans DB&T is one of the largest agricultural lenders in the state of Iowa. Agricultural loans continue to be emphasized by both DB&T and GSB due to their concentration of customers in rural markets. Agricultural loans remain balanced, however, in proportion to the rest of Heartland's consolidated loan portfolio. In connection with their agricultural lending, all of the Bank Subsidiaries have remained close to their traditional geographic market areas. The majority of the outstanding agricultural operating and real estate loans are within 60 miles of their main or branch offices. Agricultural loans, many of which are secured by crops, machinery and real estate, are provided to finance capital improvements and farm operations as well as acquisitions of livestock and machinery. The agricultural loan departments work closely with all agricultural customers, including companies and individual farmers, and review the preparation of budgets and cash flow projections for the ensuing crop year. These budgets and cash flow projections are monitored closely during the year and reviewed with agricultural customers at least once a year. In addition, the Bank Subsidiaries work closely with governmental agencies, including the Farmers Home Administration, to assist agricultural customers in obtaining credit enhancement products such as loan guarantees. Real Estate Mortgage Loans Mortgage lending has been a focal point of the Bank Subsidiaries as each of them continues to build real estate lending business. A stable rate environment along with expanded production capabilities at RCB combined to increase the number of loan originations as compared to prior years. The majority of home loans generated by the Bank Subsidiaries were sold to government agencies in the secondary mortgage market with servicing rights retained. Management believes that the retention of mortgage servicing provides the Bank Subsidiaries with a relatively steady source of fee income as compared to fees generated solely from mortgage origination operations. Moreover, the retention of such servicing rights allows each of the Bank Subsidiaries to continue to have regular contact with mortgage customers. Consumer Lending The Bank Subsidiaries' consumer lending departments provide all types of consumer loans including motor vehicle, home improvement, home equity, student loans, credit cards, signature loans and small personal credit lines. Consumer loan demand is also serviced through Citizens which currently serves the consumer credit needs of over 2,200 customers in the three state area of Iowa, Illinois and Wisconsin from its Dubuque, Iowa, and Madison, Wisconsin, offices. Trust Departments The trust departments for DB&T, GSB and FCB have been providing trust services to their respective communities for many years. Trust personnel from DB&T also work with RCB and WCB personnel to provide trust services to all bank subsidiaries. Currently, the Bank Subsidiaries have over $434 million of consolidated assets under management and provide a full complement of trust and investment services for individuals and corporations. The trust department of DB&T is nationally recognized as a leading provider of socially responsible investment services and manages investment portfolios for religious and other non-profit organizations located throughout the United States. The Bank Subsidiaries' trust departments are also active in the management of employee benefit and retirement plans in their market areas. The Bank Subsidiaries have targeted their trust departments as primary areas for future growth. Brokerage and Other Services DB&T contracts with a third-party vendor, Focused Investments LLC, an affiliate of Wayne Hummer & Co., to operate independent securities offices within DB&T's main office, Grandview and Kennedy Mall branch offices and GSB's main office. DB&T's Farley office also schedules regular hours for a broker to be available to meet with customers. Focused Investments LLC offers full- service stock and bond trading, direct investments, annuities and mutual funds. DB&T Insurance has continued to grow its personal and commercial insurance lines and the number of independent insurance companies it represents. DB&T Insurance is a multi-line insurance agency in the Dubuque area and offers a complete array of vehicle, property and casualty, life and disability insurance, as well as commercial lines and tax-free annuities. B. MARKET AREAS DB&T is located in the Dubuque County area of Iowa which encompasses the city of Dubuque and a number of surrounding rural communities. The city of Dubuque is located in northeastern Iowa, on the Mississippi River, approximately 175 miles west of Chicago, Illinois, and approximately 200 miles northeast of Des Moines, Iowa. It is strategically situated at the intersection of the state borders of Iowa, Illinois and Wisconsin. Based upon the results of the 1990 census, the city of Dubuque had a total population of approximately 61,000. In addition to its main banking office, DB&T has seven branch offices, all of which are located in the Dubuque County area. As a subsidiary of DB&T, DB&T Insurance has substantially the same market area as the parent organization. Citizens also operates within this market area, and, in addition, an office was opened in Madison, Wisconsin, during June, 1996. GSB is located in Galena, Illinois, which is less than five miles from the Mississippi River, approximately 20 miles east of Dubuque and 155 miles west of Chicago. GSB also has an office in Stockton, Illinois, and as such, services customers in Jo Daviess County, Illinois. Based on the 1990 census, the county had a population of approximately 22,000 people. FCB's main office is in Keokuk, Iowa, which is located in the southeast corner of Iowa near the borders of Iowa, Missouri and Illinois. Due to its location, FCB serves customers in the tri- county region of Lee County, Iowa, Hancock County, Illinois and Clark County, Missouri. Lee, Hancock and Clark Counties have populations of approximately 43,100, 23,900 and 8,500, respectively. FCB has one branch office in Keokuk and another branch in the city of Carthage in Hancock County, Illinois. Keokuk is an industrial community with a population of approximately 13,500. RCB is located on the northeast edge of Rockford, Illinois, which is approximately 75 miles west of Chicago in Winnebago County. Based on the 1990 census, the county had a population of 284,000 and the city of Rockford had a population of 140,000. WCB operates one office from its location in Cottage Grove, Wisconsin, which is approximately 10 miles east of Madison in Dane County. A branch office was opened in Middleton, a suburb of Madison, in February, 1998. The county had a population of 390,000 and the village of Cottage Grove had a population of 1,100 according to the 1990 census. C. COMPETITION Heartland encounters competition in all areas of its business pursuits. In order to compete effectively, to develop its market base, to maintain flexibility and to move in pace with changing economic and social conditions, Heartland continuously refines and develops its products and services. The principal methods of competition in the financial services industry are price, service and convenience. The Bank Subsidiaries' combined market area is highly competitive. Many financial institutions based in the communities surrounding Dubuque, Galena, Rockford, Cottage Grove and Keokuk actively compete for customers within Heartland's market area. The Bank Subsidiaries also face competition from finance companies, insurance companies, mortgage companies, securities brokerage firms, money market funds, loan production offices and other providers of financial services. Heartland competes for loans principally through the range and quality of the services it provides, interest rates and loan fees. Heartland believes that its long-standing presence in the community and personal service philosophy enhance its ability to compete favorably in attracting and retaining individual and business customers. Heartland actively solicits deposit-oriented clients and competes for deposits by offering customers personal attention, professional service and competitive interest rates. D. EMPLOYEES At December 31, 1997, Heartland employed 338 full-time equivalent employees. Heartland places a high priority on staff development which involves extensive training, including customer service training. New employees are selected on the basis of both technical skills and customer service capabilities. None of Heartland's employees are covered by a collective bargaining agreement with Heartland. Heartland offers a variety of employee benefits and management considers its employee relations to be excellent. E. ACCOUNTING STANDARDS Statement of Financial Accounting Standards ("SFAS")- SFAS No. 125 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS No. 125") was effective for Heartland for transactions occurring after December 31, 1996, and provided standards for accounting recognition or derecognition of assets and liabilities. The adoption of SFAS No. 125 did not have a material effect on Heartland. SFAS No. 130 "Reporting Comprehensive Income" will be effective for Heartland for the year beginning January 1, 1998 and establishes the standards for the reporting and display of comprehensive income in the financial statements. Comprehensive income represents net earnings and certain amounts reported directly in stockholders' equity, such as the net unrealized gain or loss on available-for-sale securities. F. SUPERVISION AND REGULATION General Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of Heartland can be affected not only by management decisions and general economic conditions, but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities including, but not limited to, the Board of Governors of the Federal Reserve System (the "FRB"), the FDIC, the OTS, the Iowa Superintendent of Banking (the "Superintendent"), the Illinois Commissioner of Banks and Real Estate (the "Commissioner"), the Wisconsin Division of Banking (the "Division"), the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission (the "SEC"). The effect of such statutes, regulations and policies can be significant, and cannot be predicted with a high degree of certainty. Federal and state laws and regulations generally applicable to financial institutions, such as Heartland and its subsidiaries, regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends. The system of supervision and regulation applicable to Heartland and its subsidiaries establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC's deposit insurance funds and the depositors, rather than the shareholders, of financial institutions. The following references to material statutes and regulations affecting Heartland and its subsidiaries are brief summaries thereof and do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations. Any change in applicable law or regulations may have a material effect on the business of Heartland and its subsidiaries. Recent Regulatory Developments Pending Legislation Legislation is pending in the Congress that would allow bank holding companies to engage in a wider range of nonbanking activities, including greater authority to engage in securities and insurance activities. The expanded powers generally would be available to a bank holding company only if the bank holding company and its bank subsidiaries remain well-capitalized and well-managed. Additionally, the pending legislation would eliminate the federal thrift charter by requiring each federal thrift to convert to a national bank or to a state bank or state thrift. Under the pending legislation, any federal thrift that failed to convert to a national or state bank within two years following enactment of the legislation would, by operation of law, become a national bank as of the second anniversary of enactment of the legislation. The pending legislation would combine the OTS with the Office of the Comptroller of the Currency by the second anniversary of the enactment of the legislation, and would merge the Bank Insurance Fund (the "BIF") and the Savings Association Insurance Fund (the "SAIF") as of the earlier of January 1, 2000 or the second anniversary of enactment of the legislation. At this time, Heartland is unable to predict whether the proposed legislation will be enacted and, therefore, is unable to predict the impact such legislation may have on the operations of Heartland and the Bank Subsidiaries. Heartland General Heartland, as the sole shareholder of DB&T, GSB, RCB and WCB, is a bank holding company. As a bank holding company, Heartland is registered with, and is subject to regulation by, the FRB under the BHCA. In accordance with FRB policy, Heartland is expected to act as a source of financial strength to the Bank Subsidiaries and to commit resources to support the Bank Subsidiaries in circumstances where Heartland might not do so absent such policy. Under the BHCA, Heartland is subject to periodic examination by the FRB and is required to file with the FRB periodic reports of its operations and such additional information as the FRB may require. Heartland's ownership of FCB makes Heartland a savings and loan holding company as defined in the HOLA. Although savings and loan holding companies generally are subject to supervision and regulation by the OTS, companies that, like Heartland, are both bank holding companies and savings and loan holding companies are exempt from OTS supervision, although federal law requires the FRB to consult with the OTS, as appropriate, in establishing the scope of an FRB examination of any such company, to provide the OTS, upon request, with copies of FRB examination reports and other supervisory information concerning any such company and to cooperate with the OTS in any enforcement action against any such holding company if the conduct at issue involves the company's savings association subsidiary. Investments and Activities Under the BHCA, a bank holding company must obtain FRB approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank; or (iii) merging or consolidating with another bank holding company. Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the FRB may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located. In approving interstate acquisitions, however, the FRB is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) or which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company. The BHCA also prohibits, with certain exceptions, Heartland from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. The principal exception to this prohibition allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the FRB to be "so closely related to banking ... as to be a proper incident thereto." Under current regulations of the FRB, Heartland and its non-bank subsidiaries are permitted to engage in, among other activities, such banking-related businesses as the operation of a thrift, sales and consumer finance, equipment leasing, a computer service bureau, including software development, and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies. Federal law also prohibits acquisition of "control" of federally- insured depository institutions, such as the Bank Subsidiaries, or bank holding companies, such as Heartland, without prior notice to certain federal bank regulators. "Control" is defined in certain cases as acquisition of 10% of the outstanding shares of a depository institution or bank holding company. Capital Requirements Bank holding companies are required to maintain minimum levels of capital in accordance with FRB capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The FRB's capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: a risk-based requirement expressed as a percentage of total risk-weighted assets and a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated companies, with minimum requirements of 4% to 5% for all others. For purposes of these capital standards, Tier 1 capital consists primarily of permanent stockholders' equity less intangible assets (other than certain mortgage servicing rights and purchased credit card relationships) and total capital means Tier 1 capital plus certain other debt and equity instruments which do not qualify as Tier 1 capital and a portion of the allowance for loan and lease losses. The risk-based and leverage standards described above are minimum requirements, and higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the FRB's capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets), well above the minimum levels. As of December 31, 1997, Heartland had regulatory capital in excess of the FRB's minimum requirements, with a risk-based capital ratio of 12.71% and a leverage ratio of 8.76%. Dividends The FRB has issued a policy statement with regard to the payment of cash dividends by bank holding companies. In the policy statement, the FRB expressed its view that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company's financial health, such as by borrowing. Additionally, the FRB possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. In addition to the restrictions on dividends that may be imposed by the FRB, the Delaware General Corporation Law (the "DGCL") allows Heartland to pay dividends only out of its surplus (as defined and computed in accordance with the provisions of the DGCL), or if Heartland has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Federal Securities Regulation Heartland's common stock is registered with the SEC under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Consequently, Heartland is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act. The Bank Subsidiaries General DB&T is an Iowa-chartered bank, the accounts of which are insured by the BIF of the FDIC. As a BIF-insured, Iowa-chartered bank, DB&T is subject to the examination, supervision, reporting and enforcement requirements of the Superintendent, as the chartering authority for Iowa banks, and the FDIC, as administrator of the BIF. GSB and RCB are Illinois-chartered banks, the deposit accounts of which are insured by the BIF of the FDIC. As BIF-insured, Illinois-chartered banks, GSB and RCB are subject to the examination, supervision, reporting and enforcement requirements of the Commissioner, as the chartering authority for Illinois banks, and the FDIC, as administrator of the BIF. WCB is a Wisconsin-chartered bank, the deposit accounts of which are insured by the BIF of the FDIC. As a BIF-insured, Wisconsin- chartered bank, WCB is subject to the examination, supervision, reporting and enforcement requirements of the Division, as the chartering authority for Wisconsin banks, and the FDIC, as administrator of the BIF. FCB is a federally chartered savings association, the deposits of which are insured by the SAIF of the FDIC. As a SAIF-insured, federally chartered savings association, FCB is subject to the examination, supervision, reporting and enforcement requirements of the OTS, as the chartering authority for federal savings associations, and the FDIC as administrator of the SAIF. Deposit Insurance As FDIC-insured institutions, the Bank Subsidiaries are required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their respective levels of capital and results of supervisory evaluations. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. During the year ended December 31, 1997, FDIC deposit insurance assessments for both BIF and SAIF members ranged from 0% of deposits to 0.27% of deposits. For the semi-annual assessment period beginning January 1, 1998, assessment rates for both BIF and SAIF members will continue to range from 0% of deposits to 0.27% of deposits. The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. Management of Heartland is not aware of any activity or condition that could result in termination of the deposit insurance of any of the Bank Subsidiaries. FICO Assessments Since 1987, a portion of the deposit insurance assessments paid by SAIF members has been used to cover interest payments due on the outstanding obligations of the FICO, the entity created to finance the recapitalization of the Federal Savings and Loan Insurance Corporation, the SAIF's predecessor insurance fund. Pursuant to federal legislation enacted September 30, 1996, commencing January 1, 1997, both SAIF members and BIF members became subject to assessments to cover the interest payments on outstanding FICO obligations. Such FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. Until January 1, 2000, the FICO assessments made against BIF members may not exceed 20% of the amount of the FICO assessments made against SAIF members. Between January 1, 2000 and the maturity of the outstanding FICO obligations in 2019, BIF members and SAIF members will share the cost of the interest on the FICO bonds on a pro rata basis. During the year ended December 31, 1997, the FICO assessment rate for SAIF members was approximately 0.063% of deposits while the FICO assessment rate for BIF members was approximately 0.013% of deposits. During the year ended December 31, 1997, the Bank Subsidiaries paid FICO assessments totaling $116,000. Supervisory Assessments All Iowa banks, Illinois banks, Wisconsin banks, and Federal savings associations are required to pay supervisory fees to the Superintendent, the Commissioner, the Division, and the OTS, respectively, to fund the operations of such agencies. The amount of such supervisory fees is based upon each institution's total assets. During the year ended December 31, 1997, the Bank Subsidiaries paid supervisory assessments totaling $61,000. Capital Requirements The FDIC has established the following minimum capital standards for state-chartered insured non-member banks, such as DB&T, GSB, RCB and WCB: a leverage requirement consisting of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly- rated banks with minimum requirements of 4% to 5% for all others, and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. For purposes of these capital standards, Tier 1 capital and total capital consist of substantially the same components as Tier 1 capital and total capital under the FRB's capital guidelines for bank holding companies (see "--Heartland--Capital Requirements"). Pursuant to the HOLA and OTS regulations, savings associations, such as FCB, are subject to the following minimum capital requirements: a core capital requirement, consisting of a minimum ratio of core capital to total assets of 3%; a tangible capital requirement consisting of a minimum ratio of tangible capital to total assets of 1.5%; and a risk-based capital requirement, consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must consist of core capital. For purposes of these capital standards, core capital consists primarily of permanent stockholders' equity less intangible assets other than certain supervisory goodwill, certain mortgage servicing rights and certain purchased credit card relationships and less investments in subsidiaries engaged in activities not permitted for national banks; tangible capital is substantially the same as core capital except that all intangible assets other than certain mortgage servicing rights must be deducted; and total capital means core capital plus certain debt and equity instruments that do not qualify as core capital and a portion of the allowances for loan and lease losses. The capital requirements described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, the regulations of the FDIC and the OTS provide that additional capital may be required to take adequate account of, among other things, interest rate risk or the risks posed by concentrations of credit or nontraditional activities. During the year ended December 31, 1997, none of the Bank Subsidiaries was required by its primary federal regulator to increase its capital to an amount in excess of the minimum regulatory requirements. As of December 31, 1997, each of the Bank Subsidiaries exceeded its minimum regulatory capital requirements, as follows: Total Risk-Based Leverage Tangible Capital Ratio Capital Ratio Capital Ratio DB&T 10.92% 7.81% N/A GSB 13.09 7.06 N/A RCB 12.04 7.79 N/A WCB 18.32 11.11 N/A FCB 11.05 7.53 7.69% The OTS has proposed to amend its regulations to establish a minimum core capital requirement of 3% of total assets for any savings association assigned a composite rating of 1 under the Uniform Financial Institutions Rating System ("UFIRS") as of the association's most recent OTS examination, with a minimum core capital requirement of 4% of total assets for all other savings associations. It is not anticipated that the adoption of this proposal would affect FCB's ability to comply with the OTS capital requirements. Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include: requiring the submission of a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and, ultimately, appointing a receiver for the institution. Additionally, institutions insured by the FDIC may be liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of commonly controlled FDIC insured depository institutions or any assistance provided by the FDIC to commonly controlled FDIC-insured depository institutions in danger of default. Dividends Iowa law provides that an Iowa-chartered bank, such as DB&T, may not pay dividends in an amount greater than its undivided profits. Under the laws of Illinois and Wisconsin, Illinois- chartered banks, such as GSB and RCB, and Wisconsin-chartered banks, such as WCB, respectively, are subject to a substantially similar limitation on dividends. OTS regulations impose limitations upon all capital distributions by savings associations, including cash dividends. The rule establishes three tiers of institutions. An institution that exceeds all fully phased-in capital requirements before and after the proposed capital distribution (a "Tier 1 Institution") can, after prior notice to, but without the approval of, the OTS, make capital distributions during a calendar year in an aggregate amount of up to the higher of (i) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (i.e., the excess capital over its fully phased-in capital requirements) at the beginning of the calendar year, or (ii) 75% of its net income over the most recent preceding four quarter period. Any additional capital distributions would require prior OTS approval. As of December 31, 1997, FCB was a Tier 1 Institution. The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, each of the Bank Subsidiaries exceeded its minimum capital requirements under applicable guidelines as of December 31, 1997. Further, under applicable regulations of the OTS, FCB may not pay dividends in an amount which would reduce its capital below the amount required for the liquidation account established in connection with FCB's conversion from the mutual to the stock form of ownership in 1991. As of December 31, 1997, approximately $21.7 million was available to be paid as dividends to Heartland by the Bank Subsidiaries. Notwithstanding the availability of funds for dividends, however, the banking regulators may prohibit the payment of any dividends by the Bank Subsidiaries if such payment is deemed to constitute an unsafe or unsound practice. The OTS has proposed to amend its regulations governing capital distributions (including cash dividends) by savings associations, such as FCB. The proposed amendment would require prior OTS approval for any capital distribution by a savings association that is not eligible for expedited processing under the OTS's application processing regulations. In order to qualify for expedited processing, a savings association must: (i) have a composite UFIRS rating of 1 or 2; (ii) have a Community Reinvestment Act rating of satisfactory or better; (iii) have a compliance rating of 1 or 2; (iv) meet all applicable regulatory capital requirements; and (v) not have been notified by the OTS that it is a problem association or an association in troubled condition. Savings associations that qualify for expedited processing would be required to obtain OTS approval prior to making a capital distribution only if the amount of the proposed capital distribution, when aggregated with all other capital distributions during the same calendar year, would exceed an amount equal to the association's year-to-date net income plus its retained net income for the preceding two years. The proposed amendment will continue to require that the OTS be given prior notice of certain types of capital distributions, including any capital distribution by a savings association that, like FCB, is a subsidiary of a savings and loan holding company. Insider Transactions The Bank Subsidiaries are subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to Heartland and its subsidiaries, on investments in the stock or other securities of Heartland and its subsidiaries and the acceptance of the stock or other securities of Heartland or its subsidiaries as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank Subsidiaries to their respective directors and officers, to directors and officers of Heartland and its subsidiaries, to principal stockholders of Heartland, and to "related interests" of such directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of Heartland or one of its subsidiaries or a principal stockholder of Heartland may obtain credit from banks with which any of the Bank Subsidiaries maintains a correspondent relationship. Safety and Soundness Standards The federal banking agencies have adopted guidelines which establish operational and managerial standards to promote the safety and soundness of federally-insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings. In general, the guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution's primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. The preamble to the guidelines states that the agencies expect to require a compliance plan from an institution whose failure to meet one or more of the guidelines is of such severity that it could threaten the safety and soundness of the institution. Failure to submit an acceptable plan, or failure to comply with a plan that has been accepted by the appropriate federal regulator, would constitute grounds for further enforcement action. Branching Authority Iowa law strictly regulates the establishment of bank offices. Under the Iowa Banking Act, an Iowa state bank, such as DB&T, may not establish a bank office outside the boundaries of the counties contiguous to or cornering upon the county in which the principal place of business of the bank is located. Further, Iowa law prohibits an Iowa bank from establishing de novo branches in a municipality other than the municipality in which the bank's principal place of business is located, if another bank already operates one or more offices in the municipality in which the de novo branch is to be located. The number of offices an Iowa bank may establish in a particular municipality is also limited depending upon the municipality's population. Illinois banks, such as GSB and RCB, have the authority under Illinois law to establish branches anywhere in the State of Illinois, subject to receipt of all required regulatory approvals. Likewise, under Wisconsin law, Wisconsin banks may, subject to regulatory approval, establish branch offices anywhere in the State of Wisconsin. Federally chartered savings associations which qualify as "domestic building and loan associations," as defined in the Internal Revenue Code, or meet the qualified thrift lender test (see "-The Bank Subsidiaries -- Qualified Thrift Lender Test") have the authority, subject to receipt of OTS approval, to establish branch offices anywhere in the United States, either de novo or through acquisitions of all or part of another financial institution. If a federal savings association fails to qualify as a "domestic building and loan association," as defined in the Internal Revenue Code, and fails to meet the qualified thrift lender test, the association may branch only to the extent permitted for national banks located in the savings association's home state. As of December 31, 1997, FCB qualified as a "domestic building and loan association," as defined in the Internal Revenue Code, and met the QTL test. Effective June 1, 1997 (or earlier if expressly authorized by applicable state law), the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act") allows banks to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of- state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law. The legislation allows individual states to "opt-out" of certain provisions of the Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997. The laws of Iowa, Illinois and Wisconsin permit interstate bank mergers, subject to certain conditions, including, in each case, a prohibition against interstate mergers unless any Iowa, Illinois or Wisconsin bank involved has been in existence and continuous operation for more than five years. State Bank Activities Under federal law and FDIC regulations, FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC-insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. Impermissible investments and activities must be divested or discontinued within certain time frames set by the FDIC. These restrictions have not had, and are not currently expected to have, a material impact on the operations of DB&T, GSB, RCB or WCB. Qualified Thrift Lender Test The HOLA requires every savings association to satisfy a "qualified thrift lender" ("QTL") test. Under the HOLA, a savings association will be deemed to meet the QTL test if it either (i) maintains at least 65% of its "portfolio assets" in "qualified thrift investments" on a monthly basis in nine out of every 12 months or (ii) qualifies as a "domestic building and loan association," as defined in the Internal Revenue Code. For purposes of the QTL test, "qualified thrift investments" consist of mortgage loans, mortgage-backed securities, education loans, small business loans, credit card loans and certain other housing- and consumer-related loans and investments. "Portfolio assets" consist of a savings association's total assets less goodwill and other intangible assets, the association's business properties and a limited amount of the liquid assets maintained by the association pursuant to the liquidity requirements of the HOLA and OTS regulations (see "--The Bank Subsidiaries--Liquidity Requirements"). A savings association that fails to meet the QTL test must either convert to a bank charter or operate under certain restrictions on its activities. A savings association that fails the QTL test may requalify as a QTL but it may do so only once. As of December 31, 1997, FCB satisfied the QTL test, with a ratio of qualified thrift investments to portfolio assets of 74.25% and qualified as a "domestic building and loan association," as defined in the Internal Revenue Code. Liquidity Requirements OTS regulations currently require each savings association to maintain, for each calendar quarter, an average daily balance of liquid assets (including cash, certain time deposits, bankers' acceptances, and specified United States Government, state or federal agency obligations) equal to at least 4% of either (i) its liquidity base (i.e., its net withdrawable accounts plus borrowings repayable in 12 months or less) as of the end of the preceding calendar quarter or (ii) the average daily balance of its liquidity base during the preceding calendar quarter. This liquidity requirement may be changed from time to time by the OTS to an amount within a range of 4% to 10% of the liquidity base, depending upon economic conditions and the deposit flows of savings associations. The OTS may also require a savings association to maintain a higher level of liquidity than the minimum 4% requirement if the OTS deems necessary to ensure the safe and sound operation of the association. Penalties may be imposed for failure to meet liquidity ratio requirements. At December 31, 1997, FCB was in compliance with OTS liquidity requirements, with a liquidity ratio of 8.91%. Federal Reserve System FRB regulations, as presently in effect, require depository institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts), as follows: for transaction accounts aggregating $47.8 million or less, the reserve requirement is 3% of total transaction accounts; and for transaction accounts aggregating in excess of $47.8 million, the reserve requirement is $1.434 million plus 10% of the aggregate amount of total transaction accounts in excess of $47.8 million. The first $4.7 million of otherwise reservable balances are exempted from the reserve requirements. These reserve requirements are subject to annual adjustment by the FRB. The Bank Subsidiaries are in compliance with the foregoing requirements. The balances used to meet the reserve requirements imposed by the FRB may be used by FCB to satisfy liquidity requirements imposed by the OTS. G. GOVERNMENTAL MONETARY POLICY AND ECONOMIC CONDITIONS The earnings of Heartland are affected by the policies of regulatory authorities, including the Federal Reserve System whose monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the economy and in the money markets, as a result of actions by monetary and fiscal authorities, interest rates, credit availability and deposit levels may change due to circumstances beyond the control of Heartland. Future policies of the Federal Reserve System and other authorities cannot be predicted, nor can their effect on future earnings be predicted. ITEM 2. PROPERTIES The principal offices of Heartland are located in DB&T's main office at 1398 Central Avenue, Dubuque, Iowa 52001. This office is owned by DB&T and consists of a three-story glazed terra cotta building constructed in 1922. The main office building currently comprises approximately 59,500 square feet, all of which is occupied by DB&T and Heartland. Construction of a three-story addition of approximately 32,000 square feet was completed in 1994. DB&T has a total of seven branch offices in addition to its main office. Five of these offices are located in the city of Dubuque, and three branches are located in the surrounding Iowa communities of Epworth, Farley and Holy Cross. DB&T owns all of its branch offices without material encumbrances, except its branch located at Kennedy Mall. DB&T owns the buildings but leases the land under long term agreements at its Kennedy Mall branch and Main Street office location. The DB&T subsidiaries, operate out of the main office. Citizens' Dubuque office is located in the Main Street Office location of DB&T. The Madison office for Citizens is located in a leased building at 1771 Thierer Road, Madison, Wisconsin 53707. GSB's main office is located at 971 Gear Street on the west side of Galena, Illinois. Construction of this new 18,000 square foot brick banking facility was completed in 1996. A drive-up facility is also located in downtown Galena. One branch office is located in Stockton, Illinois, which is located approximately 24 miles east of Galena. Each of these offices is owned without material encumbrances. The main office of FCB is located at 4th and Concert Street, Keokuk, Iowa 52632. The property was purchased by FCB in 1983 and consists of a one-story brick building constructed in 1951. This building comprises approximately 6,000 square feet, all of which is occupied by FCB. During 1996, FCB opened a 2,100 square foot branch on the northwest side of Keokuk. FCB also has one branch office located in Carthage, Illinois, which is located approximately 15 miles east of Keokuk, Iowa. The one-story wooden frame building constructed in 1976 comprises approximately 3,000 square feet, all of which is occupied by FCB. Each of these offices are owned without material encumbrances. RCB operates from an 8,000 square foot one-story brick building located at 6700 East Riverside Boulevard, Rockford, Illinois 61114. The main office of WCB is located at 580 N. Main Street, Cottage Grove, Wisconsin 53527. The property was constructed by WCB in 1972 and consists of a one-story stucco building. This building comprises approximately 6,000 square feet, all of which is occupied by WCB. A branch facility was purchased in Middleton, Wisconsin in 1997. This branch facility is a one-story wood building totaling 2,500 square feet, all of which is occupied by WCB and is owned without material encumbrances. ULTEA leases a 1900 square foot facility at 2976 Triverton Pike, Madison, Wisconsin 53711. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which Heartland or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1997 to a vote of security holders. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Heartland's Common Stock was held by approximately 750 shareholders of record as of March 23, 1998, and is traded in the over-the-counter market. The following table shows, for the periods indicated, the range of reported prices per share of Heartland's Common Stock in the over-the-counter market. These quotations represent inter-dealer prices without retail markups, markdowns or commissions and do not necessarily represent actual transactions. Heartland Common Stock Actual Calendar Quarter High Low 1996: First $17 11/16 $16 3/16 Second 20 17 1/4 Third 25 17 1/4 Fourth 24 3/4 24 1997: First $24 $26 19/32 Second 25 1/4 27 9/32 Third 25 30 9/32 Fourth 26 30 Cash dividends have been declared by Heartland quarterly during the past two years ending December 31, 1997. The following table sets forth the cash dividends per share paid on Heartland's Common Stock for the past two years: Calendar Quarter 1997 1996 First $.13 $.10 Second .13 .10 Third .13 .10 Fourth .13 .10 ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) For the Years Ended December 31, 1997 1996 1995 -------------------------------- STATEMENT OF INCOME DATA Interest income $ 59,261 $ 51,886 $ 49,149 Interest expense 31,767 27,644 25,529 -------- -------- -------- Net interest income 27,494 24,242 23,620 Provision for loan and lease losses 1,279 1,408 820 -------- -------- -------- Net interest income after provision for loan and lease losses 26,215 22,834 22,800 Noninterest income 8,565 7,364 4,981 Noninterest expense 22,927 19,507 17,323 Provision for income taxes 3,338 2,685 2,884 -------- -------- -------- Net income $ 8,515 $ 8,006 $ 7,574 ======== ======== ======== PER COMMON SHARE DATA Net income-basic $ 1.80 $ 1.70 $ 1.58 Net income-diluted 1.78 1.69 1.58 Cash dividends 0.52 .40 .30 Dividend payout ratio 28.96% 23.53% 19.03% Book value $ 16.38 $ 14.84 $ 13.76 Weighted average shares outstanding-basic 4,738,171 4,715,009 4,805,184 BALANCE SHEET DATA Investments and federal funds sold $234,666 $183,966 $171,726 Total loans and leases, net of unearned 556,406 484,085 454,905 Allowance for loan and lease losses 7,362 6,191 5,580 Total assets 852,060 736,552 677,313 Total deposits 623,532 558,343 534,587 Long-term obligations 43,023 42,506 45,400 Redeemable preferred stock - - - Stockholders' equity 77,772 70,259 64,506 EARNINGS PERFORMANCE DATA Return on average total assets 1.09% 1.16% 1.18% Return on average stockholders' equity 11.59 12.00 12.28 Net interest margin ratio (1) 3.89 3.98 4.13 ASSET QUALITY RATIOS Nonperforming assets to total assets 0.34% 0.34% 0.28% Nonperforming loans and leases to total loans and leases 0.37 0.41 0.26 Net loan and lease charge-offs to average loans and leases 0.08 0.17 0.08 Allowance for loan and lease losses to total loans and leases 1.32% 1.28% 1.23% Allowance for loan and lease losses to nonperforming loans and leases 362.30 313.63 463.84 CAPITAL RATIOS Average equity to average assets 9.39% 9.66% 9.59% Total capital to risk-adjusted assets 12.71 14.28 14.46 Tier 1 leverage 8.76 9.54 9.47 SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) For the Years Ended December 31, 1994 1993 -------------------- STATEMENT OF INCOME DATA Interest income $43,373 $ 43,265 Interest expense 20,128 21,126 -------- -------- Net interest income 23,245 22,139 Provision for loan and lease losses 811 1,014 -------- -------- Net interest income after provision for loan and lease losses 22,434 21,125 Noninterest income 4,965 5,470 Noninterest expense 17,244 16,338 Provision for income taxes 3,015 3,251 -------- -------- Net income $ 7,140 $ 7,006 ======== ======== PER COMMON SHARE DATA Net income-basic $ 1.47 $ 1.47 Net income-diluted 1.47 1.47 Cash dividends .26 .20 Dividend payout ratio 17.99% 13.33% Book value $ 11.76 $ 11.52 Weighted average shares outstanding-basic 4,845,648 4,774,718 BALANCE SHEET DATA Investments and federal funds sold $162,968 $211,394 Total loans and leases, net of unearned 422,216 374,778 Allowance for loan and lease losses 5,124 4,433 Total assets 626,490 620,214 Total deposits 513,239 498,279 Long-term obligations 23,562 25,055 Redeemable preferred stock - 67 Stockholders' equity 56,930 55,098 EARNINGS PERFORMANCE DATA Return on average total assets 1.18% 1.17% Return on average stockholders' equity 12.82 14.20 Net interest margin ratio (1) 4.32 4.11 ASSET QUALITY RATIOS Nonperforming assets to total assets 0.17% 0.30% Nonperforming loans and leases to total loans and leases 0.21 0.32 Net loan and lease charge-offs to average loans and leases Allowance for loan and lease losses 0.03 0.04 to total loans and leases 1.21% 1.18% Allowance for loan and lease losses to nonperforming loans and leases 580.95 374.09 CAPITAL RATIOS Average equity to average assets 9.22% 8.23% Total capital to risk-adjusted assets 15.04 14.37 Tier 1 leverage 9.32 8.49 (1) Tax equivalent using a 34% tax rate. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS The following presents management's discussion and analysis of the consolidated financial condition and results of operations of Heartland Financial USA, Inc. ("Heartland") as of the dates and for the periods indicated. This discussion should be read in conjunction with the Selected Financial Data, Heartland's Consolidated Financial Statements and the Notes thereto and other financial data appearing elsewhere in this report. The consolidated financial statements include the accounts of Heartland and its wholly-owned subsidiaries: Dubuque Bank and Trust Company ("DB&T"); DB&T Insurance, Inc.; DB&T Community Development Corp.; Galena State Bank and Trust Company ("GSB"); Riverside Community Bank ("RCB"); First Community Bank, FSB ("FCB"); Wisconsin Community Bank ("WCB"; previously Cottage Grove State Bank); Citizens Finance Co. ("Citizens"); ULTEA, Inc. ("ULTEA"); DBT Investment Corporation and Keokuk Bancshares, Inc. This report, including the Chairman's Report to Stockholders and President's Message, contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Heartland intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of Heartland are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. Heartland's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on the operations and future prospects of Heartland and the subsidiaries include, but are not limited to, changes in: interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Heartland's market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning Heartland and its business, including additional factors that could materially affect Heartland's financial results, is included in Heartland's filings with the Securities and Exchange Commission. OVERVIEW Heartland recorded its seventh consecutive year of increased annual earnings during 1997, up $509,000 (6.36%) from 1996. On a basic per common share basis, the 1997 earnings increased 5.88%. These sustained increases are particularly gratifying given the increased emphasis and the related costs associated with the expansion of Heartland's asset base and development of other noninterest income sources. The initiatives undertaken included: The conversion of all Heartland banks to new banking software. The acquisition of WCB on March 1 and its purchase of a branch facility in Middleton, Wisconsin. Expansion into the vehicle leasing and fleet management business with the purchase of ULTEA in December, 1996. Enhancement of banking operations in Rockford, Illinois and the recently announced de novo expansion into Albuquerque, New Mexico. Net income increased $432,000 (5.70%) in 1996 from 1995. On a basic per common share basis, 1996 net income increased 7.59% from 1995. This performance reflected significantly improved noninterest income during 1996, which was partially mitigated by increased costs related to the first full year of operation of RCB and the one-time Savings Association Insurance Fund ("SAIF") special assessment at FCB. Total noninterest income increased 16.31% during 1997 compared to an increase of 47.84% during 1996. Gains on sales of securities accounted for 61.94% of the $2,383,000 change during 1996. During 1997, gains on sales of securities decreased $443,000. Exclusive of these gains on sales of securities, noninterest income increased 30.03% during 1997. During both years, there were substantial increases in core noninterest income components which include service charges, trust fees and gains on the sale of loans. Rental income on operating leases at ULTEA was also a major contributor to the 1997 growth in noninterest income. Concurrent with the growth of the Heartland organization, noninterest expense increased $3,420,000 (17.53%) and $2,184,000 (12.61%) during 1997 and 1996, respectively, compared to the previous year. The increases were largely due to costs associated with the initiatives discussed earlier. While management remains committed to the control of overhead, they are also committed to investing sufficient resources to profitably expand the franchise. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income is the difference between interest income earned on earning assets and interest expense paid on interest bearing liabilities. As such, net interest income is affected by changes in the volume and yields on earning assets and the volume and rates paid on interest bearing liabilities. Net interest margin is the ratio of tax equivalent net interest income to average earning assets. Net interest income on a fully tax equivalent basis was $28,280,000, $25,476,000 and $24,721,000 for 1997, 1996 and 1995, respectively, an increase of 11.01% for 1997 and 3.05% for 1996. Expressed as a percentage of average earning assets, Heartland's net interest margin decreased to 3.89% in 1997 and 3.98% in 1996, compared to 4.13% in 1995. These decreases occurred for several reasons: The return on Heartland's securities portfolio declined as several higher-yielding securities matured or were called and the average life of the portfolio was reduced to 1.75 years at December 31, 1997. The additional investment during 1996 of nearly $3 million in low-income housing projects, while the investment generates income tax credits, negatively impacted the net interest margin calculation. With strong loan demand, rates paid on interest bearing deposits were elevated somewhat to sustain deposit growth. Growth in noninterest bearing deposits remained relatively flat during both years. Heartland bank subsidiaries increased their reliance on Federal Home Loan Bank ("FHLB") funding, which is typically more expensive than core deposits. Heartland continues to manage its balance sheet on a proactive basis. The following table sets forth certain information relating to Heartland's average consolidated balance sheets and reflects the yield on average earning assets and the cost of average interest bearing liabilities for the years indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities. Average balances are derived from daily balances, and nonaccrual loans are included in each respective loan category. ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES (1) (Dollars in thousands) For the Year Ended December 31, 1997 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $169,086 $ 10,393 6.15% Nontaxable (1) 19,700 1,773 9.00 --------- --------- ------ Total securities 188,786 12,166 6.44 --------- --------- ------ Interest bearing deposits 2,972 98 3.30 Federal funds sold 12,570 681 5.42 --------- --------- ------ Loans and leases: Commercial and commercial real estate (1) 222,157 19,683 8.86 Residential mortgage 178,362 14,083 7.90 Agricultural and agricultural real estate (1) 66,294 6,037 9.11 Consumer 55,218 5,672 10.27 Direct financing leases, net 6,739 501 7.43 Fees on loans - 1,126 - Less: allowance for loan and lease losses (6,998) - - --------- --------- ------ Net loans and leases 521,772 47,102 9.03 --------- --------- ------ Total earning assets 726,100 60,047 8.27 --------- --------- ------ NONEARNING ASSETS Total nonearning assets 56,596 - - --------- --------- ------ TOTAL ASSETS $782,696 $ 60,047 7.67% ========= ========= ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $237,730 $ 8,317 3.50% Time, $100,000 and over 34,913 1,961 5.62 Other time deposits 268,201 15,487 5.77 Short-term borrowings 70,313 3,740 5.32 Other borrowings 36,406 2,262 6.21 --------- --------- ------ Total interest bearing liabilities 647,563 31,767 4.91 --------- --------- ------ NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 51,770 - - Accrued interest and other liabilities 9,906 - - --------- --------- ------ Total noninterest bearing liabilities 61,676 - - --------- --------- ------ Stockholders' Equity 73,457 - - --------- --------- ------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $782,696 $ 31,767 4.06% ========= ========= ====== Net interest income (1) $ 28,280 ========= Net interest income to total earning assets (1) 3.89% ====== Interest bearing liabilities to earning assets 89.18% ========= ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES (1) (Dollars in thousands) For the Year Ended December 31, 1996 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $136,107 $ 8,392 6.17% Nontaxable (1) 31,005 3,108 10.02 --------- --------- ------ Total securities 167,112 11,500 6.88 --------- --------- ------ Interest bearing deposits 4,332 163 3.76 Federal funds sold 11,532 610 5.29 --------- --------- ------ Loans and leases: Commercial and commercial real estate (1) 195,372 17,058 8.73 Residential mortgage 160,511 12,637 7.87 Agricultural and agricultural real estate (1) 58,975 5,377 9.12 Consumer 41,302 4,250 10.29 Direct financing leases, net 7,502 549 7.32 Fees on loans - 976 - Less: allowance for loan and lease losses (6,026) - - --------- --------- ------ Net loans and leases 457,636 40,847 8.93 --------- --------- ------ Total earning assets 640,612 53,120 8.29 --------- --------- ------ NONEARNING ASSETS Total nonearning assets 50,473 - - --------- --------- ------ TOTAL ASSETS $691,085 $ 53,120 7.69% ========= ========= ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $214,401 $ 7,474 3.49% Time, $100,000 and over 37,806 2,131 5.64 Other time deposits 239,300 13,585 5.68 Short-term borrowings 37,100 1,943 5.24 Other borrowings 41,936 2,511 5.99 --------- --------- ------ Total interest bearing liabilities 570,543 27,644 4.85 --------- --------- ------ NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 45,205 - - Accrued interest and other liabilities 8,606 - - --------- --------- ------ Total noninterest bearing liabilities 53,811 - - --------- --------- ------ Stockholders' equity 66,731 - - --------- --------- ------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $691,085 $ 27,644 4.00% ========= ========= ====== Net interest income (1) $ 25,476 ========= Net interest income to total earning assets (1) 3.98% ====== Interest bearing liabilities to earning assets 89.06% ========= ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS & RATES (1) (Dollars in thousands) For the Year Ended December 31, 1995 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $116,683 $ 7,562 6.48% Nontaxable (1) 25,518 2,671 10.47 -------- ------- ------ Total securities 142,201 10,233 7.20 -------- ------- ------ Interest bearing deposits 3,059 116 3.79 Federal funds sold 12,765 740 5.80 -------- -------- ------ Loans and leases: Commercial and commercial real estate (1) 186,062 16,403 8.82 Residential mortgage 155,208 12,211 7.87 Agricultural and agricultural real estate (1) 60,171 5,422 9.01 Consumer 35,881 3,650 10.17 Direct financing leases, net 9,362 670 7.16 Fees on loans - 805 - Less: allowance for loan and lease losses (5,454) - - --------- -------- ------ Net loans and leases 441,230 39,161 8.88 --------- -------- ------ Total earning assets 599,255 50,250 8.39 --------- -------- ------ NONEARNING ASSETS Total nonearning assets 43,501 - - --------- -------- ------ TOTAL ASSETS $642,756 $50,250 7.82% ========= ======== ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $206,353 $ 7,338 3.56% Time, $100,000 and over 30,091 1,658 5.51 Other time deposits 233,983 13,033 5.57 Short-term borrowings 21,665 1,236 5.71 Other borrowings 37,253 2,264 6.08 --------- -------- ------ Total interest bearing liabilities 529,345 25,529 4.82 --------- -------- ------ NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 43,467 - - Accrued interest and other liabilities 8,281 - - --------- -------- ------ Total noninterest bearing liabilities 51,748 - - --------- -------- ------ Stockholders' equity 61,663 - - --------- -------- ------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $642,756 $25,529 3.97% ========= ======== ====== Net interest income (1) $24,721 ======== Net interest income 4.13% to total earning assets (1) ====== Interest bearing liabilities to earning assets 88.33% ========= (1) Tax equivalent basis is calculated using an effective tax rate of 34%. The following table allocates the changes in net interest income to differences in either average balances or average rates for earning assets and interest bearing liabilities. The changes have been allocated proportionately to the change due to volume and change due to rate. Interest income is measured on a tax equivalent basis using a 34% tax rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME (Dollars in thousands) For the Year Ended December 31, 1997 Compared to 1996 Change Due to Volume Rate Net ----------------------- EARNING ASSETS/ INTEREST INCOME Securities Taxable $2,033 $ (32) $2,001 Nontaxable (1,133) (202) (1,335) Interest bearing deposits (51) (14) (65) Federal funds sold 55 16 71 Loans and leases 5,725 530 6,255 ------- ------- ------- TOTAL EARNING ASSETS 6,629 298 6,927 LIABILITIES/INTEREST EXPENSE Interest bearing deposits Savings accounts 813 30 843 Time, $100,000 and over (163) (7) (170) Other time deposits 1,641 261 1,902 Short-term borrowings 1,739 58 1,797 Other borrowings (331) 82 (249) ------- ------- ------- TOTAL INTEREST BEARING LIABILITIES 3,699 424 4,123 ------- ------- ------- NET INTEREST INCOME $2,930 $ (126) $2,804 ======= ======= ======= ANALYSIS OF CHANGES IN NET INTEREST INCOME (Dollars in thousands) For the Year Ended December 31, 1996 Compared to 1995 Change Due to Volume Rate Net ----------------------- EARNING ASSETS/ INTEREST INCOME Securities Taxable $1,260 $ (430) $ 830 Nontaxable 574 (137) 437 Interest bearing deposits 48 (1) 47 Federal funds sold (71) (59) (130) Loans and leases 1,456 230 1,686 ------- ------- ------- TOTAL EARNING ASSETS 3,267 (397) 2,870 LIABILITIES/INTEREST EXPENSE Interest bearing deposits Savings accounts 286 (150) 136 Time, $100,000 and over 425 48 473 Other time deposits 296 256 552 Short-term borrowings 883 (176) 707 Other borrowings 285 (38) 247 ------- ------- ------- TOTAL INTEREST BEARING LIABILITIES 2,175 (60) 2,115 ------- ------- ------- NET INTEREST INCOME $1,092 $(337) $ 755 ======= ======= ======= ANALYSIS OF CHANGES IN NET INTEREST INCOME (Dollars in thousands) For the Year Ended December 31, 1995 Compared to 1994 Change Due to Volume Rate Net ----------------------- EARNING ASSETS/ INTEREST INCOME Securities Taxable $(1,267) $ 582 $ (685) Nontaxable (154) (385) (539) Interest bearing deposits 12 32 44 Federal funds sold 363 185 548 Loans and leases 3,831 2,413 6,244 -------- ------- ------- TOTAL EARNING ASSETS 2,785 2,827 5,612 LIABILITIES/INTEREST EXPENSE Interest bearing deposits Savings accounts (36) 1,851 1,815 Time, $100,000 and over 368 270 638 Other time deposits 658 1,112 1,770 Short-term borrowings (111) 387 276 Other borrowings 737 165 902 -------- ------- ------- TOTAL INTEREST BEARING LIABILITIES 1,616 3,785 5,401 ------- ------- ------- NET INTEREST INCOME $ 1,169 $ (958) $ 211 ======= ======= ======= PROVISION FOR LOAN AND LEASE LOSSES The provision expense for loan and lease losses decreased $129,000 (9.16%) during 1997 compared to an increase of $588,000 (71.71%) during 1996. The additional provision expense during 1996 resulted from a $433,000 (118.96%) increase in net charge- offs, primarily due to a $469,000 writedown on a pool of leases purchased from the Bennett Funding Group. The allowance for loan and lease losses as a percentage of total loans and leases was 1.32% at December 31, 1997, 1.28% at December 31, 1996 and 1.23% at December 31, 1995. NONINTEREST INCOME (Dollars in thousands) For the Years Ended December 31, 1997 1996 1995 ------------------------ Service charges and fees $ 2,723 $ 2,437 $ 2,106 Trust fees 2,009 1,810 1,472 Brokerage commissions 324 212 110 Insurance commissions 563 650 611 Securities gains, net 1,446 1,889 413 Rental income on operating leases 811 - - Gains on sale of loans 373 131 73 Other noninterest income 316 235 196 -------- -------- -------- Total noninterest income $ 8,565 $ 7,364 $ 4,981 ======== ======== ======== The above table shows Heartland's noninterest income for the years indicated. Total noninterest income increased $1,201,000 (16.31%) during 1997, as compared to an increase of $2,383,000 (47.84%) during 1996. One of the most significant components of noninterest income is service charges and fees, which increased $286,000 (11.74%) during 1997 when compared to 1996. Of this increase, $173,000 was attributable to the acquisition of WCB. During 1996, service charges and fees increased $331,000 (15.72%) compared to 1995. The growth experienced during 1996 reflected the addition of new merchants in the credit card processing area. The increased emphasis Heartland has placed on enhancing revenues from services provided to customers has influenced the growth of fee income over the two-year period. Trust fees increased $199,000 (10.99%) in 1997 and $338,000 (22.96%) in 1996, as compared to the respective previous year's total. This strong performance resulted from the increase in assets under management, ending 1997 at $434,003,000, an increase of $67,845,000 (18.53%) during 1997 and $76,813,000 (26.55%) during 1996. This growth reflected especially strong equity and debt markets, combined with the development of new trust relationships through continued calling efforts. Brokerage commissions increased $112,000 (52.83%) in 1997 from the previous year's total. During 1996, brokerage commissions increased $102,000 (92.73%) from 1995's total. Results for both years benefited from the replacement of two sales personnel lost in 1995, combined with continued efforts to integrate the brokerage area into Heartland's retail divisions. Securities gains decreased $443,000 (23.45%) during 1997 compared to 1996. During 1996, securities gains increased $1,476,000 (357.38%) over the 1995 total. The significant increase experienced during 1996 resulted from the recognition of a gain of $1,174,000 on the sale of Federal Home Loan Mortgage Corporation common stock held in the investment portfolio at FCB. Heartland was able to sustain a portion of those gains during 1997 due to the strong performance of its equity portfolio. The expansion into the vehicle leasing and fleet management business with the first full year of operation of ULTEA as a Heartland subsidiary contributed an additional $811,000 to noninterest income during 1997. NONINTEREST EXPENSE (Dollars in thousands) For the Years Ended December 31, 1997 1996 1995 ------------------------ Salaries and employee benefits $13,070 $11,035 $ 9,730 Occupancy, net 1,354 1,268 1,059 Furniture and equipment 1,880 1,336 1,315 Outside services 1,439 1,155 1,164 FDIC deposit insurance assessment 116 746 681 Advertising 826 996 696 Depreciation on equipment under operating leases 584 - - Other noninterest expense 3,658 2,971 2,678 -------- -------- -------- Total noninterest expense $22,927 $19,507 $17,323 ======== ======== ======== Efficiency ratio (1) 64.77% 63.03% 59.15% ======== ======== ======== (1) Noninterest expense divided by the sum of net interest income and noninterest income less securities gains. The above table shows Heartland's noninterest expense for the years indicated. Noninterest expense increased $3,420,000 (17.53%) in 1997 as compared to 1996. Total 1996 noninterest expense represented an increase of $2,184,000 (12.61%) from the 1995 total. Salaries and employee benefits expense represented 57.01% of the total 1997 noninterest expense, increasing $2,035,000 (18.44%) from the total for 1996. During 1996, salaries and employee benefits expense increased $1,305,000 (13.41%) over the 1995 total. In addition to the normal merit and cost of living raises, these increases were attributable to Heartland's continued expansion efforts, particularly the additions of RCB, WCB and ULTEA. Also recorded during 1997 was $267,000 in compensation expense associated with the final distribution of stock under the Heartland Executive Restricted Stock Purchase Plan. The $209,000 (19.74%) increase in occupancy costs for 1996 represented additional depreciation and property tax costs associated with the construction of new facilities at the subsidiary banks. Equipment expenses increased $544,000 (40.72%) during 1997 compared to the 1996 total. The conversion to Fiserv's Comprehensive Banking Systems software was the major component of this increase. Heartland elected to maintain the data processing function in-house to provide its subsidiary banks with enhanced technology and flexibility. The addition of ULTEA added $584,000 to noninterest expense during 1997 for the depreciation on equipment under operating leases. Federal Deposit Insurance Corporation ("FDIC") premium expense decreased $630,000 (84.45%) during 1997 compared to 1996. The one-time special assessment on all savings associations to capitalize the SAIF amounted to $545,000 at FCB and was recorded during 1996. Exclusive of this one-time charge, FDIC premiums decreased $480,000 (70.48%) in 1996 compared to 1995. During 1995, the FDIC premium expense was reduced when the premium charged to members of the Bank Insurance Fund ("BIF") dropped from .23% to .04% of deposits and subsequently to $2,000 per year for well capitalized banks. Three of Heartland's four banks were affected by this reduction, which took effect in September of 1995. FCB, as a SAIF member, experienced a reduction in FDIC premium expense on January 1, 1997, when the assessment dropped from .23% to .065% of deposits. Advertising and public relations expense was reduced $170,000 (17.07%) during 1997, compared to the 1996 total. During 1996, advertising and public relations expense experienced the largest single percentage increase within the noninterest expense category, rising $300,000 (43.10%) compared to the 1995 total. The contribution of stock from FCB's securities portfolio to a public charitable trust during 1996 at a cost basis of $220,000, with an associated market value of $820,000, during 1996 was the primary component of the changes during both years. Heartland utilizes and is dependent upon data processing systems and software to conduct its business. The data processing systems and software include those developed and maintained by Heartland's third-party data processing vendor and purchased software which is run on personal computer networks. Heartland has completed an assessment and work plan to assure that all hardware and software utilized by Heartland subsidiaries will function properly in the year 2000. Management is working with vendors to become compliant by the end of 1998. Noninterest expense includes the cost of such projects. Heartland management continues to review the cost associated with the year 2000 project and presently has not identified any situations that will require material cost expenditures to become fully compliant. INCOME TAXES Income tax expense for 1997 increased $653,000 (24.32%) over 1996. The effective tax rate increased from 25.11% in 1996 to 28.16% in 1997. A reduction in tax-exempt income during 1997 contributed to this increase. The $199,000 (6.90%) decrease in total tax expense for 1996, despite the increase in net income, was driven primarily by the addition of $195,000 in tax credits associated with the investment in low-income housing projects. The one-time contribution of appreciated property to a public charitable trust also was a factor in this decrease. FINANCIAL CONDITION LENDING ACTIVITIES Heartland's major source of income is interest on loans and leases. The table below presents the composition of Heartland's loan portfolio at the end of the years indicated. LOAN PORTFOLIO (Dollars in thousands) At December 31, 1997 1996 Amount Percent Amount Percent ------ ------- ------ ------- Commercial and commercial real estate $242,868 43.46% $206,523 42.46% Residential mortgage 175,268 31.37 166,999 34.33 Agricultural and agricultural real estate 69,302 12.40 57,526 11.83 Consumer 64,223 11.49 48,361 9.94 Lease financing, net 7,171 1.28 7,042 1.44 -------- ------- -------- ------- Gross loans and leases 558,832 100.00% 486,451 100.00% ======= ======= Unearned discount (2,077) (1,962) Deferred loan fees (349) (404) --------- --------- Total loans and leases 556,406 484,085 Allowance for loan and lease losses (7,362) (6,191) --------- --------- Loans and leases, net $549,044 $477,894 ========= ========= LOAN PORTFOLIO (Dollars in thousands) At December 31, 1995 1994 Amount Percent Amount Percent ------ ------- ------ ------- Commercial and commercial real estate $191,866 42.00% $170,998 40.32% Residential mortgage 158,324 34.66 150,147 35.41 Agricultural and agricultural real estate 59,089 12.94 56,736 13.38 Consumer 38,988 8.54 36,068 8.51 Lease financing, net 8,530 1.86 10,076 2.38 -------- ------- -------- ------- Gross loans and leases 456,797 100.00% 424,025 100.00% ======= ======= Unearned discount (1,510) (1,438) Deferred loan fees (382) (371) --------- --------- Total loans and leases 454,905 422,216 Allowance for loan and lease losses (5,580) (5,124) --------- --------- Loans and leases, net $449,325 $417,092 ========= ========= LOAN PORTFOLIO (Dollars in thousands) At December 31, 1993 Amount Percent ------ ------- Commercial and commercial real estate $156,117 41.49% Residential mortgage 124,118 32.98 Agricultural and agricultural real estate 54,998 14.61 Consumer 36,236 9.63 Lease financing, net 4,855 1.29 -------- ------- Gross loans and leases 376,324 100.00% ======= Unearned discount (1,256) Deferred loan fees (290) --------- Total loans and leases 374,778 Allowance for loan and lease losses (4,433) --------- Loans and leases, net $370,345 ========= The table below sets forth the remaining maturities by loan and lease category. MATURITY AND RATE SENSITIVITY OF LOANS AND LEASES (1) December 31, 1997 (Dollars in thousands) Over 1 Year Through 5 Years One Year Fixed Floating or less Rate Rate ------------------------------ Commercial and commercial real estate $ 97,759 $ 86,592 $ 35,414 Residential mortgage 15,354 21,413 15,314 Agricultural and agricultural real estate 34,861 22,402 6,103 Consumer 18,272 31,882 6,188 Lease financing, net 2,203 4,724 - -------- -------- -------- Total $168,449 $167,013 $ 63,019 ======== ======== ======== Over 5 Years Fixed Floating Rate Rate Total ------------------------------- Commercial and commercial real estate $ 5,596 $ 17,507 $242,868 Residential mortgage 25,103 98,084 175,268 Agricultural and agricultural real estate 859 5,077 69,302 Consumer 1,649 6,232 64,223 Lease financing, net 244 - 7,171 -------- -------- -------- Total $ 33,451 $126,900 $558,832 ======== ======== ======== (1) Maturities based upon contractual dates. Net loans and leases grew $71,150,000 (14.89%) from December 31, 1996, to December 31, 1997, compared to $28,569,000 (6.36%) from December 31, 1995, to December 31, 1996. The loan portfolio at WCB accounted for $22,906,000 (32.19%) of the growth during 1997. The largest dollar growth occurred in commercial and commercial real estate loans, which increased $36,345,000 (17.60%) compared to $14,657,000 (7.64%) during 1996. The WCB acquisition accounted for $10,789,000 (29.68%) of the growth in commercial and commercial real estate loans during 1997. Exclusive of the WCB loan portfolio, agricultural and consumer loan outstandings experienced the most significant percentage growth during 1997. Agricultural and agricultural real estate loans, exclusive of WCB, increased $10,569,000 (18.37%) during 1997 compared to a decrease of $1,563,000 (2.65%) during 1996. The 1996 decrease reflected the consolidation occurring in the agricultural sector and loan paydowns resulting from strong commodity prices. Consumer loan outstandings grew $11,474,000 (23.73%) during 1997, exclusive of the WCB loan portfolio, compared to $9,373,000 (24.04%) during 1996. These increases were attributed to significant growth in consumer lines of credit and dealer paper, partially as a result of the expansion of Citizens into Madison, Wisconsin. Growth in residential mortgage loan outstandings declined during 1997 as customers elected to take fixed rate 15- and 30- year mortgages which the subsidiary banks elected to sell into the secondary market while retaining servicing. In 1997, exclusive of WCB, and 1996 Heartland's total outstanding residential mortgage loans increased $1,406,000 (.84%) and $8,675,000 (5.48%), respectively. Although the risk of nonpayment for any reason exists with respect to all loans, specific risks are associated with each type of loan. The primary risks associated with commercial and agricultural loans are the quality of the borrower's management and the impact of national and regional economic factors. Risks associated with real estate loans include fluctuating land values and concentrations of loans in a specific type of real estate. Consumer loans also have risks associated with concentrations of loans in a single type of loan and the risk of a borrower's unemployment as a result of deteriorating economic conditions. Heartland monitors its loan concentrations and does not believe it has concentrations in any specific industry other than agriculture. Heartland's strategy with respect to the management of these types of risks, whether loan demand is weak or strong, is to encourage the Heartland banks to follow tested and prudent loan policies and underwriting practices which include: (i) granting loans on a sound and collectible basis; (ii) investing funds profitably for the benefit of stockholders and the protection of depositors; (iii) serving the needs of the community and each bank's general market area while obtaining a balance between maximum yield and minimum risk; (iv) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan; (v) administering loan policies through a Board of Directors and an officers' loan committee; (vi) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category; and (vii) ensuring that each loan is properly documented and, if appropriate, guaranteed by government agencies and that insurance coverage is adequate. NONPERFORMING LOANS AND LEASES AND OTHER NONPERFORMING ASSETS The table below sets forth the amounts of nonperforming loans and leases and other nonperforming assets on the dates indicated. NONPERFORMING ASSETS (Dollars in thousands) December 31, 1997 1996 1995 1994 1993 ---------------------------------- Nonaccrual loans and leases $1,819 $1,697 $ 977 $ 748 $ 979 Loan and leases contractually past due 90 days or more 187 247 226 134 206 Restructured loans and leases 26 30 - - - ------ ------ ------ ------ ------ Total nonperforming loans and leases 2,032 1,974 1,203 882 1,185 Other real estate 774 532 640 134 623 Other repossessed assets 124 21 51 39 23 ------ ------ ------- ------ ------ Total nonperforming assets $2,930 $2,527 $1,894 $1,055 $1,831 ====== ====== ====== ====== ====== Nonperforming loans and leases to total loans and leases 0.37% 0.41% 0.26% 0.21% 0.32% Nonperforming assets to total loans and leases plus repossessed property 0.53% 0.52% 0.42% 0.25% 0.49% Nonperforming assets to total assets 0.34% 0.34% 0.28% 0.17% 0.30% Under Heartland's internal loan review program, a loan review officer is responsible for reviewing existing loans and leases, identifying potential problem loans and leases and monitoring the adequacy of the allowance for possible loan and lease losses at each of the Heartland banks. Heartland constantly monitors and continues to develop systems to oversee the quality of its loan portfolio. One integral part is a loan rating system which assigns a rating on each loan and lease within the portfolio based on the borrower's repayment ability, collateral position and repayment history. This emphasis on quality is reflected in Heartland's credit quality figures which compare very favorably to peer data in the September 1997 Bank Holding Company Performance Report published by the Federal Reserve Board for bank holding companies with assets of $500 million to $1 billion. In this report, the peer group reported nonperforming assets to total assets of .50%, .54% and .60% for September 30, 1997, December 31, 1996 and 1995, respectively. ALLOWANCE FOR LOAN AND LEASE LOSSES The adequacy of the allowance for loan and lease losses is determined by an internally-developed system which equally weighs formulas established by the Office of the Comptroller of the Currency and the Bank Administration Institute, in addition to Heartland's historical charge-offs. This system addresses loan portfolio composition, loan and lease delinquencies, potential and existing internally classified credits and other factors that, in management's judgment, deserve evaluation in estimating loan and lease losses. The adequacy of the allowance for loan and lease losses is monitored on an ongoing basis by the loan review staff, senior management and the Heartland Board of Directors. Heartland increased its allowance for loan and lease losses during 1997 and 1996 due to a number of factors considered by the Heartland Loan Review Committee, including the following: (i) a continued increase in higher-risk consumer and more-complex commercial and agricultural loans from relatively lower-risk real estate loans; (ii) the economies in Heartland's primary market areas have been stable for some time and the growth of the allowance is intended to anticipate the cyclical nature of most economies; and (iii) the third consecutive year of increases in the amount of nonaccrual loans. There can be no assurances that the allowance for loan and lease losses will be adequate to cover all losses, but management believes that the allowance for loan and lease losses was adequate at December 31, 1997. While management uses available information to provide for loan and lease losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan and lease losses carried by the Heartland subsidiaries. Such agencies may require Heartland to make additional provisions to the allowance based upon their judgment about information available to them at the time of their examinations. The table below summarizes activity in the allowance for loan and lease losses for the years indicated, including amounts of loans and leases charged off, amounts of recoveries, additions to the allowance charged to income and the ratio of net charge-offs to average loans and leases outstanding. ANALYSIS OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) December 31, 1997 1996 1995 1994 1993 -------------------------------------- Allowance at beginning of year $6,191 $5,580 $5,124 $4,433 $3,406 Charge-offs: Commercial and commercial real estate 93 578 108 94 4 Residential mortgage 21 23 6 16 48 Agricultural and agricultural real estate 21 2 - - 35 Consumer 449 323 381 244 214 Lease financing - - - - - ------ ------ ------ ------ ------ Total charge-offs 584 926 495 354 301 ------ ------ ------ ------ ------ Recoveries: Commercial and commercial real estate 36 16 22 27 50 Residential mortgage 8 1 15 5 23 Agricultural and agricultural real estate 2 45 8 43 5 Consumer 99 67 86 148 96 Lease financing - - - - - ------ ------ ------ ------ ------ Total recoveries 145 129 131 223 174 ------ ------ ------ ------ ------ Net charge-offs 439 797 364 131 127 Provision for loan and lease losses 1,279 1,408 820 811 1,014 Additions related to acquisitions 331 - - - 140 Keokuk merger adjustments - - - 11 - ------ ------ ------ ------ ------ Allowance at end of period $7,362 $6,191 $5,580 $5,124 $4,433 ====== ====== ====== ====== ====== Net charge-offs to average loans and leases 0.08% 0.17% 0.08% 0.03% 0.04% ======= ======= ======= ======= ====== The table below shows Heartland's allocation of the allowance for loan and lease losses by types of loans and leases and the amount of unallocated reserves. ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 1997 1996 --------------------------------------- Loan/ Loan/ Lease Lease Category Category to Gross to Gross Loans & Loans & Amount Leases Amount Leases ------ --------- ------ --------- Commercial and commercial real estate $1,889 43.46% $1,568 42.46% Residential mortgage 725 31.37 590 34.33 Agricultural and agricultural real estate 577 12.40 480 11.83 Consumer 1,044 11.49 818 9.94 Lease financing(1) 30 1.28 28 1.44 Unallocated 3,097 - 2,707 - ------- ------- ------- ------- $7,362 100.00% $6,191 100.00% ======= ======= ======= ======= ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 1995 1994 --------------------------------------- Loan/ Loan/ Lease Lease Category Category to Gross to Gross Loans & Loans & Amount Leases Amount Leases ------ --------- ------ --------- Commercial and commercial real estate $1,430 42.00% $1,321 40.32% Residential mortgage 500 34.66 501 35.41 Agricultural and agricultural real estate 518 12.94 423 13.38 Consumer 618 8.54 593 8.51 Lease financing(1) 34 1.86 45 2.38 Unallocated 2,480 - 2,241 - ------- ------- ------- ------- $5,580 100.00% $5,124 100.00% ======= ======= ======= ======= ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 1993 -------------------------- Loan/ Lease Category to Gross Loans & Amount Leases ------- -------- Commercial and commercial real estate $1,535 41.49% Residential mortgage 547 32.98 Agricultural and agricultural real estate 395 14.61 Consumer 659 9.63 Lease financing(1) - 1.29 Unallocated 1,297 - ------- ------- $4,433 100.00% ======= ======= 1) Prior to 1994, reserve allocations for lease financing receivables were included in the commercial and commercial real estate allocations. SECURITIES The primary objective of the securities portfolio continues to be to provide the Heartland bank subsidiaries with a source of liquidity given their high loan-to-deposit ratios. Securities represented 23.68% of total assets at December 31, 1997, as compared to 24.98% at December 31, 1996 and 21.88% at December 31, 1995. Consistent with Heartland's efforts during 1996 to maximize the return on the portfolio while maintaining a conservative investment philosophy, the composition of the portfolio during 1997 was maintained at the 1996 levels. The most dramatic shift occurred in the mortgage-backed securities area, which increased $35,564,000 (90.14%) during 1996, as compared to 1995. This increase reflected management's decision to increase its investment in fixed-rate collateralized mortgage obligations ("CMO's"). To reduce its exposure to prepayments, Heartland purchased tightly structured tranches in well-seasoned CMO's. These investments closely resemble treasury securities in their repayment predictability and accordingly are less volatile to interest rate fluctuations, while still providing an increased spread when compared to U.S. treasuries with similar maturities. As treasury securities matured during 1997, many of the replacement purchases were made in these CMO products. During 1997, the investment in mortgage-backed securities increased $5,577,000 (7.43%), exclusive of the acquisition of WCB, and treasury securities decreased $775,000 (5.49%). Heartland increased its investment in U.S. government agencies by $13,827,000 (29.11%) during 1996. While spreads between agencies and comparable CMO's are typically wide, the state tax-exempt nature on selected agencies purchased for Heartland's Illinois bank subsidiaries made them attractive. Management determined that its investment in mutual funds provided insufficient returns compared to other investments of similar duration. Accordingly, the total investment in mutual funds was reduced by $6,617,000 (92.88%) during 1996. Heartland also reduced its investment in state and political subdivisions during 1996. This decrease was driven by calls on these securities and more attractive returns on other comparable maturity investments. The tables below presents the composition and maturities of the securities portfolio by major category. SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) December 31, 1997 1996 1995 ------------------------------------------------ % of % of % of Portfolio Portfolio Portfolio Amount Amount Amount ------------------------------------------------ U. S. Treasury securities $ 13,342 6.61% $ 14,117 7.66% $ 11,501 7.75% U. S. government agencies 64,360 31.90 61,332 33.34 47,505 32.05 Mortgage-backed securities 87,015 43.13 75,017 40.78 39,453 26.62 Mutual funds 512 0.26 507 0.28 7,124 4.81 States and political subdivisions 20,702 10.26 18,812 10.23 22,782 15.37 Other securities 15,817 7.84 14,181 7.71 19,861 13.40 -------- ------ -------- ------- ------- ------- Total $201,748 100.00% $183,966 100.00% $148,226 100.00% ======== ====== ======== ======= ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Held to Maturity Available for Sale % of % of December 31, 1997 Amount Portfolio Amount Portfolio --------------------------------------- U.S. Treasury securities $ - -% $ 13,342 6.61% U.S. government agencies 598 .30 63,762 31.60 Mortgage-backed securities 325 .16 86,690 42.97 Mutual funds - - 512 0.26 States and political subdivisions 2,956 1.46 17,746 8.80 Other securities - - 15,817 7.84 ------ ------- -------- ------- Total $3,879 1.92% $197,869 98.08% ====== ======= ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Total % of December 31, 1997 Amount Portfolio ------------------- U.S. Treasury securities $ 13,342 6.61% U.S. government agencies 64,360 31.90 Mortgage-backed securities 87,015 43.13 Mutual funds 512 0.26 States and political subdivisions 20,702 10.26 Other securities 15,817 7.84 -------- ------- Total $201,748 100.00% ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Held to Maturity Available for Sale % of % of December 31, 1996 Amount Portfolio Amount Portfolio --------------------------------------- U.S. Treasury securities $ - -% $ 14,117 7.66% U.S. government agencies - - 61,332 33.34 Mortgage-backed securities - - 75,017 40.78 Mutual funds - - 507 0.28 States and political subdivisions 2,151 1.17 16,661 9.06 Other securities - - 14,181 7.71 ------ ------- -------- ------- Total $2,151 1.17% $181,815 98.83% ====== ======= ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Total % of December 31, 1996 Amount Portfolio ------------------- U.S. Treasury securities $ 14,117 7.66% U.S. government agencies 61,332 33.34 Mortgage-backed securities 75,017 40.78 Mutual funds 507 0.28 States and political subdivisions 18,812 10.23 Other securities 14,181 7.71 -------- ------- Total $183,966 100.00% ======== ======= SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) After One But Within One Year Within Five Years --------------- ----------------- December 31, 1997 Amount Yield Amount Yield ------------------------------------ U.S. Treasury securities $ 5,055 5.93% $ 8,287 6.32% U.S. government agencies 35,560 5.90 26,843 6.11 Mortgage-backed securities 4,003 6.35 6,751 7.62 States and political subdivisions (1) 619 6.57 5,095 9.94 Other securities 101 9.05 623 8.38 ------- ------- ------ ------- Total $45,338 5.96% $47,599 6.80% ======= ======= ======= ======= SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) After Five But Within Ten Years After Ten Years ---------------- ----------------- Amount Yield Amount Yield ------------------------------------ U.S. Treasury securities $ - -% $ - -% U.S. government agencies 1,940 3.44 17 10.25 Mortgage-backed securities 20,688 7.06 55,573 6.60 States and political subdivisions (1) 5,103 8.32 9,885 9.17 Other securities - - - - ------- ------- ------- ------- Total $27,731 7.04% $65,475 6.99% ======= ======= ======= ======= SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) Total Amount Yield ------------------- U.S. Treasury securities $ 13,342 6.17% U.S. government agencies 64,360 5.92 Mortgage-backed securities 87,015 6.78 States and political subdivisions (1) 20,702 9.07 Other securities 724 8.47 -------- ------- Total 186,143 6.70% ======= Mutual funds 512 Equity securities 15,093 -------- Total $201,748 ======== (1) Rates on obligations of states and political subdivisions have been adjusted to tax equivalent yields using a 34% income tax rate. DEPOSITS AND BORROWED FUNDS Heartland has a relatively stable core deposit base drawn primarily from within its market areas. Exclusive of WCB, total average deposits increased $27,578,000 (5.14%) from the total average deposits during 1996. This is an improvement over the $22,818,000 (4.44%) increase experienced during 1996 and was primarily attributable to strong growth at GSB and RCB. Average noninterest bearing deposits increased $2,575,000 (5.70%), exclusive of WCB, during 1997 and $1,738,000 (4.00%) during 1996. Average interest bearing deposits increased $25,003,000 (5.09%), exclusive of WCB, during 1997 and $21,080,000 (4.48%) during 1996. Much of the deposit growth experienced during 1996 was a direct result of the success RCB experienced in its first full year of operation. Heartland's other subsidiary banks experienced only moderate growth driven by continued nationwide customer dissatisfaction with deposit rates and the attractiveness of alternative investment products such as mutual funds. For each of the years ended December 31, 1997, 1996 and 1995, respectively, the mix of individual account balances to total deposits has remained very constant. The table below sets forth the distribution of Heartland's average deposit account balances and the average interest rates paid on each category of deposits for the years indicated. AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 1997 Percent Average of Balance Deposits Rate ------------------------ Demand deposits $ 51,770 8.74% 0.00% Savings accounts 237,730 40.12 3.50 Time deposits less than $100,000 268,201 45.25 5.77 Time deposits of $100,000 or more 34,913 5.89 5.62 -------- ------- Total deposits $592,614 100.00% ======== ======= AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 1996 Percent Average of Balance Deposits Rate ------------------------ Demand deposits $ 45,205 8.42% 0.00% Savings accounts 214,401 39.95 3.49 Time deposits less than $100,000 239,300 44.59 5.68 Time deposits of $100,000 or more 37,806 7.04 5.64 -------- ------- Total deposits $536,712 100.00% ======== ======= AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 1995 Percent Average of Balance Deposits Rate ------------------------ Demand deposits $ 43,467 8.46% 0.00% Savings accounts 206,353 40.15 3.56 Time deposits less than $100,000 233,983 45.53 5.57 Time deposits of $100,000 or more 30,091 5.86 5.51 -------- ------- Total deposits $513,894 100.00% ======== ======= The following table sets forth the amount and maturities of time deposits of $100,000 or more at December 31, 1997. Time Deposits $100,000 and Over (Dollars in thousands) December 31, 1997 ------------ 3 months or less $ 6,564 Over 3 months through 6 months 8,892 Over 6 months through 12 months 10,593 Over 12 months 12,836 ------- $38,885 ======= The Heartland banks own stock in the FHLB of Des Moines and of Chicago, enabling them to borrow funds from their respective FHLB for short- or long-term purposes under a variety of programs. During 1997, Heartland used additional FHLB advances as loan demand exceeded deposit growth. Total FHLB borrowings at December 31, 1997 and 1996, were $64,400,000 and $51,900,000, respectively. Heartland also utilizes securities sold under agreements to repurchase as a source of funds. DB&T and RCB provide repurchase agreements to their customers as a cash management tool, sweeping excess funds from demand deposit accounts into these agreements. This source of funding does not increase Heartland's reserve requirements, nor does it create an expense relating to FDIC premiums on deposits. Although the aggregate balance of repurchase agreements is subject to variation, the account relationships represented by these balances are principally local and have been maintained for relatively long periods of time. On October 31, 1997, Heartland entered into a four year, unsecured revolving credit agreement with an unaffiliated bank. The total borrowings under this credit line were $3,500,000 at December 31, 1997. The following table reflects short-term borrowings which in the aggregate have average balances during the period greater than 30% of stockholders equity at the end of the period. SHORT-TERM BORROWINGS (Dollars in thousands) At or for the Year Ended December 31, 1997 1996 1995 ------------------------ Balance at end of period $96,239 $56,358 $23,241 Maximum month-end amount outstanding 96,239 56,358 42,205 Average month-end amount outstanding 73,170 42,025 25,965 Weighted average interest rate at year-end 5.49% 5.75% 5.56% Weighted average interest rate for the year ended 5.32% 5.24% 5.71% CAPITAL RESOURCES Heartland's risk-based capital ratios, which take into account the different credit risks among banks' assets, have remained strong over the past three years. Tier 1 and total risk-based capital ratios were 11.54% and 12.71%, respectively, on December 31, 1997, compared with 13.10% and 14.28% at December 31, 1996, and 13.28% and 14.46% for December 31, 1995. At December 31, 1997, Heartland's leverage ratio, the ratio of Tier 1 capital to total average assets, was 8.76% compared to 9.54% and 9.47% at December 31, 1996, and 1995, respectively. Commitments for capital expenditures are an important factor in evaluating capital adequacy. Heartland completed the acquisition of WCB on March 1, 1997. Cash payments remaining under the agreement are $823,000 in 1998, $823,000 in 1999, $594,000 in 2000 and $584,000 in 2001. During the fourth quarter of 1997, Heartland entered into an agreement with a group of New Mexico business leaders to establish a new bank in Albuquerque. Pending regulatory approval, the new bank is expected to begin operations in the spring of 1998. Heartland's portion of the $15,000,000 initial capital investment is $12,000,000, of which $1,200,000 has already been advanced. Additional expenditures relating to expansion efforts are not estimable at this time. Heartland intends to fund this transaction through its revolving credit line. Heartland's capital ratios are detailed in the table below. RISK-BASED CAPITAL RATIOS(1) (Dollars in thousands) December 31, 1997 1996 1995 Amount Ratio Amount Ratio Amount Ratio ---------------------------------------------- Capital Ratios: Tier 1 capital $ 71,713 11.54% $ 67,701 13.10% $ 60,780 13.28% Tier 1 capital minimum requirement 24,854 4.00 20,667 4.00 18,302 4.00 -------- ------ -------- ------ -------- ----- - - Excess $ 46,859 7.54% $ 47,034 9.10% $ 42,478 9.28% ======== ====== ======== ====== ======== ====== Total capital $ 78,995 12.71% $ 73,777 14.28% $ 66,165 14.46% Total capital minimum requirement 49,707 8.00 41,334 8.00 36,603 8.00 -------- ------ -------- ------ -------- ------ Excess $ 29,288 4.71% $ 32,443 6.28% $ 29,562 6.46% ======== ====== ======== ====== ======== ====== Total risk- adjusted assets $621,338 $516,678 $457,539 ======== ======== ======== (1) Based on the risk-based capital guidelines of the Federal Reserve, a bank holding company is required to maintain a Tier 1 to risk-adjusted assets ratio of 4.00% and total to risk-adjusted assets ratio of 8.00%. LEVERAGE RATIOS (1) (Dollars in thousands) December 31, 1997 1996 1995 Amount Ratio Amount Ratio Amount Ratio ---------------------------------------------- Capital Ratios: Tier 1 capital $ 71,713 8.76% $ 67,701 9.54% $ 60,780 9.47% Tier 1 capital minimum requirement (2) 32,729 4.00 28,375 4.00 25,666 4.00 -------- ------ -------- ------ -------- ------ Excess $ 38,984 4.76% $ 39,326 5.54% $ 35,114 5.47% ======== ====== ======== ====== ======== ====== Average adjusted assets $818,232 $709,387 $641,650 ======== ======== ======== (1)The leverage ratio is defined as the ratio of Tier 1 capital to average total assets. (2)Management of Heartland has established a minimum target leverage ratio of 4.00%. Based on Federal Reserve guidelines, a bank holding company generally is required to maintain a leverage ratio of 3.00% plus an additional cushion of at least 100 basis points. LIQUIDITY Liquidity refers to Heartland's ability to maintain a cash flow which is adequate to meet maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund operations and to provide for customers' credit needs. Heartland's usual and primary sources of funding have been deposits, loan and mortgage-backed security principal repayments, sales of loans, cash flow generated from operations and, more recently, FHLB borrowings. Heartland's short-term borrowing balances are dependent on commercial cash management and smaller correspondent bank relationships and, as such, will normally fluctuate. Heartland believes these balances, on average, to be stable sources of funds; however, it intends to rely on deposit growth and additional FHLB borrowings in the future. In the event of short-term liquidity needs, the Heartland banks may purchase federal funds from each other or from correspondent banks. This source is used from time to time. The Heartland banks may also borrow money from the Federal Reserve Bank, but have not done so during any period covered in this report. Finally, the Heartland banks' FHLB memberships give them the ability to borrow funds for short- or long-term purposes under a variety of programs. To meet general corporate commitments and provide the nonbanking subsidiaries with working capital, Heartland may borrow under its revolving credit agreement which provides for total borrowings pursuant to the agreement of up to $20,000,000 at any one time. The agreement contains specific covenants which, among other things, limit dividend payments and restrict the sale of assets by Heartland under certain circumstances. Also contained within the agreement are certain financial covenants, including the maintenance by Heartland of a maximum nonperforming assets to total loans ratio, minimum return on average assets ratio, maximum funded debt to total equity capital ratio, and requires that each of Heartland's banking subsidiaries remain well capitalized, as defined from time to time by the federal banking regulators. At December 31, 1997, Heartland was in compliance with the above covenants. MARKET RISK MANAGEMENT Market risk is the risk of loss arising from adverse changes in market prices and rates. Heartland's market risk is comprised primarily of interest rate risk resulting from its core banking activities of lending and deposit gathering. Interest rate risk measures the impact on earnings from changes in interest rates and the effect on current fair market values of Heartland's assets, liabilities and off-balance sheet contracts. The objective is to measure this risk and manage the balance sheet to avoid unacceptable potential for economic loss. Heartland management continually develops and applies strategies to mitigate market risk. Exposure to market risk is reviewed on a regular basis by the asset/liability committees at the banks and, on a consolidated basis, by the Heartland Funds Management Committee. Monthly, management utilizes both the standard balance sheet GAP report and an independently developed income statement GAP report to analyze the effect of changes in interest rates on net interest income and to manage interest rate risk. Also utilized periodically during the year is an interest rate sensitivity analysis which simulates changes in net interest income in response to various interest rate scenarios. This analysis considers current portfolio rates, existing maturities, repricing opportunities and market interest rates, in addition to prepayments and growth under different interest rate assumptions. Through the use of these tools Heartland has determined that the balance sheet is structured such that changes in net interest margin in response to changes in interest rates would be minimal, all other factors being held constant. Management does not believe that Heartland's primary market risk exposures and how those exposures were managed in 1997 have changed when compared to 1996. Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. Heartland was not a party to these types of derivatives at December 31, 1997. However, Heartland does enter into 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 and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower. Standby letters of credit are conditional commitments issued by Heartland to guarantee the performance of a customer to a third party up to a stated amount and with specified terms and conditions. These commitments to extend credit and standby letters of credit are not recorded on the balance sheet until the instrument is exercised. The table below summarizes the scheduled maturities of market risk sensitive assets and liabilities as of December 31, 1997. Quantitative and Qualitative Disclosures about Market Risk Table of Market Risk-Sensitive Instruments (Dollars in thousands) December 31, 1997 MATURING IN: 1998 1999 2000 2001 ------------------------------------ ASSETS Federal funds sold $ 32,918 $ - $ - $ - Time deposits in other financial institutions 134 36 2 - Securities 60,610 51,573 18,139 8,853 Loans and leases: Fixed rate loans 130,305 67,407 50,447 23,187 Variable rate loans 70,038 36,088 28,623 14,834 -------- -------- -------- -------- Loans and leases, net 200,343 103,495 79,070 38,021 -------- -------- -------- -------- Total Market Risk- Sensitive Assets $294,005 $155,104 $ 97,211 $ 46,874 ======== ======== ======== ======== LIABILITIES Savings $252,292 $ - $ - $ - Time deposits Fixed rate time certificates less than $100,000 129,294 64,623 40,086 18,130 Variable rate time certificates less than $100,000 7,010 281 - - -------- -------- -------- -------- Time deposits less than $100,000 136,304 64,904 40,086 18,130 Time deposits of $100,000 or more 26,049 8,030 3,203 800 Federal funds purchased, securities sold under repurchase agreements and other short-term borrowings 96,239 - - - Other borrowings: Fixed rate borrowings - 15,634 11,905 584 Variable rate borrowings - - - 3,500 -------- -------- -------- -------- Other borrowings - 15,634 11,905 4,084 -------- -------- -------- -------- Total Market Risk- Sensitive Liabilities $510,884 $ 88,568 $ 55,194 $ 23,014 ======== ======== ======== ======== Average Estimated Interest Fair MATURING IN: 2002 Thereafter Total Rate Value ------------------------------------------ ASSETS Federal funds sold $ - $ - $ 32,918 6.13% $ 32,918 Time deposits in other financial institutions - 22 194 7.84 194 Securities 1,949 60,624 201,748 6.97 201,868 Loans and leases: Fixed rate loans 25,962 20,184 317,492 8.76 312,867 Variable rate loans 10,231 79,100 238,914 8.42 245,648 -------- -------- -------- -------- Loans and leases, net 36,193 99,284 556,406 558,515 -------- -------- -------- -------- Total Market Risk- Sensitive Assets $ 38,142 $159,930 $791,266 $793,495 ======== ======== ======== ======== LIABILITIES Savings $ - $ - $252,292 3.42% $252,292 Time deposits Fixed rate time certificates less than $100,000 11,819 162 264,114 5.77 264,543 Variable rate time certificates less than $100,000 - - 7,291 5.83 7,291 -------- -------- -------- -------- Time deposits less than $100,000 11,819 162 271,405 271,834 Time deposits of $100,000 or more 803 - 38,885 5.75 39,035 Federal funds purchased, securities sold under repurchase agreements and other short-term borrowings - - 96,239 5.49 96,239 Other borrowings: Fixed rate borrowings 5,000 4,400 37,523 6.20 37,788 Variable rate borrowings 2,000 - 5,500 6.65 5,500 -------- -------- -------- -------- Other borrowings 7,000 4,400 43,023 43,288 -------- -------- -------- -------- Total Market Risk Sensitive Liabilities $ 19,622 $ 4,562 $701,844 $702,688 ======== ======== ======== ======== EFFECTS OF INFLATION Consolidated financial data included in this report has been prepared in accordance with generally accepted accounting principles. Presently, these principles require reporting of financial position and operating results in terms of historical dollars. Changes in the relative value of money due to inflation or recession are generally not considered. In management's opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in the expected rate of inflation, as well as on changes in monetary and fiscal policies. A financial institution's ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in today's volatile economic environment. Heartland seeks to insulate itself from interest rate volatility by ensuring that rate-sensitive assets and rate-sensitive liabilities respond to changes in interest rates in a similar time frame and to a similar degree. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996 (Dollars in thousands, except per share data) Notes 1997 1996 ----- --------- --------- ASSETS Cash and due from banks 3 $ 24,267 $ 40,080 Federal funds sold 32,918 - --------- --------- Cash and cash equivalents 57,185 40,080 Time deposits in other financial institutions 194 167 Securities: 4 Available for sale-at market (cost of $193,805 for 1997 and $179,697 for 1996) 197,869 181,815 Held to maturity-at cost (approximate market value of $3,999 for 1997 and $2,245 for 1996) 3,879 2,151 Loans and leases: 5 Held for sale 10,437 2,412 Held to maturity 545,969 481,673 Allowance for possible loan and lease losses 6 (7,362) (6,191) --------- --------- Loans and leases, net 549,044 477,894 Premises, furniture and equipment, net 7 18,346 16,715 Other real estate, net 774 532 Other assets 24,769 17,198 --------- --------- TOTAL ASSETS $852,060 $736,552 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Deposits: 8 Demand $ 60,950 $ 55,482 Savings 252,292 224,317 Time 310,290 278,544 --------- --------- Total deposits 623,532 558,343 Short-term borrowings 9 96,239 56,358 Accrued expenses and other liabilities 11,494 9,086 Other borrowings 11 43,023 42,506 --------- --------- TOTAL LIABILITIES 774,288 666,293 --------- --------- STOCKHOLDERS' EQUITY: 13,14,16 Preferred stock (par value $1 per share; authorized 200,000 shares) - - Common stock (par value $1 per share; authorized, 7,000,000 shares;issued, 4,853,626 shares at December 31, 1997, and December 31, 1996,) 4,854 4,854 Capital surplus 13,706 13,366 Retained earnings 58,914 52,864 Net unrealized gain on securities available for sale 2,545 1,327 Treasury stock at cost (106,251 and 118,066 shares at December 31, 1997, and December 31, 1996, respectively) (2,247) (2,152) --------- --------- TOTAL STOCKHOLDERS' EQUITY 77,772 70,259 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $852,060 $736,552 ========= ========= See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME For the years ended December 31, 1997, 1996 and 1995 (Dollars in thousands, except per share data) Notes 1997 1996 1995 ----- -------- -------- -------- INTEREST INCOME: Interest and fees on loans and leases 5 $46,919 $40,670 $38,968 Interest on securities: Taxable 10,393 8,392 7,552 Nontaxable 1,170 2,051 1,763 Interest on trading account securities - - 10 Interest on federal funds sold 681 610 740 Interest on interest bearing deposits in other financial institutions 98 163 116 -------- -------- -------- TOTAL INTEREST INCOME 59,261 51,886 49,149 -------- ------- -------- INTEREST EXPENSE: Interest on deposits 8 25,765 23,190 22,029 Interest on short-term borrowings 3,740 1,943 1,236 Interest on other borrowings 2,262 2,511 2,264 -------- -------- -------- TOTAL INTEREST EXPENSE 31,767 27,644 25,529 -------- -------- -------- NET INTEREST INCOME 27,494 24,242 23,620 Provision for possible loan and lease losses 6 1,279 1,408 820 -------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR POSSIBLE LOAN AND LEASE LOSSES 26,215 22,834 22,800 -------- -------- -------- OTHER INCOME: Service charges and fees 2,723 2,437 2,106 Trust fees 2,009 1,810 1,472 Brokerage commissions 324 212 110 Insurance commissions 563 650 611 Securities gains, net 1,446 1,889 413 Rental income on operating leases 811 - - Gains on sale of loans 373 131 73 Other noninterest income 316 235 196 -------- -------- -------- TOTAL OTHER INCOME 8,565 7,364 4,981 -------- -------- -------- OTHER EXPENSES: Salaries and employee benefits 12 13,070 11,035 9,730 Occupancy 13 1,354 1,268 1,059 Furniture and equipment 1,880 1,336 1,315 Outside services 1,439 1,155 1,164 FDIC deposit insurance assessment 116 746 681 Advertising 826 996 696 Depreciation on equipment under operating leases 584 - - Other noninterest expenses 3,658 2,971 2,678 ------- ------- ------- TOTAL OTHER EXPENSES 22,927 19,507 17,323 ------- ------- ------- Income before income taxes 11,853 10,691 10,458 Income taxes 10 3,338 2,685 2,884 ------- ------- ------- NET INCOME $ 8,515 $ 8,006 $ 7,574 ======= ======= ======= EARNINGS PER COMMON SHARE-BASIC $1.80 $1.70 $1.58 ======= ======= ======= EARNINGS PER COMMON SHARE- DILUTED 1 $1.78 $1.69 $1.58 ======= ======== ======= CASH DIVIDENDS DECLARED PER COMMON SHARE $0.52 $0.40 $0.30 ======= ======= ======= See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December 31, 1997, 1996 and 1995 (Dollars in thousands, except per share data) Common Capital Retained Stock Surplus Earnings ------ ------- -------- Balance at January 1, 1995 $2,427 $13,089 $43,035 Net Income - 1995 7,574 Cash dividends declared: Common, $.30 per share (1,438) Purchase of 85,138 shares of common stock Sale of 8,065 shares of common stock 1 Net unrealized gain on securities available for sale (net of tax of $2,415) ------- -------- -------- Balance at December 31, 1995 2,427 13,090 49,171 Net Income - 1996 8,006 Cash dividends declared: Common, $.40 per share (1,886) Two-for-one stock split 2,427 (2,427) Purchase of 32,446 shares of common stock Sale of 64,943 shares of common stock 276 Net unrealized loss on securities available for sale (net of tax benefit of $769) ------- -------- -------- BALANCE AT DECEMBER 31, 1996 4,854 13,366 52,864 Net Income - 1997 8,515 Cash dividends declared: Common, $.52 per share (2,465) Purchase of 32,835 shares of common stock Sale of 44,650 shares of common stock 340 Net unrealized gain on securities available for sale (net of tax of $724) ------- -------- -------- BALANCE AT DECEMBER 31, 1997 $ 4,854 $ 13,706 $ 58,914 ======= ======== ======== Net Unrealized Gain (Loss) on Securities Available Treasury For Sale Stock Total ------------- -------- ----- Balance at January 1, 1995 $ (1,439) $ (182) $ 56,930 Net Income - 1995 7,574 Cash dividends declared: Common, $.30 per share (1,438) Purchase of 85,138 shares of common stock (2,855) (2,855) Sale of 8,065 shares of common stock 235 236 Net unrealized gain on securities available for sale (net of tax of $2,415) 4,059 4,059 -------- -------- --------- Balance at December 31, 1995 2,620 (2,802) 64,506 Net Income - 1996 8,006 Cash dividends declared: Common, $.40 per share (1,886) Two-for-one stock split - Purchase of 32,446 shares of common stock (759) (759) Sale of 64,943 shares of common stock 1,409 1,685 Net unrealized loss on securities available for sale (net of tax benefit of $769) (1,293) (1,293) --------- -------- --------- BALANCE AT DECEMBER 31, 1996 1,327 (2,152) 70,259 Net Income - 1997 8,515 Cash dividends declared: Common, $.52 per share (2,465) Purchase of 32,835 shares of common stock (865) (865) Sale of 44,650 shares of common stock 770 1,110 Net unrealized gain on securities available for sale (net of tax of $724) 1,218 1,218 --------- -------- --------- BALANCE AT DECEMBER 31, 1997 $ 2,545 $(2,247) $ 77,772 ========= ======== ========= See accompanying notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 1997, 1996 and 1995 (Dollars in thousands) 1997 1996 1995 ---- ---- ---- Cash Flows from Operating Activities: Net income $ 8,515 $ 8,006 $ 7,574 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,635 1,341 1,223 Provision for possible loan and lease losses 1,279 1,408 820 Provision for income taxes 114 (393) 141 Net accretion of discount on securities (292) (769) (1,014) Securities gains, net (1,446) (1,889) (410) Market value adjustment on trading account securities - - (3) Proceeds on liquidation of trading account - - 2,578 Loans originated for sale (44,035) (23,408) (13,601) Proceeds on sales of loans 49,563 27,672 17,678 Net gain on sales of loans (373) (131) (74) Increase in accrued interest receivable (354) (530) (554) Increase in accrued interest payable 449 186 570 Other, net (2,265) (1,196) (79) ------- ------- ------- Net cash provided by operating activities 13,790 10,297 14,849 ------- ------- ------- Cash Flows from Investing Activities: Purchase of time deposits (33) (122) (2) Proceeds on maturities of time deposits 201 100 6 Proceeds from the sale of securities available for sale 20,053 22,747 32,406 Proceeds from the sale of mortgage-backed securities available for sale 3,980 1,621 8,414 Proceeds from the maturity of and principal paydowns on securities held to maturity 2,732 717 12,135 Proceeds from the maturity of and principal paydowns on securities available for sale 13,647 36,384 12,644 Proceeds from the maturity of and principal paydowns on mortgage-backed securities held to maturity - - 868 Proceeds from the maturity of and principal paydowns on mortgage-backed securities available for sale 13,175 11,767 8,380 Purchase of securities held to maturity - (500) - Purchase of securities available for sale (24,485) (58,841) (55,659) Purchase of mortgage-backed securities available for sale (30,612) (49,170) (9,701) Purchase of interest in low- income housing project - (2,865) (3,142) Net increase in loans and leases (55,546) (33,384) (37,269) Net increase in assets under operating leases (3,259) - - Capital expenditures (2,522) (5,589) (2,209) Net cash and cash equivalents (paid)/received in acquisition of subsidiaries 670 (43) - Proceeds on sale of fixed assets 1 2 61 Proceeds on sale of repossessed assets 7 208 197 -------- -------- -------- Net cash used by investing activities (61,991) (76,968) (32,871) Cash Flows from Financing Activities: Net increase in demand deposits and savings accounts 17,137 19,663 1,618 Net increase in time deposit accounts 15,182 4,093 19,730 Net increase in other borrowings 23,886 4,500 21,838 Net increase (decrease) in short-term borrowings 11,483 25,039 (1,036) Purchase of treasury stock (865) (759) (2,855) Proceeds from sale of treasury stock 948 1,296 236 Dividends (2,465) (1,886) (2,360) -------- -------- -------- Net cash provided by financing activities 65,306 51,946 37,171 -------- -------- -------- Net increase (decrease) in cash and cash equivalents 17,105 (14,725) 19,149 Cash and cash equivalents at beginning of year 40,080 54,805 35,656 -------- -------- -------- Cash and cash equivalents at end of period $57,185 $40,080 $54,805 ======== ======== ======== Supplemental disclosures: Cash paid for income/franchise taxes $ 3,090 $ 3,065 $ 1,754 Cash paid for interest $31,318 $27,458 $24,959 Securities contributed to public charitable trust fund - $ 220 - Other borrowings transferred to short-term borrowings $25,500 $ 8,000 - Securities transferred from held to maturity to available for sale - - $23,204 Mortgage-backed securities transferred from held to maturity to available for sale - - $ 4,449 See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) ONE SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations-Heartland Financial USA, Inc. ("Heartland") is a multi-bank holding company primarily operating full-service retail banking offices in Dubuque and Lee Counties in Iowa, Jo Daviess, Hancock and Winnebago Counties in Illinois and Dane County in Wisconsin, serving communities in and around those counties. The principal services of Heartland, through its subsidiaries, are FDIC-insured deposit accounts and related services, and loans to businesses and individuals. The loans consist primarily of commercial and commercial real estate and residential real estate. Principles of Presentation-The consolidated financial statements include the accounts of Heartland and its wholly-owned subsidiaries: Dubuque Bank and Trust Company ("DB&T"), DB&T Insurance, Inc., DB&T Community Development Corp., Galena State Bank and Trust Company ("GSB"), Riverside Community Bank ("RCB"), Wisconsin Community Bank ("WCB", previously Cottage Grove State Bank), First Community Bank, FSB ("FCB"), Citizens Finance Co.("Citizens"), ULTEA, Inc. ("ULTEA"), DBT Investment Corporation and Keokuk Bancshares, Inc. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and with general practice within the banking industry. In preparing such financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for possible loan and lease losses. Securities-All securities consist of debt or marketable equity securities. Trading Securities-Trading securities represent those which Heartland intends to actively trade and are stated at fair value with changes in market value reflected in other income. Securities Available for Sale-Available for sale securities consist of those securities not classified as held to maturity or trading, which management intends to hold for indefinite periods of time or that may be sold in response to changes in interest rates, prepayments or other similar factors. Such securities are stated at fair value with any unrealized gain or loss, net of applicable income tax, reported as a separate component of stockholders' equity. Security premiums and discounts are amortized/accreted using the interest method over the period from the purchase date to the maturity or call date of the related security. Gains or losses from the sale of available for sale securities are determined based upon the adjusted cost of the specific security sold. Securities Held to Maturity-Securities which Heartland has the ability and positive intent to hold to maturity are classified as held to maturity. Such securities are stated at amortized cost, adjusted for premiums and discounts that are amortized/accreted using the interest method over the period from the purchase date to the maturity date of the related security. Loans and Leases-Interest on loans is accrued and credited to income based primarily on the principal balance outstanding. Income from leases is recorded in decreasing amounts over the term of the contract resulting in a level rate of return on the lease investment. The policy of Heartland is to discontinue the accrual of interest income on any loan or lease when, in the opinion of management, there is a reasonable doubt as to the timely collection of the interest and principal. When interest accruals are deemed uncollectible, interest credited to income in the current year is reversed and interest accrued in prior years is charged to the allowance for possible loan and lease losses. Nonaccrual loans and leases are returned to an accrual status when, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the timely payment of interest and principal. Under Heartland's credit policies, all nonaccrual and restructured loans are defined as impaired loans. Loan impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, except where more practical, at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent. Net nonrefundable loan and lease origination fees and certain direct costs associated with the lending process are deferred and recognized as a yield adjustment over the life of the related loan or lease. Loans held for sale are stated at the lower of individual cost or estimated fair value. Loans are sold on a nonrecourse basis with servicing retained, and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan. Mortgage loan servicing rights retained on loans sold to others, which are not material to the financial position or results of operation, are not included in the accompanying consolidated financial statements. The unpaid principal balances of these loans as of December 31, 1997 and 1996, were $109,203 and $84,515, respectively. Custodial escrow balances maintained in connection with the loan servicing were approximately $667 and $511 as of December 31, 1997 and 1996, respectively. Allowance for Possible Loan and Lease Losses-The allowance for possible loan and lease losses is maintained at a level estimated by management to provide for known and inherent risks in the loan and lease portfolios. The allowance is based upon a continuing review of past loan and lease loss experience, current economic conditions, volume growth, the underlying collateral value of the loans and leases and other relevant factors. Loans and leases which are deemed uncollectible are charged off and deducted from the allowance. Provisions for possible loan and lease losses and recoveries on previously charged-off loans and leases are added to the allowance. Premises, Furniture and Equipment-Premises, furniture and equipment are stated at cost less accumulated depreciation. The provision for depreciation of premises, furniture and equipment is determined by straight-line and accelerated methods over the estimated useful lives of 18 to 39 years for buildings, 15 years for land improvements and 3 to 7 years for furniture and equipment. Other Real Estate-Other real estate represents property acquired through foreclosures and settlements of loans. Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less cost to dispose. The excess, if any, of such costs at the time acquired over the fair value is charged against the allowance for possible loan and lease losses. Subsequent write downs estimated on the basis of later evaluations, gains or losses on sales and net expenses incurred in maintaining such properties are charged to operations. Goodwill-Goodwill represents the excess of the purchase price of acquired subsidiaries' net assets over their fair value. Goodwill is amortized over periods from 15 to 25 years on the straight- line basis. On a periodic basis, Heartland reviews goodwill for events or circumstances that may indicate a change in the recoverability of the underlying basis. Income Taxes-Heartland and its subsidiaries file a consolidated federal income tax return. For state tax purposes, DB&T, GSB, FCB, WCB and RCB ("Banks")file income or franchise tax returns as required. The other entities file corporate income or franchise tax returns as required by the various states. Heartland has a tax allocation agreement which provides that each subsidiary of the consolidated group pay a tax liability to, or receive a tax refund from Heartland, computed as if the subsidiary had filed a separate return. Heartland recognizes certain income and expenses in different time periods for financial reporting and income tax purposes. The provision for deferred income taxes is based on an asset and liability approach and represents the change in deferred income tax accounts during the year, including the effect of enacted tax rate changes. Deferred tax assets are recognized if their expected realization is "more likely than not". Treasury Stock-Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price. Trust Department Assets-Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Banks. Earnings Per Share - Basic earning per share, pursuant to Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings Per Share" ("SFAS No. 128"), is determined using net income and weighted average common shares outstanding. Diluted earnings per share, as defined by SFAS No. 128, is computed by dividing net income by the weighted average common shares and assumed incremental common shares issued. Amounts used in the determination of basic and diluted earnings per share for the years ended December 31, 1997, 1996, and 1995 are shown in the table below. 1997 1996 1995 ------ ------ ------- Net income $8,515 $8,006 $7,574 ====== ====== ====== Weighted average common shares outstanding 4,738 4,715 4,805 Assumed incremental common shares issued upon exercise of stock options 50 20 3 ------ ------ ------ Weighted average common shares for diluted earnings per share 4,788 4,735 4,808 ====== ====== ====== Cash Flows-For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. Effect of New Financial Accounting Standards - SFAS No. 125 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS No. 125") was effective for Heartland for transactions occurring after December 31, 1996, and provided standards for accounting recognition or derecognition of assets and liabilities. The adoption of SFAS No. 125 did not have a material effect on Heartland. SFAS No. 130 "Reporting Comprehensive Income" will be effective for Heartland for the year beginning January 1, 1998, and establishes the standards for the reporting and display of comprehensive income in the financial statements. Comprehensive income represents net earnings and certain amounts reported directly in stockholders' equity, such as the net unrealized gain or loss on available for sale securities. TWO ACQUISITIONS Heartland regularly explores opportunities for acquisitions of financial institutions and related businesses. Generally, management does not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. On March 1, 1997, Heartland acquired Cottage Grove State Bank (subsequently named WCB), a $39,287 Wisconsin state bank located in Cottage Grove, Wisconsin, at a cost of $7,890. The stockholders of Cottage Grove State Bank, at the date of acquisition, received cash of $4,892 and the remaining balance in contracts payable over three or four years, at their discretion, bearing rates of 7.00% and 7.50%, respectively. The amount paid in excess of the equity of WCB allocated to securities and office property and equipment was $138 and $672, respectively. The amounts are being amortized over the remaining lives of the assets using the methods and lives as described in note one. The remaining purchase price paid in excess of the fair value of net assets acquired was $2,465 and is being amortized using the straight-line method over 25 years. This transaction was accounted for as a purchase; accordingly, WCB's results of operations were included in the consolidated financial statements from the acquisition date. Pro forma unaudited operating results, giving effect to the WCB acquisition as if it had occurred at the beginning of the years ended December 31, 1997 and 1996 are as follows: 1997 1996 ---- ---- Interest income $59,749 $54,758 Interest expense 32,037 29,214 Provision for loan losses 1,334 1,492 Noninterest income 8,606 7,623 Noninterest expense 23,075 20,527 ------- ------- Income before income taxes 11,909 11,148 Income taxes 3,374 2,913 ------- ------- Net income $ 8,535 $ 8,235 ======= ======= Earnings per common share-basic $ 1.80 $ 1.75 ======= ======= On December 24, 1996, Heartland acquired all of the assets and assumed certain liabilities of ULTEA, LLC of Madison, Wisconsin, in exchange for 16,160 shares of Heartland common stock. ULTEA had total assets of $1,916 at December 31, 1996. The excess of the purchase price over the fair value of net assets acquired was $293. The acquisition was accounted for as a purchase transaction and, accordingly, the operations of ULTEA were included in the consolidated results of operations of Heartland beginning December 25, 1996. The acquisition did not have a material effect on the results of operations for the year of acquisition on either an actual or pro forma basis. During the fourth quarter of 1997, Heartland entered into an agreement with a group of New Mexico business leaders to establish a new bank in Albuquerque. Pending regulatory approval, the new bank will begin operations in the spring of 1998. Heartland's portion of the $15,000 initial capital investment is $12,000, of which $1,200 has already been advanced. THREE CASH AND DUE FROM BANKS The Banks are required to maintain certain average cash reserve balances as a member of the Federal Reserve System. The reserve balance requirements at December 31, 1997 and 1996, were $1,420 and $4,470 respectively. FOUR SECURITIES The amortized cost, gross unrealized gains and losses and estimated fair values of held to maturity and available for sale securities as of December 31, 1997 and 1996, are summarized as follows: Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value -------- -------- -------- -------- 1997 Securities held to maturity: U. S. government corporations and agencies $ 598 $ 2 $ - $ 600 Mortgage-backed securities 325 - - 325 Obligations of states and political subdivisions 2,956 119 (1) 3,074 -------- -------- --------- -------- Total $ 3,879 $ 121 $ (1) $ 3,999 ======== ======== ========= ======== Securities available for sale: U.S. Treasury securities $ 13,232 $ 110 $ - $ 13,342 U.S. government corporations and agencies 63,649 177 (64) 63,762 Mortgage-backed securities 86,010 813 (133) 86,690 Obligations of states and political subdivisions 16,741 1,054 (49) 17,746 Corporate debt securities 700 24 - 724 -------- -------- --------- -------- Total debt securities 180,332 2,178 (246) 182,264 Mutual funds 548 - (36) 512 Equity securities 12,925 2,199 (31) 15,093 -------- -------- --------- -------- Total $193,805 $ 4,377 $ (313) $197,869 ======== ======== ========= ======== Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value -------- -------- -------- -------- 1996 Securities held to maturity: Obligations of states and political subdivisions $ 2,151 $ 94 $ - $ 2,245 -------- -------- -------- -------- Total $ 2,151 $ 94 $ - $ 2,245 ======== ======== ======== ======== Securities available for sale: U.S. Treasury securities $ 14,016 $ 101 $ - $ 14,117 U.S. government corporations and agencies 61,431 235 (334) 61,332 Mortgage-backed securities 74,522 754 (259) 75,017 Obligations of states and political subdivisions 15,846 903 (88) 16,661 Corporate debt securities 1,300 41 - 1,341 -------- -------- --------- -------- Total debt securities 167,115 2,034 (681) 168,468 Mutual funds 548 - (41) 507 Equity securities 12,034 859 (53) 12,840 -------- -------- --------- -------- Total $179,697 $ 2,893 $ (775) $181,815 ======== ======== ========= ======== The amortized cost and estimated fair value of debt securities held to maturity and available for sale at December 31, 1997, by contractual maturity, are as follows. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without penalties. Estimated Amortized Fair Cost Value --------- --------- Securities held to maturity: Due in 1 year or less $ 350 $ 350 Due in 1 to 5 years 1,810 1,832 Due in 5 to 10 years 1,374 1,441 Due after 10 years 345 376 -------- -------- Total $ 3,879 $ 3,999 ======== ======== Securities available for sale: Due in 1 year or less $ 44,928 $ 44,988 Due in 1 to 5 years 45,150 45,789 Due in 5 to 10 years 26,020 26,357 Due after 10 years 64,234 65,130 -------- -------- Total $180,332 $182,264 ======== ======== As of December 31, 1997, securities with a market value of $113,126 were pledged to secure public and trust deposits, short- term borrowings and for other purposes as required by law. Gross gains and losses related to sales of securities for the years ended December 31, 1997, 1996 and 1995, are summarized as follows: 1997 1996 1995 -------- -------- -------- Securities sold: Proceeds from sales $24,033 $24,368 $40,820 Gross security gains 1,526 2,240 571 Gross security losses 80 351 158 FIVE LOANS AND LEASES Loans and leases as of December 31, 1997 and 1996, were as follows: 1997 1996 ------ ------ Loans: Commercial and commercial real estate $242,868 $206,523 Residential mortgage 175,268 166,999 Agricultural and agricultural real estate 69,302 57,526 Consumer 64,223 48,361 --------- --------- Loans, gross 551,661 479,409 Unearned discount (2,077) (1,962) Deferred loan fees (349) (404) --------- --------- Loans, net 549,235 477,043 --------- --------- Direct financing leases: Gross rents receivable 6,240 5,603 Estimated residual value 2,097 2,319 Unearned income (1,166) (880) --------- --------- Direct financing leases, net 7,171 7,042 --------- -------- Allowance for possible loan and lease losses (7,362) (6,191) --------- --------- Loans and leases, net $549,044 $477,894 ========= ========= Direct financing leases receivable are generally short-term equipment leases. Future minimum lease payments as of December 31, 1997, are as follows: 1998 $2,563; 1999, $2,073; 2000, $1,383; 2001, $1,125; 2002, $908 and thereafter, $285. As DB&T is the largest subsidiary of Heartland, the majority of the loan portfolio is concentrated in northeast Iowa, northwest Illinois and southwest Wisconsin. Loans and leases on a nonaccrual status amounted to $1,819 and $1,697 at December 31, 1997 and 1996, respectively. The allowance for loan and lease losses related to these nonaccrual loans was $208 and $198, respectively. Nonaccrual loans of $1,163 and $1,210 were not subject to a related allowance for loan and lease losses at December 31, 1997 and 1996, respectively, because of the net realizable value of loan collateral, guarantees and other factors. The average balances of nonaccrual loans for the years ended December 31, 1997, 1996 and 1995 were $1,585, $1,212 and $758, respectively. For the years ended December 31, 1997, 1996 and 1995, interest income which would have been recorded under the original terms of these loans and leases amounted to approximately $87, $108 and $54, respectively and interest income actually recorded amounted to approximately $9, $7 and $14 respectively. Loans are made in the normal course of business to directors, officers and principal holders of equity securities of Heartland. The terms of these loans, including interest rates and collateral, are similar to those prevailing for comparable transactions and do not involve more than a normal risk of collectibility. Changes in such loans during the year ended December 31, 1997, were as follows: 1997 -------- Balance at beginning of year $14,408 New loans 9,190 Repayments (8,183) -------- Balance at end of year $15,415 ======== SIX ALLOWANCE FOR POSSIBLE LOAN AND LEASE LOSSES Changes in the allowance for possible loan and lease losses for the years ended December 31, 1997, 1996 and 1995, were as follows: 1997 1996 1995 ------ ------ ------- Balance at beginning of year $6,191 $5,580 $5,124 Provision for possible loan and lease losses 1,279 1,408 820 Recoveries on loans and leases previously charged off 145 129 131 Loans and leases charged off (584) (926) (495) Additions related to acquisitions 331 - - -------- ------- ------- Balance at end of year $7,362 $6,191 $5,580 ======== ======= ======= SEVEN PREMISES, FURNITURE AND EQUIPMENT Premises, furniture and equipment as of December 31, 1997 and 1996, were as follows: 1997 1996 ------- ------- Land and land improvements $ 2,107 $ 1,774 Buildings and building improvements 15,366 13,953 Furniture and equipment 12,064 10,034 ------- ------- Total 29,537 25,761 Less accumulated depreciation (11,191) (9,046) ------- ------- Premises, furniture and equipment, net $18,346 $16,715 ======= ======= Depreciation expense on premises, furniture and equipment was $1,786 for 1997, $1,221 for 1996 and $1,100 for 1995. EIGHT DEPOSITS The aggregate amount of time certificates of deposit in denominations of one hundred thousand dollars or more as of December 31, 1997 and 1996, were $38,885 and $36,087, respectively. At December 31, 1997, the scheduled maturities of time certificates of deposit were as follows: 1997 --------- 1998 $162,353 1999 72,934 2000 43,289 2001 18,930 2002 thereafter 12,784 -------- Total $310,290 ======== Interest expense on deposits for the years ended December 31, 1997, 1996 and 1995, was as follows: 1997 1996 1995 ------ ------ ------ Savings and insured money market accounts $ 8,317 $ 7,474 $ 7,338 Time certificates of deposit in denominations of $100 or more 1,961 2,131 1,658 Other time deposits 15,487 13,585 13,033 ------- ------- ------- Interest expense on deposits $25,765 $23,190 $22,029 ======= ======= ======= NINE SHORT-TERM BORROWINGS Short-term borrowings as of December 31, 1997 and 1996, were as follows: 1997 1996 ------- ------- Securities sold under agreements to repurchase $45,328 $18,185 Federal funds purchased 6,550 23,450 Federal Home Loan Bank ("FHLB") advances 27,500 10,000 U.S. Treasury demand note 15,728 4,645 Notes payable on leased assets 310 78 Contracts payable to previous stockholders of WCB for acquisition 823 - ------- ------- Total $96,239 $56,358 ======= ======= See Note 11 related to collateral pledged for FHLB advances. All repurchase agreements as of December 31, 1997 and 1996, were due within six months. Average and maximum balances and rates on aggregate short-term borrowings outstanding during the years ended December 31, 1997, 1996 and 1995, were as follows: 1997 1996 1995 ------- ------- ------- Maximum month-end balance $96,239 $56,358 $42,205 Average month-end balance 73,170 42,025 25,965 Weighted average interest rate for the year 5.32% 5.24% 5.71% Weighted average interest rate at year-end 5.49 5.75 5.56 TEN INCOME TAXES Income taxes for the years ended December 31, 1997, 1996 and 1995, were as follows: Current Deferred Total ------------------------- 1997: Federal $2,977 $ (47) $2,930 State 428 (20) 408 ------ ------ ------ Total $3,405 $ (67) $3,338 ====== ====== ====== 1996: Federal $2,291 $ (42) $2,249 State 500 (64) 436 ------ ------ ------ Total $2,791 $ (106) $2,685 ====== ====== ====== 1995: Federal $2,258 $ 243 $2,501 State 347 36 383 ------ ------ ------ Total $2,605 $ 279 $2,884 ====== ====== ====== Temporary differences between the amounts reported in the financial statements and the tax basis of assets and liabilities result in deferred taxes. No valuation allowance was required for deferred tax assets. Based upon Heartland's level of historical taxable income and anticipated future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that Heartland will realize the benefits of these deductible differences. Deferred tax liabilities and assets for the years ended December 31, 1997, and 1996, were as follows: 1997 1996 ------ ------ Deferred tax assets: Allowance for possible loan and lease losses $2,710 $ 2,385 Loan origination fees - 52 Deferred compensation 240 246 Bonus payable - 24 Net operating loss 225 175 ------- -------- Gross deferred tax assets $3,175 $ 2,882 ------- -------- Deferred tax liabilities: Unrealized gain on securities available for sale $(1,519) $ (790) Fixed assets (1,440) (1,019) Leases (1,360) (1,418) Tax bad debt reserves (830) (790) Securities (145) (124) Prepaid expenses (120) (95) Discount accretion (35) (13) -------- -------- Gross deferred tax liabilities $(5,449) $(4,249) -------- -------- Net deferred tax (liability) $(2,274) $(1,367) ======== ======== The actual income taxes differ from the expected amounts (computed by applying the U.S. federal corporate tax rate of 35% for 1997, 1996 and 1995, to income before income taxes) as follows: 1997 1996 1995 -------------------------- Computed "expected" amount $4,149 $3,742 $3,660 Increase (decrease) resulting from: Nontaxable interest income (510) (560) (658) State income taxes, net of federal tax benefit 260 280 249 Appreciated property contributed - (230) - Graduated income tax rates (100) (110) (105) Tax credits (440) (440) (200) Other (21) 3 (62) ------ ------ ------- Income taxes $3,338 $2,685 $2,884 ====== ====== ======= Effective tax rates 28.2% 25.1% 27.6% Heartland has investments in certain low-income housing projects totaling $6,028 and $5,993 as of December 31, 1997 and 1996, respectively, which are included in other assets in the consolidated financial statements. These investments are expected to generate federal income tax credits of approximately $440 per year through 2005. ELEVEN OTHER BORROWINGS Other borrowings at December 31, 1997 and 1996, were as follows: 1997 1996 ------- ------- Advances from the FHLB; weighted average maturity dates at December 31, 1997 and 1996, were August, 2001 and November, 2000, respectively; and weighted average interest rates were 6.06% and 5.89%, respectively $36,900 $41,900 Notes payable on leased assets with interest rates varying from 8.25% to 9.75% 622 606 Revolving credit line 3,500 - Contracts payable to previous stock- holders of WCB for acquisition due in annual payments over three-or four-year schedules at interest rates of 7.00% to 7.50% through March, 2001. 2,001 - ------- ------ Total $43,023 $42,506 ======= ======= DB&T, GSB and RCB are members of the FHLB of Des Moines or of Chicago. The advances from the FHLB are collateralized by the Banks' investment in FHLB stock of $6,431 and $5,567 at December 31, 1997, and December 31, 1996, respectively. Additional collateral is provided by the Banks' one-to-four unit residential mortgages totaling $142,777 at December 31, 1997, and $156,775 at December 31, 1996. On October 31, 1997, Heartland entered into a four-year, unsecured revolving credit line with an unaffiliated bank, which provides for variable-rate borrowings of up to $20,000. Under the terms of this agreement, Heartland must maintain a minimum return on average assets, maximum nonperforming assets to total loans ratio, maximum funded debt to total equity capital ratio and each of Heartland's banking subsidiaries must remain well capitalized. Future payments at December 31, 1997, for all other borrowings were as follows: 1999 $ 15,634 2000 11,905 2001 4,084 2002 7,000 Thereafter 4,400 -------- Total $ 43,023 ======== TWELVE EMPLOYEE BENEFIT PLANS The Banks sponsor retirement plans covering substantially all employees. Contributions to the plans are subject to approval by the Boards of Directors of the Banks, which fund and record as an expense all approved contributions. Costs charged to operating expenses were $418 for 1997, $382 for 1996 and $335 for 1995. Heartland also has a non-contributory, defined contribution pension plan covering substantially all employees of the Banks. Annual contributions are based upon 5% of qualified compensation as defined in the plan. Costs charged to operating expense were $418 for 1997, $382 for 1996 and $335 for 1995. The Banks also have employee savings plans covering substantially all employees of the Banks. Under the employee savings plans, the Banks make matching contributions of up to 2% of the participants' wages. Costs charged to operating expenses were $150 for 1997, $140 for 1996 and $124 for 1995. THIRTEEN COMMITMENTS AND CONTINGENT LIABILITIES Heartland leases certain land and facilities under operating leases. Minimum future rental commitments at December 31, 1997, for all non-cancelable leases were as follows: 1998 $208 1999 192 2000 53 2001 36 2002 22 Thereafter 112 ---- Total $623 ==== Rental expense for premises and equipment leased under operating leases was $78 for 1997, $128 for 1996 and $59 for 1995. In the normal course of business, the Banks make various commitments and incur certain contingent liabilities that are not presented in the accompanying consolidated financial statements. The commitments and contingent liabilities include various guarantees, commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based upon management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial properties. Standby letters of credit and financial guarantees written are conditional commitments issued by the Banks to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At December 31, 1997 and 1996, commitments to extend credit aggregated $140,677 and $103,168 and standby letters of credit aggregated $5,267 and $7,750, respectively. Heartland does not anticipate any material loss as a result of the commitments and contingent liabilities. FOURTEEN STOCK PLANS In 1991, Heartland adopted a stock purchase plan which provides executive officers of Heartland and the Banks the opportunity to purchase up to a cumulative total of 200,000 common shares of Heartland stock. Under this plan, Heartland may issue treasury shares at a price equal to the price paid when acquired as treasury shares. Cumulative shares sold through December 31, 1997 and 1996, under the plan were 199,900 and 172,366, respectively. Total compensation expense associated with this plan was $267 and $42 for 1997 and 1996, respectively. No compensation expense was recognized for issuances prior to 1996, as the issuance price was equal to market. A summary of the activity in the executive restricted stock purchase plan for the years ended December 31, 1997, 1996 and 1995 follows: 1997 1996 1995 ------ ------ ------ Granted 27,634 69,538 15,350 Exercised 27,534 41,904 15,350 Forfeited 100 27,634 - Average Offering Price $16.20 $16.20 $14.59 Heartland's Stock Option Plan ("Plan") is administered by the Compensation Committee ("Committee") of the Board of Directors whose members determine to whom options will be granted and the terms of each option. Under the Plan, 600,000 common shares have been reserved for issuance. Directors and key policy-making employees are eligible for participation in the Plan. Options may be granted that are either intended to be "incentive stock options" as defined under Section 422 of the Internal Revenue Code or not intended to be incentive stock options ("non- qualified stock options"). The exercise price of stock options granted will be established by the Committee but may not be less than the fair market value of the shares on the date that the option is granted. Each option granted is exercisable in full at any time or from time to time, subject to vesting provisions, as determined by the Committee and as provided in the option agreement, but such time may not exceed ten years from the grant date. At December 31, 1997 and 1996, respectively, there were 314,003 and 380,753 shares available for issuance under the Plan. Under the Plan, stock appreciation rights ("SARS") may also be granted alone or in tandem with or with reference to a related stock option, in which event the grantee, at the exercise date, has the option to exercise the option or the SARS, but not both. SARS entitle the holder to receive in cash or stock, as determined by the Committee, an amount per share equal to the excess of the fair market value of the stock on the date of exercise over the fair value at the date the SARS or related options were granted. SARS may be exercisable for up to ten years after the date of grant. No SARS have been granted under the Plan. A summary of the status of the Plan as of December 31, 1997, 1996 and 1995, and changes during the years ended follows: 1997 1996 1995 Weighted- Weighted- Weighted- Average Average Average Shares Exercise Shares Exercise Shares Exercise (000) Price (000) Price (000) Price ------ -------- ------ -------- ------ -------- Outstanding at beginning of year 196 $17 124 $16 - $ - Granted 73 24 111 19 124 16 Exercised (2) 26 (23) 21 - - Forfeited (6) 26 (16) 22 - - ---- ---- --- --- Outstanding at end of year 261 $18 196 $17 124 $16 ==== === === Options exercisable at end of year 3 $24 3 $24 - Weighted-average fair value of options granted during the year $7.66 $4.13 $6.60 As of December 31, 1997 and 1996, options outstanding had exercise prices ranging from $16.00 to $24.00 per share and a weighted-average remaining contractual life of 8.00 and 8.62 years, respectively. The fair value of stock options granted was determined utilizing the Black Scholes Valuation model. Significant assumptions include: 1997 1996 1995 ------ ------ ------ Risk-free interest rate 6.30% 5.68% 6.59% Expected option life 10 Years 10 Years 10 Years Expected volatility 24.27% 28.62% 28.62% Expected dividends 2.17% 2.29% 1.88% Heartland applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost for its stock options has been recognized in the financial statements. Had Heartland determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123 "Accounting for Stock-Based Compensation" ("SFAS No. 123"), Heartland's net income would have been reduced to the pro forma amounts indicated below: 1997 1996 1995 ---- ---- ---- Net income as reported $8,515 $8,006 $7,574 Pro forma 8,317 7,853 7,514 Earnings per share-basic as reported $1.80 $1.70 $1.58 Pro forma 1.76 1.67 1.56 Earnings per share-diluted as reported $1.78 $1.69 $1.58 Pro forma 1.74 1.66 1.56 Pro forma net income reflects only options granted in 1997, 1996 and 1995. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net income amounts presented above because compensation is reflected over the options' vesting period, and compensation cost for options granted prior to January 1, 1995, is not considered. In 1996, Heartland adopted the Heartland Employee Stock Purchase Plan ("ESPP"), which permits all eligible employees to purchase shares of Heartland common stock at a price of not less than 85% of the fair market value on the determination date (as determined by the Committee). A maximum of 200,000 shares is available for sale under the ESPP. For the years ended December 31, 1997 and 1996, Heartland approved a price of 100% of fair market value at December 31, 1996 and July 1, 1996, respectively. At December 31, 1997 and 1996, respectively, 9,573 and 6,265 shares were purchased under the ESPP at no charge to Heartland's earnings. During each of the years ended December 31, 1997, 1996 and 1995, Heartland acquired shares for use in the executive stock purchase plan, the Plan and the ESPP. Shares acquired totaled 32,835, 37,309 and 85,138 for 1997, 1996 and 1995, respectively. FIFTEEN FAIR VALUE OF FINANCIAL INSTRUMENTS Following are disclosures of the estimated fair value of Heartland's financial instruments. The estimated fair value amounts have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts Heartland could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. December 31, December 31, 1997 1996 ------------------------------------- Carrying Fair Carrying Fair Amount Value Amount Value ------------------------------------- Financial Assets: Cash and cash equivalents $ 57,185 $ 57,185 $ 40,080 $ 40,080 Time deposits in other banks 194 194 167 167 Securities available for sale 197,869 197,869 181,815 181,815 Securities held to maturity 3,879 3,999 2,151 2,245 Loans and leases, net of unearned 556,406 558,515 484,085 484,828 Financial Liabilities: Demand deposits $ 60,950 $ 60,950 $ 55,482 $ 55,482 Savings deposits 252,292 252,292 224,317 224,317 Time deposits 310,290 310,869 278,544 280,353 Short-term borrowings 96,239 96,239 56,358 56,368 Other borrowings 43,023 43,288 42,506 42,420 Cash and Cash Equivalents and Time Deposits in Other Banks - The carrying amount is a reasonable estimate of fair value. Securities - For securities either held to maturity or available for sale, fair value equals quoted market price if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans and Leases - The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value of loans held for sale is estimated using quoted market prices. Deposits - The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Short-term and Other Borrowings - Rates currently available to the Banks for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. Commitments to Extend Credit, Unused Lines of Credit and Standby Letters of Credit - Based upon management's analysis of the off balance sheet financial instruments, there are no significant unrealized gains or losses associated with these financial instruments based upon our review of the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. SIXTEEN REGULATORY CAPITAL REQUIREMENTS AND RESTRICTIONS ON SUBSIDIARY DIVIDENDS The Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Banks' financial statements. The regulations prescribe specific capital adequacy guidelines that involve quantitative measures of a bank's assets, liabilities and certain off balance sheet items as calculated under regulatory accounting practices. Capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Banks to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 1997 and 1996, that the Banks met all capital adequacy requirements to which they were subject. As of December 31, 1997, the most recent notification from the FDIC categorized each of the Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Banks must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution's category. The Banks' actual capital amounts and ratios are also presented in the table below. To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------- ----- As of December 31, 1997 Total Capital (to Risk- Weighted Assets) Consolidated $78,995 12.71% $49,707 >8.0% N/A DB&T 43,180 10.92 31,629 >8.0 $39,537 >10.0% GSB 9,526 13.09 5,821 >8.0 7,276 >10.0 FCB 9,068 11.05 6,563 >8.0 8,204 >10.0 RCB 3,710 12.04 2,465 >8.0 3,081 >10.0 WCB 4,855 18.32 2,120 >8.0 2,650 >10.0 Tier 1 Capital (to Risk- Weighted Assets) Consolidated $71,713 11.54% $24,854 >4.0% N/A DB&T 38,754 9.80 15,815 >4.0 $23,722 > 6.0% GSB 8,615 11.84 2,910 >4.0 4,366 > 6.0 FCB 8,197 9.99 3,282 >4.0 4,922 > 6.0 RCB 3,354 10.89 1,232 >4.0 1,849 > 6.0 WCB 4,524 17.07 1,060 >4.0 1,590 > 6.0 Tier 1 Capital (to Average Assets) Consolidated $71,713 8.76% $32,729 >4.0% N/A DB&T 38,754 7.81 19,841 >4.0 $24,801 > 5.0% GSB 8,615 7.06 4,883 >4.0 6,103 > 5.0 FCB 8,197 7.53 4,355 >4.0 5,444 > 5.0 RCB 3,354 7.79 1,723 >4.0 2,153 > 5.0 WCB 4,524 11.11 1,628 >4.0 2,035 > 5.0 To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------- ----- As of December 31, 1996 Total Capital (to Risk- Weighted Assets) Consolidated $73,777 14.28% $41,334 >8.0% N/A DB&T 43,882 12.67 27,709 >8.0 $34,637 >10.0% GSB 9,140 13.74 5,322 >8.0 6,652 >10.0 FCB 13,322 15.17 7,026 >8.0 8,783 >10.0 RCB 3,171 19.42 1,306 >8.0 1,633 >10.0 Tier 1 Capital (to Risk- Weighted Assets) Consolidated $67,701 13.10% $20,667 >4.0% N/A DB&T 39,593 11.43 13,855 >4.0 $20,782 > 6.0% GSB 8,307 12.49 2,661 >4.0 3,991 > 6.0 FCB 12,603 14.35 3,513 >4.0 5,270 > 6.0 RCB 3,029 18.55 653 >4.0 980 > 6.0 Tier 1 Capital (to Average Assets) Consolidated $67,701 9.54% $28,375 >4.0% N/A DB&T 39,593 8.50 18,634 >4.0 $23,293 > 5.0% GSB 8,307 7.52 4,416 >4.0 5,520 > 5.0 FCB 12,603 10.93 4,613 >4.0 5,766 > 5.0 RCB 3,029 12.16 996 >4.0 1,245 > 5.0 The ability of Heartland to pay dividends to its stockholders is dependent upon dividends paid by its subsidiaries. The Banks are subject to certain statutory and regulatory restrictions on the amount they may pay in dividends. To maintain acceptable capital ratios in the Banks, certain portions of their retained earnings are not available for the payment of dividends. Retained earnings which could be available for the payment of dividends to Heartland totaled approximately $21,741 as of December 31, 1997, under the most restrictive minimum capital requirements. SEVENTEEN PARENT COMPANY ONLY FINANCIAL INFORMATION Condensed financial information for Heartland Financial USA, Inc. is as follows: Balance Sheets December 31, 1997 1996 --------- --------- Assets: Cash and interest bearing deposits $ 716 $ 3,208 Investment in subsidiaries 80,584 66,722 Other assets 1,703 204 Due from subsidiaries 1,350 215 --------- --------- Total $ 84,353 $ 70,349 ========= ========= Liabilities and stockholders' equity: Liabilities: Contracts payable for acquisition of WCB $ 2,824 $ - Notes payable 3,500 - Accrued expenses and other liabilities 257 90 --------- --------- Total liabilities 6,581 90 --------- --------- Stockholders' equity: Common stock 4,854 4,854 Capital surplus 13,706 13,366 Retained earnings 58,914 52,864 Net unrealized gain on securities available for sale 2,545 1,327 Treasury stock (2,247) (2,152) --------- --------- Total stockholders' equity 77,772 70,259 --------- --------- Total $ 84,353 $ 70,349 ========= ========= Income Statements for the Years Ended December 31, 1997 1996 1995 ------ ------ ------ Operating revenues: Dividends from subsidiaries $2,621 $5,611 $6,574 Other 10 4 - ------ ------ ------ Total operating revenues 2,631 5,615 6,574 ------ ------ ------ Operating expenses: Outside services 219 197 154 Other operating expenses 350 443 460 Interest 208 - - ------ ------ ------ Total operating expenses 777 640 614 ------ ------ ------ Equity in undistributed earnings 6,398 2,815 1,421 ------ ------ ------ Income before income tax benefit 8,252 7,790 7,381 Income tax benefit 263 216 193 ------ ------ ------ Net income $8,515 $8,006 $7,574 ====== ====== ====== Statements of Cash Flows For the Years Ended December 31, 1997 1996 1995 ------ ------ ------ Cash flows from operating activities: Net income $8,515 $8,006 $7,574 Adjustments to reconcile net income to net cash provided by operating activities: Undistributed earnings of subsidiaries (6,398) (2,815) (1,421) (Increase) decrease in due from subsidiaries (1,135) (215) 720 Increase (decrease) in other liabilities 167 (54) 17 (Increase) decrease in other assets (1,499) (178) 94 ------- ------- ------- Net cash provided (used) by operating activities (350) 4,744 6,984 ------- ------- ------- Cash flows from investing activities: Capital injections for subsidiaries (2,855) (543) (4,000) Payments for purchase of subsidiaries (7,890) - - Retirement of subsidiary stock 4,500 - - Other - - 18 ------- ------- ------- Net cash used by investing activities (6,245) (543) (3,982) ------- ------- ------- Cash flows from financing activities: Payments on other borrowings (1,042) - (162) Proceeds from contracts payable 3,865 - - Proceeds from notes payable 3,500 - - Cash dividends paid (2,465) (1,886) (2,360) Purchase of treasury stock (865) (759) (2,855) Sale of treasury stock 1,110 1,296 236 ------- ------- ------- Net cash provided (used) by financing activities 4,103 (1,349) (5,141) ------- ------- ------- Net increase (decrease) in cash and cash equivalents (2,492) 2,852 (2,139) Cash and cash equivalents at beginning of year 3,208 356 2,495 ------- ------- ------- Cash and cash equivalents at end of year $ 716 $3,208 $ 356 ======= ======= ======= Representations of Management Management is responsible for the contents of the consolidated financial statements and other information contained in other sections of this annual report. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles appropriate to reflect, in all material respects, the substance of events and transactions that should be included. The consolidated financial statements reflect management's judgments and estimates as to the effects of events and transactions that are accounted for or disclosed. The company maintains accounting and reporting systems, supported by an internal accounting control system, which are adequate to provide reasonable assurance that transactions are authorized, assets are safeguarded, and reliable consolidated financial statements are prepared, recognizing the cost and expected benefits of internal accounting controls. A staff of internal auditors conducts ongoing reviews of accounting practices and internal accounting controls. The consolidated financial statements as of December 31, 1997, 1996 and 1995, of Heartland Financial USA, Inc. and its wholly- owned subsidiaries: Dubuque Bank and Trust Company; DB&T Insurance, Inc.; DB&T Community Development Corp.; Galena State Bank and Trust Company; Riverside Community Bank; Keokuk Bancshares, Inc.; First Community Bank, FSB; Wisconsin Community Bank; Citizens Finance Co.; ULTEA, Inc. and DBT Investment Corporation were audited by independent certified public accountants. Their role is to render independent professional opinions of the fairness of the consolidated financial statements based upon performance of procedures they deem appropriate under generally accepted auditing standards. The Audit Committees of the Boards of Directors of member banks meet periodically with the internal auditors to review matters relating to internal accounting controls and the nature, extent and results of audit efforts. The internal auditors and independent certified public accountants have free access to the Audit Committees. /s/ Lynn B. Fuller Lynn B. Fuller President, Heartland Financial USA, Inc; President and CEO, Dubuque Bank and Trust Company /s/ John K. Schmidt John K. Schmidt Executive Vice President and CFO, Heartland Financial USA, Inc.; Senior Vice President and CFO, Dubuque Bank and Trust Company INDEPENDENT AUDITORS' REPORT The Board of Directors Heartland Financial USA, Inc. We have audited the accompanying consolidated balance sheets of Heartland Financial USA, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heartland Financial USA, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP Des Moines, IA January 22, 1998 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information in the Heartland Proxy Statement for the 1998 annual meeting of stockholders dated April 6, 1998, (the "1998" Proxy Statement") under the caption "Election of Directors" and under the caption "Security Ownership of Directors and Executive Officers and Certain Beneficial Owners" is incorporated by reference. The information regarding executive officers is included pursuant to Instruction 3 to Item 401 (b) and (c) of Regulation S-K and is noted below. EXECUTIVE OFFICERS The term of office for the executive officers of Heartland is from the date of election until the next annual organizational meeting of the Board of Directors. The names and ages of the executive officers of Heartland as of December 31, 1997, offices held by these officers on that date and other positions held with Heartland and its subsidiaries are set forth below. Position with Heartland and Subsidiaries Name Age and Principal Occupation Lynn B. Fuller 48 Director and President of Heartland; Director, President and Chief Executive Officer of DB&T; Director of GSB, FCB, WCB, Keokuk, DB&T Insurance, Citizens, DBT Investment and DB&T Development; President of DB&T Insurance, DB&T Development and Citizens; Chairman and Director of RCB; Chairman and Director of ULTEA. Lynn S. Fuller 73 Chairman of the Board and Chief Executive Officer of Heartland; Director and Vice Chairman of the Board of DB&T; Director of DB&T Insurance, Citizens and DB&T Development James A. Schmid 74 Vice Chairman of the Board of Heartland; Chairman of the Board of DB&T; Director of DB&T Insurance, Citizens and DB&T Development John K. Schmidt 38 Executive Vice President and Chief Financial Officer of Heartland; Senior Vice President and Chief Financial Officer of DB&T; Treasurer of DB&T Insurance and Citizens; Director of DBT Investment; Vice President and Assistant Secretary of ULTEA Greg R. Miller 49 Executive Vice President of Heartland; Director and Vice-Chairman of the Board of FCB Kenneth J. Erickson 46 Senior Vice President of Heartland; Senior Vice President, Lending of DB&T; Senior Vice President of Cit- izens; Director of ULTEA Edward H. Everts 46 Senior Vice President, Heartland; Senior Vice President of Operations and Retail Banking of DB&T Douglas J. Horstmann 44 Senior Vice President, Lending of Heartland; Senior Vice President, Lending of DB&T; Executive Vice President of DB&T Development Paul J. Peckosh 52 Senior Vice President, Trust of DB&T Mr. Lynn B. Fuller is the son of Mr. Lynn S. Fuller. There are no other family relationships among any of the directors or executive officers of Heartland. Lynn B. Fuller has been a director of Heartland and of DB&T since 1984 and has been President of Heartland and DB&T since 1987. He has been a director of GSB since its acquisition by Heartland in 1992 and of Keokuk and FCB since the merger in 1994. Mr. Fuller joined DB&T in 1971 as a consumer loan officer and was named DB&T's Executive Vice President and Chief Executive Officer in 1985. He was named Chairman and Director of RCB in conjunction with the opening of the de novo operation in 1995. Lynn S. Fuller has been a director of Heartland since its formation in 1981 and of DB&T since 1964. Mr. Fuller began his banking career in 1946 in Minnesota, and he returned to Iowa in 1949 to serve as Executive Vice President and Cashier of Jackson State Savings Bank in Maquoketa. Mr. Fuller joined DB&T in 1964. He was later named President of DB&T and held this position until 1987. Mr. Fuller remains as the Chairman of the Board and Chief Executive Officer of Heartland. James A. Schmid has been a director of Heartland since its formation in 1981 and of DB&T since 1966. Mr. Schmid also currently serves as the Vice Chairman of Heartland and as the Chairman of the Board of DB&T. John K. Schmidt has been Heartland's Executive Vice President and Chief Financial Officer since 1991. He has been employed by DB&T since September, 1984 and became DB&T's Vice President, Finance in 1986, and Senior Vice President and Chief Financial Officer in January, 1991. Mr. Schmidt is a certified public accountant and worked at KPMG Peat Marwick in Des Moines, Iowa, from 1982 until joining DB&T. Greg R. Miller was appointed Executive Vice President of Heartland in 1996. Mr. Miller joined FCB in 1987 as Executive Vice President and was appointed President and Chief Executive Officer of FCB in 1988 and held these positions until 1997. Mr. Miller remains as Vice-Chairman of the Board of FCB. He became a Heartland director in 1994 in conjunction with the merger of Heartland with FCB. Mr. Miller is a certified public accountant and was the Chief Executive Officer of Keokuk Area Hospital immediately prior to joining FCB. Kenneth J. Erickson has been Senior Vice President of Heartland since 1992 and Senior Vice President, Lending of DB&T since 1989. Mr. Erickson joined DB&T in 1975 and was appointed Vice President, Commercial Loans in 1985. Edward H. Everts was appointed as Senior Vice President of Heartland in 1996. Mr. Everts joined DB&T as Senior Vice President, Operations and Retail Banking in 1992. Prior to his service with DB&T, Mr. Everts was Vice President and Lead Retail Banking Manager of First Bank, Duluth, Minnesota. Douglas J. Horstmann has been Senior Vice President, Lending, of DB&T since 1989. Mr. Horstmann joined DB&T in 1980 and was appointed Vice President, Commercial Loans in 1985. Prior to joining DB&T, Mr. Horstmann was an examiner for the Iowa Division of Banking. Paul J. Peckosh has been Senior Vice President, Trust, of DB&T since 1991. Mr. Peckosh joined DB&T in 1975 as Assistant Vice President, Trust and was appointed Vice President, Trust in 1980. Mr. Peckosh is an attorney and graduated from the Marquette University of Law School in 1970. ITEM 11. EXECUTIVE COMPENSATION The information in the 1998 Proxy Statement, under the caption "Executive Compensation" is incorporated by reference, except for the information contained under the heading "Compensation Committee Report on Executive Compensation" and "Stockholder Return Performance Presentation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the 1998 Proxy Statement, under the caption "Security Ownership of Certain Beneficial Owners and Management" is incorporated by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the 1998 Proxy Statement under the caption "Transactions with Management" is incorporated by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The documents filed as a part of this report are listed below: 3. Exhibits The exhibits required by Item 601 of Regulation S-K are included along with this Form 10-K and are listed on the "Index of Exhibits" immediately following the signature page. (b) Reports of Form 8-K: There were no reports on Form 8-K filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 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 on March 17, 1998. Heartland Financial USA, Inc. By: /s/ Lynn S. Fuller /s/John K. Schmidt - ------------------------ ------------------------ Lynn S. Fuller John K. Schmidt Chairman and Executive Vice President Principal Executive Officer and Principal Financial and Accounting Officer Date: March 17, 1998 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 17, 1998. /s/ Lynn B. Fuller /s/ Lynn S. Fuller - ----------------------------- ----------------------------- Lynn B. Fuller Lynn S. Fuller President and Director Chairman, CEO and Director /s/ James A. Schmid /s/ Mark C. Falb - ----------------------------- ----------------------------- James A. Schmid Mark C. Falb Vice Chairman and Director Director /s/ Gregory R. Miller /s/ Evangeline K. Jansen - ----------------------------- ----------------------------- Gregory R. Miller Evangeline K. Jansen Director and Director Executive Vice President /s/ Robert Woodward - ----------------------------- Robert Woodward Director 3. Exhibits 3.1 Certificate of Incorporation of Heartland Financial USA, Inc. (Filed as Exhibit 3.1 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 3.2 Bylaws of Heartland Financial USA, Inc. (Filed as Exhibit 3.2 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 4.1 Specimen Stock Certificate of Heartland Financial USA, Inc. (Exhibit 4.1 to the Registration Statement on Form S-4 filed with the Commission May 4, 1994, as amended (SEC File No. 33-76228) 10.1 Heartland Financial USA, Inc. 1993 Stock Option Plan (Filed as Exhibit 10.1 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.2 Heartland Financial USA, Inc. Executive Restricted Stock Purchase Plan (Filed as Exhibit 10.2 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.3 Dubuque Bank and Trust Management Incentive Compensation Plan (Filed as Exhibit 10.3 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.4 Dubuque Bank and Trust Executive Death Benefit Plan (Filed as Exhibit 10.4 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.5 ATM License Agreement between Dubuque Bank and Trust Company and Plus Systems, Inc., dated January 2, 1992, (Filed as Exhibit 10.9 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.6 Service Mark License Agreement between Dubuque Bank and Trust Company and Cirrus System, Inc., dated September 1, 1988, (Filed as Exhibit 10.10 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.7 CSMA/FI Debit Processing Agreement between Dubuque Bank and Trust Company and Card Services--Members Associated dated May 4, 1993, (Filed as Exhibit 10.11 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.8 Bank Marketing Agreement between ADP, Inc. and Heartland Bancorp dated August 26, 1993, (Filed as Exhibit 10.12 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.9 Lease Agreement dated May 28, 1970, for Unit 710, Kennedy Mall, Dubuque, Iowa, and as amended July 22, 1976, between Dubuque Bank and Trust Company and The Kennedy Mall, Inc. (Filed as Exhibit 10.14 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.10 Lease Agreement for 1275 Main Street, Dubuque, Iowa, between Fischer & Co. and Dubuque Bank and Trust Company (as successor to Epworth Savings Bank) dated February 1, 1968 (Filed as Exhibit 10.15 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.11 Processing Agreement between ITS, Inc., and Dubuque Bank and Trust Company (Filed as Exhibit 10.16 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.12 Heartland Financial Money Purchase Pension Plan and Defined Contribution Master Plan and Trust Agreement dated January 1, 1995. (Filed as Exhibit 10.21 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.13 Heartland Financial USA, Inc. Self-Funded Employee Health Benefit Plan dated January 1, 1996. (Filed as Exhibit 10.22 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.14 Heartland Financial USA, Inc. Self-Funded Employee Dental Benefit Plan dated January 1, 1996. (Filed as Exhibit 10.23 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.15 Claim Processing Agreement between Seabury & Smith, Inc. and Heartland Financial USA, Inc. dated January 1, 1996. (Filed as Exhibit 10.24 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.16 Dubuque Bank and Trust Company Executive Death Benefit Program Plan Revisions, Enrollment Booklet, and Universal Life Split-Dollar Agreement effective December 1, 1995, and similar agreement are in place at Galena State Bank and Trust Company, First Community Bank, FSB, and Riverside Community Bank. (Filed as Exhibit 10.25 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.17 Employment Agreement between Heartland Financial USA, Inc. and Willard C. Brenner dated August 1, 1995. (Filed as Exhibit 10.28 to Registrant's Form 10K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.18 Employment Agreement between Heartland Financial USA, Inc. and Thomas E. Belmont dated August 11, 1995. (Filed as Exhibit 10.29 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.19 Investment Center Agreement between Focused Investment LLC and Heartland Financial USA, Inc. dated August 1, 1995. (Filed as Exhibit 10.30 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.20 Principal Member for Credit Card Issuance between Dubuque Bank & Trust Company and VISA USA, Inc. dated June 26, 1995. (Filed as Exhibit 10.31 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.21 Heartland Financial USA, Inc. Employee Stock Purchase Plan effective January 1, 1996, (Filed in conjunction with Form S-8 on June 18, 1996, and incorporated by reference herein.) 10.22 The Stock Purchase Agreement between Heartland Financial USA, Inc. and the stockholders of Cottage Grove State Bank dated November 8, 1996. (Filed as Exhibit 10.36 to Registrant's Form 10K for the fiscal year ended December 31, 1996, and incorporated by reference herein.) 10.23 Agreement to Organize and Stockholder Agreement between Heartland Financial USA, Inc. and Investors in the Proposed New Mexico Bank dated November 5, 1997. 11. Statement re Computation of Per Share Earnings 21.1 Subsidiaries of the Registrant 23.1 Consent of KPMG Peat Marwick LLP 27.1 Financial Data Schedule 99.1 1998 Proxy Statement (only such parts as are incorporated by reference into this Form 10-K) EX-10 2 AGREEMENT TO ORGANIZE AND STOCKHOLDER AGREEMENT EXHIBIT 10.23 AGREEMENT TO ORGANIZE AND STOCKHOLDER AGREEMENT THIS AGREEMENT TO ORGANIZE AND STOCKHOLDER AGREEMENT (this "Agreement") is dated as of November 5, 1997, and is among HEARTLAND FINANCIAL USA, INC., a Delaware corporation (the "Company"), and those individuals who are signatories to this Agreement (individually referred to as an "Investor" and collectively as the "Investors"). RECITALS A. The Company and the Investors (collectively, the "Organizers") desire to organize a new bank under the laws of the state of New Mexico with its main office initially to be located in Albuquerque, New Mexico, and to be known as "Community Bank of Albuquerque" (the "Bank"). B. Pursuant to the terms of this Agreement, the Organizers intend to provide the Bank's initial capitalization and to take all other steps necessary to prepare the Bank to commence retail operations and transact a banking business and to effect all of the other actions contemplated by this Agreement (collectively, the "Transaction"). C. The Organizers understand that the Transaction requires the approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve"), the Financial Institutions Division of the Regulation and Licensing Department of the State of New Mexico (the "Division"), and the Federal Deposit Insurance Corporation (the "FDIC"). D. Upon the completion of the organization of the Bank, the Bank will issue shares of its capital stock (the "Bank Stock") to each of the Organizers in proportion to their contributions to the Bank's capitalization and as otherwise provided in this Agreement. E. The Organizers desire to impose certain restrictions on the sale, transfer or other disposition of the Bank Stock owned by the Organizers and to give the Company and the Investors the option to purchase and sell the shares of Bank Stock owned by them under certain circumstances specified in this Agreement. NOW, THEREFORE, in consideration of the mutual covenants herein contained and for other good and valuable consideration, the receipt of which is hereby acknowledged, each of the Organizers, intending to be legally bound hereby, agrees as follows: AGREEMENTS ARTICLE 1 BANK ORGANIZATION AND STOCK SUBSCRIPTION Section 1.1 Charter. The Organizers agree to use their best efforts to cause the Division to charter the Bank under the laws of the State of New Mexico and otherwise to effect the Transaction. The date the Bank commences a banking business with the public is referred to as the "Charter Date." Each of the undersigned hereby authorizes John K. Schmidt, an executive officer of the Company, to serve as the undersigned's lawful agent in connection with the Transaction, or if Mr. Schmidt becomes unable or unwilling to perform such functions, such other individual as may be chosen by the Company (the "Agent"). The Agent shall be primarily responsible for preparing and filing all regulatory applications deemed by him to be necessary to effect the Transaction, including, but not limited to, applications with the Federal Reserve, the Division and the FDIC. Each of the Organizers agrees to cooperate fully with the Agent in such efforts. Section 1.2. Subscriptions for Bank Stock. (a) The Organizers each agree that the Bank's initial capitalization shall be $15 million. The Company agrees to subscribe for and purchase $12 million of the initial issuance of Bank Stock and the Investors agree to subscribe for and purchase, in the aggregate, $3 million of the initial issuance of Bank Stock. Individually, each of the Investors agrees to subscribe for and purchase Bank Stock in the amount set forth opposite his or her name on Exhibit A attached hereto. The Organizers further agree that if the Charter Date shall not have occurred within eighteen months of the date of this Agreement, unless such time is extended by mutual agreement of the Organizers, this Agreement shall terminate and each of the Organizers shall: (i) receive a pro rata portion of any of the subscription funds previously contributed (after the satisfaction of all expenses incurred in attempting to organize the Bank, including the preparation and filing of all necessary regulatory applications as described in this Agreement); and (ii) accept such distribution in full satisfaction of any amounts due under this Agreement to or from any of the other Organizers, including the Company. (b) Payment by an Organizer of the aggregate cash amount for the Organizer's subscription for the Bank Stock (the "Subscription Amount") shall be made in two installments, with the first installment in an amount equal to 10% of the Organizer's aggregate Subscription Amount (the "First Installment"), and the second installment equal to the balance of the Organizer's Subscription Amount (the "Second Installment"). Each of the Organizers irrevocably agrees to deliver to the Agent either cash, or check(s) made payable to "Community Bank of Albuquerque Escrow Fund," in the amount of the Organizer's: (i) First Installment by no later than 10 days after the date of this Agreement; and (ii) Second Installment by no later than 15 days after notice from the Agent requesting payment of such amount. Section 1.3. Deposit and Expenditure of Organizers' Funds. All funds collected from the Organizers pursuant to this Agreement (the "Organizers' Funds") shall be deposited into a bank account (the "Organization Account") established with the Dubuque Bank and Trust Company, Dubuque, Iowa (the "Escrow Bank"). Upon the signature of the Agent, funds may be withdrawn from the Organization Account to be used to pay normal and customary expenses relating to the Transaction, including, but not limited to, the following: (a) expenses arising from or relating to the organization, capitalization and operation of the Bank, including the filing of all necessary regulatory applications with the Federal Reserve, the Division and the FDIC to effect the Transaction; (b) accounting, auditing, legal, investment banking, due diligence and appraisal expenses relating to or in connection with the Transaction; (c) salary payments to a proposed president of the Bank chosen by the Organizers and to any other officers or employees of the Bank that are deemed necessary by the Agent; and (d) other expenses arising from or directly relating to the Transaction. The Organizers hereby acknowledge that the Agent may begin making withdrawals from the Organization Account immediately, and accordingly, if the Transaction is not consummated, the Organizers will not receive a refund of 100% of the Organizers' Funds. Section 1.4. Books and Records. The Agent shall ensure that proper records of all expenditures from the Organization Account are maintained and such records shall be available for inspection by any Organizer. The Agent will prepare and distribute to each Organizer a monthly financial report and a copy of the monthly account statement issued by the Escrow Bank with respect to the Organization Account. Section 1.5. Additional Capital. Each of the Organizers agrees that any additional capital needed by the Bank shall be contributed by the Company in return for the issuance of additional Bank Stock. Each of the Investors hereby waives any right granted to him or her by applicable law or otherwise to subscribe for additional Bank Stock, or if the same is not waivable, each of the Investors hereby agrees to assign to the Company any such subscription right as the same may arise in the future. ARTICLE 2 REPURCHASE OPTIONS AND OBLIGATIONS Section 2.1. Repurchase Obligation at Fifth Anniversary. (a) Upon the fifth anniversary of the Charter Date (the "Fifth Anniversary"), the Company agrees to purchase from the Investors, and each of the Investors agrees to sell to the Company, all of the Bank Stock then owned by the Investors (the "Investors' Stock") on the terms set forth in this Section. The purchase price for the Investors' Stock shall be an amount equal to the "Repurchase Price," as defined below. (b) Except as provided in this Section, the Repurchase Price shall be the appraised value of the Investors' Stock as of the Fifth Anniversary as determined by Alex Sheshunoff Management Services, Inc. or its successor, or if neither such firm nor its successor is still in existence and performing appraisals of the stock of commercial banks, then by an independent, nationally recognized appraisal firm with no less than 10 years of experience in appraising the stock of commercial banks, jointly selected by the Company and the Investors. For purposes of such an appraisal, the value of the Investors' Stock shall be determined as if the whole Bank were being sold. In the event that the Investors have made the initial contact and have assisted the Company in acquiring additional banks in New Mexico or in a contiguous state, then the appraisal shall take into consideration the sale value of the Bank and those additional subsidiary banks as though they were being sold together in determining the value of the Investors' Stock. (c) Notwithstanding anything contained herein to the contrary, in no event shall the Repurchase Price be less than: (i) an amount equal to a 15% compounded return on the Investors' original investment in Bank Stock (e.g., an amount equal to $6 million based upon an original aggregate investment by the Investors of $3 million), if on the Fifth Anniversary the Bank has total assets of not less than $200 million and has earned at least a 12% return on equity during the prior 12 months (computed in accordance with generally accepted accounting principles and based upon average equity during such 12-month period); or (ii) an amount equal to a 10% compounded return on the Investors' original investment in Bank Stock (e.g., an amount equal to $5 million based upon an original aggregate investment by the Investors of $3 million) if on the Fifth Anniversary the Bank has total assets of less than $200 million or has earned less than a 12% return on equity during the prior 12 months (computed in accordance with generally accepted accounting principles and based upon average equity during such 12-month period). For purposes of this Section: (i) all references to the total assets of the Bank shall not include the amount of the assets (calculated at the time of acquisition) of any bank, thrift or other financial institution, or any branch, office or part thereof, acquired by the Bank between the date of this Agreement and the Fifth Anniversary, and (ii) in computing return on equity, if the corporate overhead allocation attributed to the Bank by the Company is greater than that attributed proportionately to the Company's other subsidiaries (based on the assets of each subsidiary), then the return on equity calculation will be adjusted based upon the average allocation per the combined assets of the subsidiaries. (d) The Repurchase Price shall be paid to Investors in two parts: (i) the first part of the Repurchase Price, which shall be equal to each Investor's total capital contribution as reflected on Exhibit A attached hereto, shall be paid to the Investor, at the Investor's election (but subject to compliance with any applicable securities laws) in cash, common stock of the Company ("Company Stock") or a combination of cash and Company Stock; and (ii) the second part of the Repurchase Price, which shall be equal to the remaining balance thereof, shall be paid to the Investor, at the Company's election (but subject to compliance with any applicable securities laws) in cash, Company Stock or a combination of cash and Company Stock. For purposes of this Section, the per share value of Company Stock shall be equal to the average per share value based upon all trades of Company Stock as reported by the media services of Bloomberg, L.P., or its successor, during the 90 day period prior to the Fifth Anniversary. Section 2.2. Tender Right. Each of the Investors shall have the right, exercisable at any time after the date hereof and through the Fifth Anniversary, to tender all of the Bank Stock owned by such Investor to the Company for purchase at a price equal to a 10% compounded return on such Investor's original investment in Bank Stock (the "Tender Right"). An Investor may exercise the Tender Right by delivering to the Company written notice of such Investor's intention to tender all of the Investor's shares of Bank Stock to the Company for purchase. Upon proper exercise of the Tender Right, the Company hereby agrees to purchase all of the shares of Bank Stock owned by the Investor selling such Bank Stock at the purchase price and on the terms set forth in this Article. Section 2.3. Reciprocal Right to Purchase. (a) Any time after the date hereof and through the Fifth Anniversary, the Company on one hand, and the Investors (considered as a single party for purposes of this Section) on the other hand, may elect to terminate this Agreement by offering to purchase 100% of the Bank Stock owned by the other. The Company may offer to purchase all of the Bank Stock owned by the Investors, or the Investors may jointly offer to purchase all of the Bank Stock owned by the Company (the "Offering Party"), at a cash price per share specified in a written notice delivered to the other (the "Offer Notice"). The Offer Notice shall include all other terms and conditions of any proposed purchase which shall be ordinary and reasonable for such types of stock purchases. Within 60 days of receipt of the Offer Notice, the party receiving such notice (the "Receiving Party") must either: (i) accept the offer described in the Offer Notice; or (ii) return the Offer Notice to the Offering Party with a binding offer by the Receiving Party to purchase all of the Bank Stock owned by the Offering Party at the same price per share and on the same terms and conditions specified in the Offer Notice (the "Reoffer Notice"). Upon the receipt by the Offering Party of a properly tendered Reoffer Notice from the Receiving Party, the Offering Party shall accept the terms of the Reoffer Notice and sell its or their Bank Stock to the Receiving Party on the terms and conditions specified in the Reoffer Notice. (b) At the closing of the purchase of the Bank Stock pursuant to the terms of this Section, the Organizer or Organizers who sell their Bank Stock shall enter into an agreement with the purchasing Organizer or Organizers that prohibits such selling Organizer or Organizers for a period of two years after such closing from directly or indirectly, engaging or investing in, owning, managing, operating, financing, controlling or participating in the ownership, management, operation, financing or control of, being associated with or in any manner connected with, lending any of their names or any similar names, lending credit to or rendering services or advice to, any bank, savings and loan association, credit union or similar financial institution that has at the time of such purchase of Bank Stock been in existence for less than two years or is formed within two years of the closing and has an office within 35 miles of any of the offices of the Bank. Section 2.4. Repurchase Upon Company Change of Control. If at any time after the date hereof and through the Fifth Anniversary there is a "Change of Control of the Company" (as defined below), the Company, or its successor, agrees to purchase from the Investors, and the Investors agree to sell to the Company, all of the Bank Stock then owned by the Investors at a price equal to the Control Premium Price, as defined below. For purposes of this Section, a "Change of Control of the Company" shall mean the acquisition by any person or entity (a "Company Acquirer") of: (a) legal or beneficial ownership (as defined by Rule 13d-3 promulgated under the Securities Exchange Act of 1934, as amended) of greater than 66-2/3% of the then issued and outstanding voting stock of the Company through any transaction; or (b) all or substantially all of the assets of the Company. The Control Premium Price shall be equal to the book value of the Investors' equity interest in the Bank, multiplied by the same multiple of book value as paid by the Company Acquirer for the stock or assets of the Company. For example, if the Company is sold to another entity for three times the Company's book value, the Control Premium Price would be equal to three times the book value of the Investors' equity interest in the Bank. Section 2.5. Terms, Time and Place of Closing. (a) Except as otherwise specifically provided by the terms of this Article, the purchase price of any Bank Stock purchased from any Organizer pursuant to the terms of this Article shall be paid by delivery of a certified or cashier's check payable to the order of the selling Organizer or Organizers in the amount of the purchase price prescribed by the terms of this Article. (b) Except as otherwise specifically provided by the terms of this Article, the closing of the purchase and sale of any Bank Stock to be purchased and sold pursuant to the provisions of this Article (the "Closing") shall be held at such place and time and on such date as may mutually be agreed upon in writing by the Organizer and the purchaser of such Bank Stock, or, if they fail to agree, at the main office of the Company at 10:00 a.m. on the later of: (a) the tenth business day following the determination of the purchase price to be paid in connection with such purchase of Bank Stock; (b) 30 business days following the action or occurrence that triggers the obligation to purchase such Bank Stock; and (c) five business days after the receipt of any necessary regulatory approvals for such purchase. (c) Except as otherwise specifically provided by the terms of this Article, at the Closing held pursuant to this Article, the purchasing Organizer or other entity shall make the delivery described in subsection (a) of this Section and the selling Organizer shall deliver to such purchaser free and clear of all liens, claims and encumbrances (other than those imposed by this Agreement and evidenced by the legend provided for below), a certificate or certificates representing the shares of Bank Stock to be purchased and sold, duly endorsed in blank, with all taxes on the transfer, if any, paid by the transferor thereof. (d) The consummation of any purchase of Bank Stock pursuant to this Article (the "Sale Stock") shall be subject to the receipt by the purchaser of any necessary regulatory approvals, which the purchaser agrees to use its best efforts to obtain as soon as practicable, provided, however, that if such purchaser is unable, after the exercise of diligent efforts, within 120 days after the last date provided in this Agreement for the closing of the purchase of the Sale Stock, or such longer period of time as may be mutually agreed upon by the prospective purchasers and prospective sellers of the Sale Stock, to obtain any necessary regulatory approvals, then: (i) each of the prospective sellers of the Sale Stock shall be released from any further obligations pursuant to the terms of this Agreement solely with respect to such Sale Stock and shall be free to sell the Sale Stock to any person or entity free of any lien or encumbrance imposed by the terms of this Agreement; and (ii) each of the prospective purchasers of the Sale Stock shall be released from any further obligations pursuant to the terms of this Agreement with respect to the purchase of the Sale Stock and shall have no further rights with respect to the Sale Stock. ARTICLE 3 REPRESENTATIONS, WARRANTIES AND COVENANTS Section 3.1. Bank Operations. Each of the Organizers agrees to use its, his or her best efforts to cause the Bank to be successful. Each of the Organizers acknowledges and agrees that in addition to core deposit growth, the Organizers will work to expand the Bank's operations through selected acquisitions of banks and other financial institutions, provided, however, that no offer will be made for any such institution without the prior consent of the Company. Section 3.2. Representations, Warranties and Covenants. Each of the undersigned Organizers hereby represents and warrants to, and acknowledges to and agrees with, the Agent and each other Organizer as follows: (a) The attorney, accountant or financial investment advisor for the Organizer (collectively, "Advisor") has had a reasonable opportunity to ask questions of and receive information and answers from the other Organizers and persons acting on behalf of the Company or the Bank concerning the Transaction, all such questions asked have been answered and all such information requested has been provided to the full satisfaction of the Organizer or the Organizer's Advisor, and the Organizer has extensively and on various occasions discussed with the other Organizers the possible risks of purchasing Bank Stock. (b) No oral or written representations have been made or oral or written information furnished to the Organizer or the Organizer's Advisor(s) in connection with the Organizer's agreement to purchase Bank Stock which were in any way inconsistent with the information stated in this Agreement. (c) The Organizer is not subscribing for Bank Stock as a result of or subsequent to any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television or radio, or presented at any seminar or meeting, or any solicitation of a subscription by a person not previously known to each of the undersigned generally or in connection with investments in securities. (d) The Organizer's overall commitment to investments which are not readily marketable is not disproportionate to the Organizer's net worth and Organizer's investment in the Bank will not cause such overall commitment to become disproportionate to the Organizer's net worth. (e) The Organizer has reached the age of majority in the state in which the Organizer resides, has adequate net worth and means of providing for the Organizer's current needs and personal contingencies, is able to bear the substantial economic risks of the investment in the Bank as evidenced by this Agreement, has no need for liquidity in such investment, and, at the present time, could afford a complete loss of such investment. (f) The Organizer has such knowledge and experience in financial and business matters so as to enable the Organizer to utilize the information made available to him or her in connection with this investment in the Bank in order to evaluate the merits and risks of such an investment and to make an informed investment decision with respect thereto and the Organizer has carefully evaluated the risk of such investment. (g) The Organizer is not relying on the Company, the Agent, any other Organizer or any other person acting on behalf of the Company, the Bank, the Agent or the Organizers with respect to the Organizer's economic considerations relating to this investment; and in regard to such considerations, the Organizer has relied on the advice of, or has consulted with, his or her own Advisor(s). (h) The Organizer is making the investment evidenced hereby solely for the Organizer's own account as principal, for investment purposes only and not with a view to the resale or participation of any portion thereof, and no other person has a direct or indirect beneficial interest in such investment. (i) The Organizer acknowledges that the Company is under no obligation to register any Company Stock that the Organizer may receive pursuant to the terms of this Agreement, and further acknowledges that the receipt by the Organizer of any Company Stock is subject to the Company's ability to satisfy the requirements of any applicable federal or state securities laws. (j) The Organizer acknowledges that a legend will be placed on each certificate representing the Bank Stock substantially as follows: Voluntary and involuntary transfer of any of the shares represented by this certificate are governed by and in all respects subject to the terms and conditions of that certain Agreement to Organize and Stockholders Agreement among Heartland Financial USA, Inc. and certain other holders of the Bank's capital stock dated as of November 5, 1997, an executed copy of which has been deposited with the Cashier of the Bank at its registered office in Albuquerque, New Mexico. Such Agreement imposes certain obligations on the holder of these shares in certain circumstances, which obligations and circumstances are described therein. No transfer of such shares will be made on the books of the Bank unless accompanied by evidence of compliance with the terms of such Agreement. (k) The Organizer recognizes that an investment in Bank Stock involves a number of significant risks, including, without limitation, the following considerations: (i) no Federal or state agency has passed upon the Bank Stock or made any finding or determination as to the fairness of the investment in Bank Stock; and (ii) there is no established market for the Bank Stock and it is unlikely that a public market for the Bank Stock will develop. (l) The Organizer acknowledges receipt of copies of certain financial and other information concerning the proposed operations of the Bank, and recognizes that the Bank is a de novo bank to be organized in the future and has no financial or operating history, that the organization and operation of the Bank entails significant risks, including, without limitation, that the organization of the Bank is subject to regulatory approvals and that there are no assurances that such approvals will be obtained. (m) Within five days after receipt of a request from the Agent, the Organizer hereby agrees to provide such information and to execute and deliver such documents as may be reasonably necessary to complete the necessary applications to organize the Bank and to comply with any and all laws and ordinances to which the Bank is subject. (n) The foregoing representations, warranties and agreements, together with all other representations and warranties made or given by the Organizer in any other written statement or document delivered in connection with the transactions contemplated hereby, shall be true and correct in all respects on and as of the date of the delivery of such statement or document as if made on and as of such date and shall survive such date. Section 3.3. Indemnification. Each Organizer agrees to indemnify and hold harmless the Bank, the Agent and each of the other Organizers and all of their respective agents and representatives who are associated with the Transaction and all of the proposed officers and directors of the Bank against any and all loss, liability, claim, damage and expense whatsoever (including, but not limited to, any and all expenses reasonably incurred in investigating, preparing or defending against any litigation commenced or threatened or any claim whatsoever) arising out of or based upon any false representations or warranty or breach or failure by the undersigned to comply with any covenant or agreement made by the undersigned herein or in any other document furnished by the undersigned to any of the foregoing in connection with the Transaction. Section 3.4. Additional Information. Each of the undersigned hereby acknowledges and agrees that the Agent may make or cause to be made such further inquiry and obtain such additional information from any of the undersigned as he may deem appropriate, and each of the undersigned hereby agrees to cooperate fully with the Agent in this regard. Section 3.5. Irrevocability; Binding Effect. Each of the undersigned hereby acknowledges and agrees that: (a) each of the undersigned is not entitled to cancel, terminate or revoke this Agreement or any agreements of each of the undersigned hereunder; and (b) this Agreement and such other agreements shall survive the death or disability of each of the undersigned and shall be binding upon and inure to the benefit of the parties and their heirs, executors, administrators, successors, legal representatives and assigns. Section 3.6. Transfer Restrictions. Each of the Investors hereby agrees that he or she will not sell, exchange, assign, transfer, pledge, hypothecate, give away (by lifetime transfer) or otherwise encumber or dispose of any shares of Bank Stock at any time owned by him or her without the express prior written consent of the Company, provided, however, that the foregoing shall not prohibit the transfer of shares of Bank Stock by testamentary transfer so long as each recipient of any shares of Bank Stock becomes a party to this Agreement and agrees to be bound by its terms. ARTICLE 4 MISCELLANEOUS Section 4.1. Modification. Neither this Agreement nor any provisions hereof shall be waived, modified, discharged or terminated except by an instrument in writing signed by the party against whom any such waiver, modification, discharge or termination is sought. Section 4.2. Notices. All notices, consents, waivers and other communications under this Agreement must be in writing (which shall include telecopier communication) and will be deemed to have been duly given if delivered by hand or by nationally recognized overnight delivery service (receipt requested), mailed with first class postage prepaid or telecopied if confirmed immediately thereafter by also mailing a copy of any notice, request or other communication by mail with first class postage prepaid to any Organizer at the address set forth on Exhibit A attached hereto or to such other person or place as an Organizer shall furnish to the other Organizers in writing. Except as otherwise provided herein, all such notices, consents, waivers and other communications shall be effective: (a) if delivered by hand, when delivered; (b) if mailed in the manner provided in this Section, five business days after deposit with the United States Postal Service; (c) if delivered by overnight express delivery service, on the next business day after deposit with such service; and (d) if by telecopier, on the next business day if also confirmed by mail in the manner provided in this Section. Section 4.3. Counterparts. This Agreement may be executed through the use of separate signature pages or in any number of counterparts, and each of such counterparts shall, for all purposes, constitute one agreement binding on all parties, notwithstanding that all parties are not signatories to the same counterpart. Section 4.4. Entire Agreement. This Agreement contains the entire agreement of the parties with respect to the subject matter hereof and there are no representations, covenants or other agreements except as stated or referred to herein. Section 4.5. Severability. Each provision of this Agreement is intended to be severable from every other provision, and the invalidity or illegality of any portion hereof shall not affect the validity or legality of the remainder hereof. Section 4.6. Assignability. This Agreement is not transferable or assignable by any of the undersigned. Section 4.7. Governing Law, Jurisdiction and Venue. This Agreement shall be governed by and construed in accordance with the laws of the State of Iowa applied to residents of that state executing contracts wholly to be performed in that state. Each of the undersigned irrevocably agrees that any action or proceeding in any way, manner or respect arising out of this Agreement or any amendment, instrument, document or agreement delivered or which may in the future be delivered in connection herewith shall be litigated only in the courts having situs within the City of Dubuque, the State of Iowa, and each of the undersigned hereby consents and submits to the jurisdiction of any local, state or federal court located within such city and state. Each of the undersigned hereby waives any right the Organizer may have to transfer or change the venue of any litigation brought against the undersigned by the Bank or the Agent. Section 4.8. Certificate of Non-Foreign Status. Each of the undersigned declares that, to the best of the Organizer's knowledge and belief, the following statements are true, correct and complete: (a) that unless an Internal Revenue Service Form 4224 has been completed, each of the undersigned is not a foreign person for purposes of U.S. income taxation (i.e., the Organizer is not a nonresident alien, nor executing this document as an officer of a foreign corporation, as a partner in a foreign partnership, or as a fiduciary of a foreign employee benefit plan, foreign trust or foreign estate); (b) that the following information contained elsewhere in the subscription documents is true, correct and complete: the U.S. taxpayer identification number (i.e., social security number) and the home address; and (c) that the undersigned agrees to inform the Bank promptly if the undersigned becomes a nonresident alien. Section 4.9. Director Benefits. Directors of the Bank will be afforded the same benefits as directors of the Company's other financial institution subsidiaries, including participation in up to $50,000 (at market value) of the Company's short term stock options. Section 4.10. Solicitation of Customers or Employees. For the period ending two years after an Organizer sells his or her Bank Stock, such individual shall not, directly or indirectly, call on, sell to, solicit business from or render services to any of the Bank's customers or recruit, persuade or attempt to recruit or persuade any employee of the Bank to leave the Bank's employ, or to become employed by any other person other than the Bank. Notwithstanding the foregoing, the provisions of this Section shall not apply to Norman R. Corzine so long as he is serving as an operating officer of Access Anytime Bancorp, Inc., a Delaware corporation, or First Savings Bank, F.S.B., a federal savings bank with its main office located in Clovis, New Mexico, or any successor to either of them. Section 4.11. Federal and State Securities and Other Laws. Each of the undersigned should also be aware of the following additional considerations: THE INVESTMENTS EVIDENCED BY THIS AGREEMENT ARE NOT, AND THE BANK STOCK TO BE ISSUED WILL NOT BE, SAVINGS ACCOUNTS OR DEPOSITS AND ARE NOT AND WILL NOT BE INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION, ANY OTHER GOVERNMENT AGENCY OR OTHERWISE. THE INTERESTS EVIDENCED BY THIS AGREEMENT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OR THE SECURITIES LAWS OF ANY STATES OR UNDER OTHER APPLICABLE BANKING LAWS OR REGULATIONS. SUCH INTERESTS HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION, ANY STATE SECURITIES COMMISSION OR OTHER REGULATORY AUTHORITY, NOR HAVE ANY OF THE FOREGOING AUTHORITIES PASSED UPON OR ENDORSED THE MERITS OF SUCH INTERESTS. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL. SIGNATURES IN WITNESS WHEREOF, this Agreement has been executed by the undersigned Organizers on the date(s) indicated below: Signature HEARTLAND FINANCIAL USA, INC. By: \s\ John K. Schmidt Title: EVP-CFO \s\ Dan Hardisty 11/4/97 \s\ J. Badahl & Assoc., 11/5/97 Inc. Profit Sharing Plan \s\ Terlun Andrew Limited Partnership 11/5/97 \s\ J. L. Bratton 11/5/97 \s\ Cornelius J. Higgins 11/5/97 \s\ Norman R. Corzine 11/5/97 \s\ Charles E. Spann 11/5/97 \s\ Sherman McCorkle 11/5/97 \s\ Ben F. Spencer 11/5/97 \s\ Arthur J. Weinstein 2/11/98 \s\ Robert W. Reidy 2/16/98 \s\ Robert H. Scott 2/17/98 \s\ Sundance Mechanical 2/17/98 & Utility Corp. \s\ Greg Leyendecker 2/17/98 \s\ Stephen Montoya 2/17/98 \s\ Elizabeth Albright 2/16/98 \s\ James A. Clark 2/17/98 \s\ Nadyne Bicknell 2/17/98 \s\ Bob Eaton 2/17/98 \s\ Kerwin Halloway 2/17/98 \s\ Charlie Wilkinson 2/17/98 EX-11 3 COMPUTATION OF PER SHARE EARNINGS Exhibit 11 EARNINGS PER SHARE Net income for the year ended December 31, 1997 $8,515,000 ========== Weighted average common shares outstanding 4,738,171 Assumed incremental common shares issued upon exercise of stock options 49,737 ---------- Weighted average common shares for diluted earnings per share 4,787,908 ========== Earnings per common share - basic $1.80 ===== Earnings per common share - diluted $1.78 ===== EX-21 4 SUBSIDIARIES OF THE REGISTRANT EXHIBIT 21.1 SUBSIDIARIES OF THE REGISTRANT 1. Galena State Bank & Trust Company, an Illinois state bank with its main office located in Galena, Illinois 2. Dubuque Bank and Trust Company, an Iowa state bank with its main office located in Dubuque, Iowa 2.a. DB&T Insurance, Inc. 2.b. DB&T Community Development Corp. 3. Keokuk Bancshares, Inc. 4 First Community Bank, FSB, a federal savings bank with its main office located in Keokuk, Iowa 4.a. KFS Services, Inc. 5. Riverside Community Bank, an Illinois state bank with its main office located in Rockford, Illinois 6. Citizens Finance Co. 7. ULTEA 8. Wisconsin Community Bank, an Wisconsin bank with its main office located in Cottage Grove, Wisconsin 8.a. DBT Investment Corporation EX-23 5 CONSENT OF KPMG PEAT MARWICK EXHIBIT 23 INDEPENDENT AUDITORS' CONSENT The Board of Directors and Stockholders Heartland Financial USA, Inc.: We consent to incorporation by reference in the Registration Statement on Form S-8 for the 1993 Stock Option Plan of Heartland Financial USA, Inc. of our report dated on January 22, 1998, relating to the consolidated balance sheets of Heartland Financial USA, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997 which report appears in the December 31, 1997 annual report on Form 10-K of Heartland Financial USA, Inc. and subsidiaries. KPMG Peat Marwick LLP Des Moines, Iowa March 27, 1998 EX-27 6 FDS SCHEDULE
9 1,000 12-MOS DEC-31-1997 DEC-31-1997 21,515 2,946 32,918 000 197,869 3,879 3,999 556,406 (7,362) 852,060 623,532 96,239 11,494 43,023 000 000 4,854 72,918 852,060 46,919 11,563 779 59,261 25,765 31,767 27,494 1,279 1,446 22,927 11,853 8,515 000 000 8,515 1.80 1.78 3.89 1,819 187 26 000 6,191 (584) 145 7,362 4,188 000 3,174
EX-27 7 RESTATED FINANCIAL DATA SCHEDULE
9 0000920112 HEARTLAND FINANCIAL USA, INC. 1,000 YEAR YEAR DEC-31-1996 DEC-31-1995 DEC-31-1996 DEC-31-1995 38,088 26,156 2,159 5,294 0 23,500 000 000 181,815 145,857 2,151 2,369 2,245 2,503 484,085 454,905 (6,191) (5,580) 736,552 677,313 558,343 534,587 56,358 23,241 9,086 9,579 42,506 45,400 000 000 000 000 4,854 2,427 65,405 62,079 736,552 677,313 40,670 38,968 10,443 9,325 773 856 51,886 49,149 23,190 22,029 27,644 25,529 24,242 23,620 1,408 820 1,889 413 19,507 17,323 10,691 10,458 8,006 7,574 000 000 000 000 8,006 7,574 1.70 1.58 1.69 1.58 3.98 4.13 1,697 977 247 226 000 000 000 000 5,580 5,124 (926) (495) 129 131 6,191 5,580 3,431 3,100 000 000 2,760 2,480 RESTATED TO REFLECT IMPLEMENTATION OF FAS 128, EARNINGS PER SHARE
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