Executive Summary / Key Takeaways

• Hills Bancorporation (HBIA) delivered robust net income growth of 19.28% in Q1 2025, driven by a significant increase in net interest income (23.46%) and strong noninterest income growth (15.90%), leading to improved profitability metrics (ROAA of 1.30%, ROAE of 11.91%).
• The core business, centered on community banking in Iowa, benefits from strong local ties and a diversified loan portfolio, although credit risk is concentrated in real estate.
• Rising credit loss expense, increasing from a benefit in Q1 2024 to a substantial expense in Q1 2025, signals potential asset quality pressures linked to economic conditions and loan portfolio migration towards higher risk categories.
• While operationally efficient compared to some peers, HBIA faces competitive challenges from more technologically advanced regional banks and fintechs, particularly regarding digital service delivery and growth pace.
• Identified material weaknesses in internal control over financial reporting require close monitoring, although management has initiated a remediation plan.

Setting the Scene: A Community Bank in a Shifting Landscape

Hills Bancorporation, rooted in the 1904 founding of Hills Bank and Trust Company, operates as a full-service commercial bank deeply embedded in the communities of Johnson, Linn, Washington, and Iowa Counties in Iowa. With nineteen full-service locations, HBIA's strategy centers on building strong local relationships and providing a diversified suite of banking services to individuals, businesses, governmental units, and institutional customers. This community-focused approach has historically fostered customer loyalty and a stable deposit base, serving as a foundational strength in the competitive Midwest banking sector.

The banking industry landscape in which HBIA operates is dynamic, characterized by competition from regional peers such as MidWestOne Financial Group (MOFG), QCR Holdings (QCRH), Heartland Financial USA (HTLF), and West Bancorp (WTBA), as well as disruptive forces from fintech firms and online banks. While HBIA's core business model remains traditional community banking, the competitive environment increasingly demands technological adaptation and operational efficiency.

HBIA's operational framework, managed as a single commercial banking segment, involves monitoring various revenue streams like lending, deposits, and trust services, with performance evaluated on a company-wide basis. The loan portfolio, while diversified across agricultural, commercial, and real estate segments, holds a significant concentration in real estate loans, making it particularly sensitive to local property market conditions.

Regarding technology, HBIA utilizes alternative electronic delivery channels, suggesting a degree of digital presence. However, specific technological differentiators or quantifiable benefits of HBIA's technology stack are not detailed. This contrasts with some peers, like MOFG, which are noted for leveraging digital platforms for potentially faster loan processing and reduced operating costs. The absence of specific, quantifiable technological advantages for HBIA suggests that while technology is used, it may not currently represent a significant competitive moat compared to rivals who are explicitly investing in and highlighting such capabilities. The risk of cyber-security incidents is acknowledged, underscoring the importance of maintaining secure and reliable technology systems.

Financial Performance: Profit Growth Amidst Rising Credit Costs

HBIA commenced 2025 with a strong financial showing in the first quarter. Net income for the three months ended March 31, 2025, reached $14.43 million, a notable increase of $2.33 million, or 19.28%, compared to $12.10 million in the same period of 2024. This performance translated into improved profitability ratios, with return on average assets climbing to 1.30% and return on average equity reaching 11.91% for Q1 2025, up from 1.12% and 10.48%, respectively, in Q1 2024.

The primary engine driving this net income growth was a substantial increase in net interest income, which rose by $6.49 million, or 23.46%, to $34.16 million in Q1 2025 from $27.67 million in Q1 2024. This expansion was largely attributed to higher interest rates earned on real estate and commercial loans and investments, supported by a modest increase in investment volume. The tax-equivalent net interest margin expanded significantly to 3.25% in Q1 2025, compared to 2.68% in Q1 2024, reflecting the favorable impact of the interest rate environment on the asset side of the balance sheet.

Noninterest income also contributed positively, increasing by $1.11 million, or 15.90%, to $8.12 million in Q1 2025. This growth was notably fueled by a 15.67% increase in trust fees, driven by a $0.11 billion rise in assets under management, and a substantial 647.12% surge in other noninterest income, primarily due to incentive and marketing bonuses from a VISA payment network growth agreement.

However, the quarter's results were tempered by a significant increase in credit loss expense. The company recorded a credit loss expense of $3.87 million in Q1 2025, a stark contrast to the $0.36 million credit loss benefit recognized in Q1 2024. This $4.23 million increase in expense is primarily linked to changes in management's qualitative factors, reflecting increased past due and nonaccrual loans, and higher charge-offs leading to elevated loss rates. Net charge-offs for the quarter were $1.06 million ($1.73 million charge-offs less $0.67 million recoveries), compared to a net recovery of $0.03 million in Q1 2024. The allowance for credit losses (ACL) increased to $52.95 million at March 31, 2025, representing 1.53% of loans held for investment, up from $50.94 million or 1.48% at December 31, 2024. This increase in credit costs highlights potential pressures on asset quality as economic conditions evolve.

Operational expenses saw a modest increase of $0.84 million, or 4.24%, totaling $20.65 million in Q1 2025. The rise was mainly driven by higher outside services expense, including increased professional fees (audit and legal) and costs related to other real estate owned (OREO).

Balance Sheet Dynamics and Liquidity Strength

HBIA's balance sheet reflected growth and strategic adjustments in the first quarter of 2025. Total assets increased by $24.07 million since December 31, 2024, reaching $4.56 billion. Cash and cash equivalents decreased by $18.19 million, influenced by debt paydowns and temporary public funds fluctuations.

Net loans grew by $29.75 million to $3.42 billion, primarily driven by increases in agricultural, commercial and financial, 1-4 family residential construction, 1-4 family first lien mortgages, and multi-family mortgages. This loan growth, however, occurs amidst lingering inflationary pressures creating uncertainty for future demand projections.

Deposits saw a significant increase of $132.21 million, largely attributable to approximately $115.00 million in temporary public funds received in March 2025. Uninsured deposits constituted 24.49% of total deposits at March 31, 2025, an increase from 21.51% at December 31, 2024, a metric that warrants attention in the current banking environment.

Borrowings decreased substantially by $163.79 million, primarily due to the maturity of $109.00 million in Bank Term Funding Program debt and other debt paydowns. Outstanding Federal Home Loan Bank (FHLB) borrowings increased to $509.90 million from $127.05 million, while Fed Funds purchased and Bank Term Funding Program borrowings were zero at quarter-end.

Management actively manages liquidity, citing readily marketable investment securities ($906.11 million at March 31, 2025) and available borrowing capacity from the FHLB ($490.28 million), Federal Reserve ($100.00 million), and credit lines ($175.00 million) as key resources. Despite the increase in uninsured deposits, management considered the Company's liquidity position sufficient at March 31, 2025.

Competitive Landscape and Strategic Positioning

HBIA operates within a competitive regional banking market. While precise, directly comparable market share figures for all niche competitors are not publicly detailed, HBIA's presence across multiple counties in Iowa positions it as a key local player. Its estimated market share in Iowa's regional banking sector is in the 4-6% range, with a recent growth trajectory of 5-7% annually. This growth rate trails behind some peers like QCRH (10%) and MOFG (8%), suggesting a more conservative expansion strategy.

HBIA's competitive advantages stem from its deep community roots, fostering strong customer loyalty and potentially allowing for some pricing power. Its diversified loan portfolio and specialized services like trust administration offer a broader value proposition compared to some competitors focused more narrowly on specific lending types, such as WTBA's emphasis on real estate lending. Operationally, HBIA demonstrates efficiency, with an estimated efficiency ratio of 65%, which appears favorable compared to QCRH (68%) and HTLF (70%), indicating effective cost management relative to revenue.

However, HBIA faces vulnerabilities, particularly in the realm of technological innovation. While the company utilizes electronic channels, the lack of specific, quantifiable technological differentiators suggests it may lag behind peers like MOFG, whose digital platforms offer tangible benefits in processing speed and cost reduction. This technological gap could impact HBIA's ability to compete effectively for digitally-savvy customers and maintain operational efficiency gains in the long term. Furthermore, HBIA's geographic concentration in specific Iowa counties makes it more susceptible to local economic downturns or trade policy impacts compared to peers with broader operational footprints like HTLF.

The competitive environment is also being shaped by indirect competitors, including fintechs and online banks, which offer digital-first experiences and potentially lower fees, posing a threat to traditional banking models like HBIA's. These players could erode market share by offering faster, cheaper services, potentially increasing HBIA's customer acquisition costs or necessitating price adjustments, impacting profitability.

HBIA's strategic response appears to involve leveraging its community brand and operational efficiency while managing risks. The emphasis on prudent underwriting and close monitoring of credit quality, especially in higher-risk segments and amidst economic uncertainty, is a key aspect of its risk management strategy. The stock repurchase program also signals a focus on returning value to shareholders and managing capital structure.

Risks and Outlook

Several risks could impact HBIA's future performance. The primary market risk is exposure to changes in interest rates, particularly repricing risk, which could negatively affect net interest income if liabilities reprice faster than assets in a rising rate environment. While the company uses simulation models and an Asset/Liability Committee to manage this, interest rates remain highly sensitive to external factors.

The economic environment, including potential recession risks stemming from interest rate hikes and geopolitical instability, poses a threat to asset quality, deposit levels, and loan demand. The significant increase in credit loss expense in Q1 2025 underscores this vulnerability.

Changes in U.S. trade policies, specifically tariffs, are highlighted as a risk due to Iowa's reliance on agricultural exports. Retaliatory tariffs could strain borrowers in the agricultural sector, increasing credit risk and potentially reducing loan demand.

Furthermore, material weaknesses in internal control over financial reporting, identified as of December 31, 2024, related to financial reporting processes, segregation of duties, and related party transactions, represent a significant operational risk. While a remediation plan is underway with third-party assistance, the effectiveness of these controls is subject to inherent limitations, and remediation is not complete until controls are tested and deemed effective.

Looking ahead, management expects net interest margin compression to persist due to competitive pressures on loan and deposit pricing. Growth in net interest income is anticipated to be contingent on earning asset growth, loan yield increases, and the Federal Reserve's interest rate policy. Credit loss expense is expected to remain dependent on loan growth, local economic conditions, and asset quality trends. Loan demand projections for the remainder of 2025 are uncertain due to lingering inflationary pressures. Management remains cautiously optimistic but acknowledges the potential need for additional credit loss provisions if economic conditions warrant.

Conclusion

Hills Bancorporation demonstrated solid profitability in the first quarter of 2025, driven by strong net interest income growth and a surge in noninterest income. The company's foundation in community banking, coupled with operational efficiency and a diversified loan portfolio, provides a degree of stability in a competitive market. However, the notable increase in credit loss expense signals potential headwinds related to asset quality and the uncertain economic outlook.

The investment thesis for HBIA centers on its ability to leverage its community strengths and operational effectiveness to navigate a challenging environment marked by interest rate sensitivity, potential economic slowdowns, and intense competition, particularly from technologically advanced peers and fintechs. Addressing the identified internal control weaknesses is also critical for maintaining investor confidence. While management expresses cautious optimism, the company's future performance will heavily depend on its success in managing credit risk, adapting to competitive pressures, and strategically enhancing its technological capabilities to maintain relevance and efficiency in the evolving financial services landscape.