Executive Summary / Key Takeaways

• Hills Bancorporation (HBIA) delivered robust net income growth of 25.72% for the first nine months of 2025, reaching $45.99 million, primarily fueled by a significant expansion in net interest income and margin.
• The company maintains a strong capital position with a Community Bank Leverage Ratio (CBLR) of 12.82%, well above regulatory minimums, providing a solid foundation amidst economic uncertainties.
• Despite strong financial performance, HBIA faces material weaknesses in internal controls over financial reporting, necessitating a comprehensive remediation plan and ongoing management oversight.
• The competitive landscape is intensifying, with larger institutions and fintech companies leveraging advanced technologies, posing a challenge to HBIA's market share and requiring strategic adaptation to emerging financial technologies.
• Outlook includes anticipated net interest margin compression due to competition, and credit loss expense dependent on loan growth and local economic conditions, particularly in an Iowa economy sensitive to trade policies and agricultural input costs.

A Legacy of Local Banking in a Shifting Landscape

Hills Bancorporation, through its subsidiary Hills Bank and Trust Company, has cultivated a deep-rooted presence in Iowa since its founding in 1904. Operating across nineteen full-service locations primarily in Johnson, Linn, and Washington Counties, the company has established itself as a full-service commercial bank serving individuals, businesses, governmental units, and institutional clients. This community-centric model, emphasizing personalized service and local expertise, forms the bedrock of HBIA's operational strategy and has historically fostered strong customer relationships and a stable deposit base. The bank's credit portfolio is diversified, though with a notable concentration in real estate loans, reflecting its engagement with the local economy.

The financial services industry is undergoing a profound transformation, driven by technological advancements and evolving customer expectations. While larger national and regional banks like Wells Fargo , U.S. Bancorp , and PNC Financial Services Group are investing heavily in digital platforms and artificial intelligence, HBIA's competitive positioning leans on its localized service model. However, this traditional strength is increasingly challenged by the rapid development of financial technologies, including digital assets, stablecoins, and distributed ledger systems. These emerging technologies, often offered by fintech platforms and digital asset service providers, enable near-instantaneous value transfer and peer-to-peer settlement, potentially operating outside the traditional banking system and creating new competitive pressures.

For HBIA, technology currently presents more of a strategic challenge and a risk management imperative than a core differentiator. The company acknowledges that its ability to compete with larger, well-capitalized technology entrants in developing or integrating such technologies is constrained by its size, risk appetite, and regulatory obligations. Management is focused on maintaining secure and reliable technology systems to prevent fraudulent activity and cyber-security incidents, including those potentially leveraging artificial intelligence. While specific quantifiable benefits or dedicated R&D initiatives for proprietary, differentiated technology are not detailed in recent filings, the company's strategic response involves adapting to these broader industry shifts to avoid erosion of its relevance in key banking functions and a reduction in customer deposits and fee income. The recent GENIUS Act, enacted in mid-2025, further underscores the increasing regulatory requirements for payment stablecoins, adding another layer of compliance and operational considerations for banking organizations.

Financial Strength Amidst Economic Crosscurrents

Hills Bancorporation demonstrated robust financial performance for the first nine months of 2025, with net income surging to $45.99 million, a 25.72% increase from $36.58 million in the comparable 2024 period. This significant growth was primarily driven by a substantial $24.62 million, or 28.93%, increase in net interest income before credit loss expense. The company's tax-equivalent net interest margin expanded to 3.41% for the nine months ended September 30, 2025, up from 2.74% in the prior year. This margin expansion was a direct result of higher interest rates on real estate and commercial loans and investments, coupled with increased loan and investment volumes. Average earning assets grew to $4.44 billion year-to-date in 2025 from $4.26 billion in 2024.

The loan portfolio experienced healthy growth, with net loans increasing by $109.34 million to $3.50 billion since December 31, 2024. This expansion was concentrated in commercial and financial, 1 to 4 family first and junior lien mortgages, and commercial real estate mortgages. On the deposit front, total deposits rose by $32.13 million in the first nine months of 2025, contributing to the company's stable funding base. While cash and cash equivalents decreased by $76.20 million to $47.20 million, this reflects the strategic deployment of liquidity into higher-yielding loans.

However, the period also saw a notable increase in credit loss expense, which rose by $8.36 million to $10.98 million. This increase is attributed to changes in economic factors, particularly management's Iowa unemployment forecast, increased loan volume, shifts in prepayment and curtailment rates, and higher net charge-offs. The allowance for credit losses stood at $59.10 million, representing 1.66% of loans held for investment, up from 1.48% at December 31, 2024.

Noninterest income experienced a decrease of $2.05 million, or 8.92%, primarily due to a $4.29 million loss on the sale of investment securities. This loss reflects strategic portfolio repositioning efforts aimed at increasing the average yield on the securities portfolio. Conversely, trust fees saw an 11.71% increase to $12.54 million, driven by a $0.27 billion rise in assets under management to $3.23 billion, reflecting positive market activity. Other noninterest income surged by 374.44% to $1.69 million, largely due to incentive and marketing bonuses from a VISA payment network growth agreement. Noninterest expenses increased by $2.91 million, or 4.92%, with outside services expense rising due to higher professional fees and increased OREO-related losses.

Capital Strength and Liquidity Management

Hills Bancorporation maintains a robust capital structure, with a Community Bank Leverage Ratio (CBLR) of 12.82% as of September 30, 2025, comfortably exceeding the 9% minimum requirement. This strong capital position provides a significant buffer against potential economic downturns and supports future growth initiatives. The company's liquidity profile is also considered sufficient, characterized by high levels of potentially liquid assets, a low dependence on volatile liabilities, and positive cash flows from operations.

The company actively manages its funding sources. Federal Home Loan Bank (FHLB) borrowings decreased to $76.58 million from $127.05 million, while Federal Funds purchased increased to $588.74 million from $437.64 million. Notably, Bank Term Funding Program borrowings, which stood at $109 million at December 31, 2024, were entirely eliminated by September 30, 2025. HBIA also possesses substantial additional borrowing capacity, including approximately $974.18 million from the FHLB, $100 million from the Federal Reserve Bank of Chicago, and $175 million in lines of credit with three correspondent banks. Uninsured deposits, while increasing to approximately $807.20 million (23.89% of total deposits), are managed within the context of these diverse liquidity resources.

Competitive Dynamics and Strategic Positioning

In the highly competitive banking sector, Hills Bancorporation differentiates itself through its deep community ties and specialized services. Its long-standing presence in Iowa fosters strong customer loyalty, particularly in niche segments like agricultural lending and local real estate. The company's regulatory licenses for trust and estate services provide a unique distribution channel, allowing it to offer specialized wealth management and fiduciary activities that resonate with its client base. This focus on personalized service and local market expertise provides a qualitative advantage against larger national players like Wells Fargo (WFC), which, despite their scale and advanced digital tools, may struggle to replicate the same level of localized engagement.

However, HBIA faces significant competitive disadvantages, primarily stemming from its smaller scale and potential technological gaps. Larger competitors such as U.S. Bancorp (USB) and PNC Financial Services Group (PNC) possess greater resources for technological innovation and operational efficiency. While HBIA strives to maintain secure and reliable technology systems, its ability to develop and integrate cutting-edge digital services at the pace of its larger rivals is limited. This could lead to net interest margin compression due to intense competition for both loans and deposits, as customers increasingly seek convenience and speed offered by more technologically advanced platforms. The rise of fintech companies and digital asset service providers further intensifies this pressure, as they offer alternative financial solutions that can bypass traditional banking channels.

Outlook and Key Risks

Management anticipates that loan demand will remain consistent through the remainder of 2025. However, the company expects net interest margin compression to impact earnings for the foreseeable future due to heightened competition for loans and deposits. Growth in net interest income is contingent on the expansion of earning assets, increasing yields on loans, and the Federal Reserve Board's ongoing interest rate stance. Credit loss expense is projected to be dependent on loan growth, local economic conditions, and overall asset quality.

The economic environment in the Midwest, as reported by the Federal Reserve's Beige Book, presents a mixed outlook. Employment has been flat, with a slight decrease anticipated over the next 12 months, particularly in the manufacturing sector. Prices are expected to continue their modest growth. Business spending has declined slightly due to uncertainty surrounding tariffs and the broader economic outlook, while agricultural income expectations for 2025 remain largely unchanged, though concerns about higher input costs for 2026 are negatively impacting capital investment. Iowa's significant role as a producer and exporter of agricultural commodities makes HBIA particularly vulnerable to changes in U.S. trade policies and retaliatory tariffs, which could lead to increased credit risk and reduced loan demand if borrowers face financial strain.

A critical risk factor for Hills Bancorporation is the identified material weaknesses in its internal controls over financial reporting. These weaknesses pertain to management review and activity-level controls over the period-end financial reporting process, segregation of duties for manual journal entries, and the identification and disclosure of related party transactions. The company has initiated a remediation plan, including engaging a third-party consultant, to strengthen its control environment. However, these weaknesses render the company's disclosure controls and procedures ineffective as of September 30, 2025, and their remediation is an ongoing process subject to management and Audit Committee oversight.

Furthermore, the rapid evolution of financial technologies, including digital assets and stablecoins, poses a long-term strategic risk. While these technologies could offer new opportunities, HBIA's ability to adapt and compete with larger, more agile technology entrants is limited. A failure to effectively participate in these emerging ecosystems could erode its market relevance and impact long-term growth. The risk of an economic recession, fueled by rising interest rates and geopolitical instability, also looms, potentially affecting asset quality, deposit levels, and loan demand.

Conclusion

Hills Bancorporation stands as a resilient community bank with a century-long legacy of serving its local Iowa markets. Its recent financial performance, marked by strong net income growth and an expanding net interest margin, underscores its operational effectiveness in a dynamic interest rate environment. The company's robust capital position and diversified liquidity sources provide a solid foundation to weather economic uncertainties.

However, the investment narrative for HBIA is not without its complexities. The identified material weaknesses in internal controls demand diligent and effective remediation, which will be a key area for investor scrutiny. Moreover, the intensifying competitive landscape, particularly from technologically advanced rivals and emerging fintech players, presents a structural challenge. While HBIA's community-centric model and specialized trust services offer a distinct competitive edge in its niche, its ability to adapt to and integrate new financial technologies will be crucial for sustained long-term growth and market relevance. Investors should weigh HBIA's proven financial stability and local market strength against the imperative to address internal control deficiencies and strategically evolve in a rapidly changing technological and economic environment.