------------------------------------- CONVERSION APPRAISAL REPORT HOME FEDERAL BANCORP, INC. PROPOSED HOLDING COMPANY FOR HOME FEDERAL SAVINGS AND LOAN ASSOCIATION OF NAMPA Nampa, Idaho Dated As Of: March 5, 2004 ------------------------------------- Prepared By: RP Financial, Lc. 1700 North Moore Street Suite 2210 Arlington, Virginia 22209 RP(R) FINANCIAL, LC. - ----------------------------------------------- Financial Services Industry Consultants March 5, 2004 Board of Directors Home Federal Savings and Loan Association of Nampa 500 12th Avenue South Nampa, Idaho 83651 Members of the Board of Directors: At your request, we have completed and hereby provide an independent appraisal ("Appraisal") of the estimated pro forma market value of the common stock which is to be issued in connection with the mutual-to-stock conversion of Home Federal Savings and Loan Association of Nampa, Nampa, Idaho ("Home Federal" or the "Association"). The common stock issued in connection with the Association's conversion will simultaneously be acquired by a holding company, Home Federal Bancorp, Inc. ("Home Federal Bancorp" or the "Company"). Pursuant to the plan of conversion, Home Federal Bancorp will offer its stock in a subscription offering to Eligible Account Holders, Tax-Qualified Employee Stock Benefit Plans including Home Federal's employee stock ownership plan (the "ESOP"), Supplemental Eligible Account Holders and Other Members. To the extent that shares remain available for purchase after satisfaction of all subscriptions received in the subscription offering, the shares may be offered for sale in a direct community offering. This Appraisal is furnished pursuant to the requirements of the Code of Federal Regulations 563b.7 and has been prepared in accordance with the "Guidelines for Appraisal Reports for the Valuation of Savings and Loan Associations Converting from Mutual to Stock Form of Organization" of the Office of Thrift Supervision ("OTS"), which have been adopted in practice by the Federal Deposit Insurance Corporation ("FDIC"). Description of Plan of Conversion - --------------------------------- The Board of Directors of the Association has adopted a plan of conversion pursuant to which the Association will convert from a federally chartered mutual savings and loan association to a federally chartered stock savings bank to be known as Home Federal Bank and issue all of its outstanding shares to the Company. Home Federal Bancorp will sell in the subscription and community offerings, Home Federal Bancorp common stock in the amount equal to the appraised value of the Association. Immediately following the conversion, the only significant assets of the Company will be the capital stock of the Association and the net conversion proceeds remaining after purchase of the Association's common stock by the Company. Home Federal Bancorp will use 50% of the net conversion proceeds to purchase the Company's common stock. A portion of the net conversion proceeds retained by the Company will be loaned to the ESOP to fund the ESOP's stock purchases in the offering, and the remainder - -------------------------------------------------------------------------------- Washington Headquarters Rosslyn Center Telephone: (703) 528-1700 1700 North Moore Street, Suite 2210 Fax No.: (703) 528-1788 Arlington, VA 22209 Toll-Free No.: (866) 723-0594 www.rpfinancial.com E-Mail: mail@rpfinancial.com Board of Directors March 5, 2004 Page 2 will initially be invested into short-term investment securities. RP Financial, LC. - ----------------- RP Financial, LC. ("RP Financial") is a financial consulting firm serving the financial services industry nationwide that, among other things, specializes in financial valuations and analyses of business enterprises and securities, including the pro forma valuation for savings institutions converting from mutual-to-stock form. The background and experience of RP Financial is detailed in Exhibit V-1. We believe that, except for the fee we will receive for our appraisal and assisting in the preparation of the Association's regulatory business plan, we are independent of the Association and the other parties engaged by Home Federal to assist in the corporate reorganization and stock issuance process. Valuation Methodology - --------------------- In preparing our appraisal, we have reviewed the regulatory applications of Home Federal, including the prospectus as filed with the OTS and the Securities and Exchange Commission ("SEC"). We have conducted a financial analysis of the Association that has included due diligence related discussions with Home Federal's management; Moss Adams LLP, the Association's independent auditor; Breyer & Associates PC, Home Federal's conversion counsel; and Keefe, Bruyette & Woods, Inc., which has been retained as the financial and marketing advisor in connection with the Company's stock offering. All conclusions set forth in the Appraisal were reached independently from such discussions. In addition, where appropriate, we have considered information based on other available published sources that we believe are reliable. While we believe the information and data gathered from all these sources are reliable, we cannot guarantee the accuracy and completeness of such information. We have investigated the competitive environment within which Home Federal operates and have assessed the Association's relative strengths and weaknesses. We have kept abreast of the changing regulatory and legislative environment and analyzed the potential impact on Home Federal and the industry as a whole. We have analyzed the potential effects of conversion on the Association's operating characteristics and financial performance as they relate to the pro forma market value of Home Federal Bancorp. We have reviewed the economy in the Association's primary market area and have compared Home Federal's financial performance and condition with selected publicly-traded thrift institutions with similar characteristics as the Association, as well as all publicly-traded thrifts. We have reviewed conditions in the securities markets in general and conditions in the market for thrift stocks in particular, including the market for existing thrift issues and the market for initial public offerings by thrifts. Our Appraisal is based on Home Federal's representation that the information contained in the regulatory applications and additional information furnished to us by the Association and its independent auditors are truthful, accurate and complete. We did not independently verify the financial statements and other information provided by the Association and its independent Board of Directors March 5, 2004 Page 3 auditors, nor did we independently value the assets or liabilities of the Association. The valuation considers Home Federal only as a going concern and should not be considered as an indication of the liquidation value of the Association. Our appraised value is predicated on a continuation of the current operating environment for Home Federal and for all thrifts. Changes in the local, state and national economy, the legislative and regulatory environment, the stock market, interest rates, and other external forces (such as natural disasters or significant world events) may occur from time to time, often with great unpredictability and may materially impact the value of thrift stocks as a whole or the Association's value alone. It is our understanding that Home Federal intends to remain an independent institution and there are no current plans for selling control of the Association as a converted institution. To the extent that such factors can be foreseen, they have been factored into our analysis. Pro forma market value is defined as the price at which Home Federal Bancorp's stock, immediately upon completion of the conversion offering, would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Valuation Conclusion - -------------------- It is our opinion that, as of March 5, 2004, the pro forma market value of the Company's common stock immediately following the offering is $90,000,000 at the midpoint, equal to 9,000,000 shares offered at a per share value of $10.00. Pursuant to conversion guidelines, the 15% offering range provides for a minimum value of $76,500,000 and a maximum value of $103,500,000. Based on the $10.00 per share offering price, this valuation range equates to total shares outstanding of 7,650,000 at the minimum and 10,350,000 at the maximum. In the event the appraised value is subject to an increase, up to 11,902,500 shares may be issued at an issue price of $10.00 per share for an aggregate market value of $119,025,000 without requiring a resolicitation. Limiting Factors and Considerations - ----------------------------------- Our valuation is not intended, and must not be construed, as a recommendation of any kind as to the advisability of purchasing shares of the common stock. Moreover, because such valuation is necessarily based upon estimates and projections of a number of matters, all of which are subject to change from time to time, no assurance can be given that persons who purchase shares of common stock in the conversion will thereafter be able to buy or sell such shares at prices related to the foregoing valuation of the pro forma market value thereof. RP Financial's valuation was determined based on the financial condition and operations of Home Federal as of December 31, 2003, the date of the financial data included in the regulatory applications and prospectus. Board of Directors March 5, 2004 Page 4 RP Financial is not a seller of securities within the meaning of any federal and state securities laws and any report prepared by RP Financial shall not be used as an offer or solicitation with respect to the purchase or sale of any securities. RP Financial maintains a policy which prohibits the company, its principals or employees from purchasing stock of its client institutions. The valuation will be updated as provided for in the conversion regulations and guidelines. These updates will consider, among other things, any developments or changes in the Association's financial performance and condition, management policies, and current conditions in the equity markets for thrift shares. These updates may also consider changes in other external factors which impact value including, but not limited to: various changes in the legislative and regulatory environment, the stock market and the market for thrift stocks, and interest rates. Should any such new developments or changes be material, in our opinion, to the valuation of the shares, appropriate adjustments to the estimated pro forma market value will be made. The reasons for any such adjustments will be explained in the update at the date of the release of the update. Respectfully submitted, RP FINANCIAL, LC. /s/ RONALD S. RIGGINS ------------------------------- Ronald S. Riggins President and Managing Director /s/ GREGORY E. DUNN ------------------------------- Gregory E. Dunn Senior Vice President RP Financial, LC. TABLE OF CONTENTS HOME FEDERAL SAVINGS AND LOAN ASSOCIATION OF NAMPA Nampa, Idaho PAGE DESCRIPTION NUMBER - ----------- ------ CHAPTER ONE OVERVIEW AND FINANCIAL ANALYSIS - ----------- Introduction 1.1 Plan of Conversion 1.1 Strategic Overview 1.2 Balance Sheet Trends 1.5 Income and Expense Trends 1.9 Interest Rate Risk Management 1.13 Lending Activities and Strategy 1.14 Asset Quality 1.18 Funding Composition and Strategy 1.18 Subsidiaries and Other Activities 1.19 Legal Proceedings 1.20 CHAPTER TWO MARKET AREA - ----------- Introduction 2.1 National Economic Factors 2.2 Market Area Demographics 2.6 Regional Economy 2.8 Deposit Trends 2.9 Competition 2.11 CHAPTER THREE PEER GROUP ANALYSIS - ------------- Peer Group Selection 3.1 Financial Condition 3.5 Income and Expense Components 3.9 Loan Composition 3.12 Interest Rate Risk 3.14 Credit Rate Risk 3.16 Summary 3.16 RP Financial, LC. TABLE OF CONTENTS HOME FEDERAL SAVINGS AND LOAN ASSOCIATION OF NAMPA Nampa, Idaho PAGE DESCRIPTION NUMBER - ----------- ------ CHAPTER FOUR VALUATION ANALYSIS - ------------ Introduction 4.1 Appraisal Guidelines 4.1 RP Financial Approach to the Valuation 4.1 Valuation Analysis 4.2 1. Financial Condition 4.3 2. Profitability, Growth and Viability of Earnings 4.4 3. Asset Growth 4.6 4. Primary Market Area 4.7 5. Dividends 4.8 6. Liquidity of the Shares 4.9 7. Marketing of the Issue 4.9 A. The Public Market 4.10 B. The New Issue Market 4.14 C. The Acquisition Market 4.15 8. Management 4.17 9. Effect of Government Regulation and Regulatory Reform 4.17 Summary of Adjustments 4.18 Valuation Approaches 4.18 1. Price-to-Earnings ("P/E") 4.19 2. Price-to-Book ("P/B") 4.20 3. Price-to-Assets ("P/A") 4.22 Comparison to Recent Conversions 4.22 Valuation Conclusion 4.23 RP Financial, LC. LIST OF TABLES HOME FEDERAL SAVINGS AND LOAN ASSOCIATION OF NAMPA Nampa, Idaho TABLE NUMBER DESCRIPTION PAGE - ------ ----------- ---- 1.1 Historical Balance Sheets 1.6 1.2 Historical Income Statements 1.10 2.1 Summary Demographic Data 2.7 2.2 Unemployment Data 2.9 2.3 Deposit Summary 2.10 2.4 Market Area Deposit Competitors 2.12 3.1 Peer Group of Publicly-Traded Thrifts 3.3 3.2 Balance Sheet Composition and Growth Rates 3.6 3.3 Income as a Percent of Average Assets and Yields, Costs, Spreads 3.10 3.4 Loan Portfolio Composition and Related Information 3.13 3.5 Interest Rate Risk Measures and Net Interest Income Volatility 3.15 3.6 Credit Risk Measures and Related Information 3.17 4.1 Market Area Unemployment Rates 4.8 4.2 Pricing Characteristics and After-Market Trends of Recent Conversions Completed 4.16 4.3 Public Market Pricing 4.21 RP Financial, LC. Page 1.1 I. OVERVIEW AND FINANCIAL ANALYSIS Introduction - ------------ Home Federal Savings and Loan Association of Nampa ("Home Federal" or the "Association"), organized in 1920, is a federally chartered savings and loan association headquartered in Nampa, Idaho. The Association serves the Treasure Valley region in southwestern Idaho through 14 branch offices and two loan centers located in the counties of Ada, Canyon, Elmore and Gem. A map of the Association's branch office locations is provided in Exhibit I-1. Home Federal is a member of the Federal Home Loan Bank ("FHLB") system, and its deposits are insured up to the regulatory maximums by the Savings Association Insurance Fund ("SAIF") of the Federal Deposit Insurance Corporation ("FDIC"). At December 31, 2003, Home Federal had $474.3 million in assets, $304.8 million in deposits and total equity of $41.4 million equal to 10.9% of total assets. Home Federal's audited financial statements are included by reference as Exhibit I-2. Plan of Conversion - ------------------ On March 16, 2004, the Board of Directors of the Association adopted a plan of conversion, incorporated herein by reference, in which the Association will convert from mutual to stock form. Home Federal Bancorp, Inc. ("Home Federal Bancorp" or the "Company"), a Delaware corporation, was recently organized to facilitate the conversion of Home Federal. In the course of the conversion, the Company will acquire all of the capital stock that the Association will issue upon its conversion from the mutual to stock form of ownership. Going forward, Home Federal Bancorp will own 100% of the Association's stock, and the Association will initially be Home Federal Bancorp's sole subsidiary. A portion of the net proceeds received from the sale of common stock will be used to purchase all of the then to be issued and outstanding capital stock of the Association and the balance of the net proceeds will be retained by the Company. At this time, no other activities are contemplated for the Company other than the ownership of the Association, a loan to the newly-formed employee stock ownership plan (the RP Financial, LC. Page 1.2 "ESOP") and reinvestment of the proceeds that are retained by the Company. In the future, Home Federal Bancorp may acquire or organize other operating subsidiaries, diversify into other banking-related activities or repurchase its stock, although there are no specific plans to undertake such activities at the present time. Strategic Overview - ------------------ Home Federal maintains a local community banking emphasis, with a primary strategic objective of meeting the borrowing and savings needs of its local customer base. Historically, Home Federal's operating strategy has been fairly reflective of a traditional thrift operating strategy in which 1-4 family residential mortgage loans and retail deposits have constituted the principal components of the Association's assets and liabilities, respectively. Beyond 1-4 family permanent mortgage loans, the Association's loan portfolio includes diversification in construction, commercial real estate, consumer and commercial business loans. Pursuant to the Association's current strategic plan, Home Federal will continue to emphasize 1-4 family lending, but will also continue to pursuer greater diversification into non-residential lending as well as consumer types of lending. Investments serve as a supplement to the Association's lending activities and the investment portfolio is considered to be indicative of a low risk investment philosophy. The investment portfolio is comprised primarily of mortgage-backed securities, with the balance of the portfolio consisting of an adjustable rate mortgage fund and FHLB stock. Retail deposits have consistently served as the primary interest-bearing funding source for the Association. In recent years, growth of checking accounts has constituted the primary source of deposit growth for the Association, with such growth facilitated by the Association's strategic emphasis on aggressively marketing those accounts. As the result of checking account growth, transaction and savings accounts currently comprise a larger portion of the Association's deposit composition than certificate of deposits ("CDs"). The Association utilizes borrowings as a supplemental funding source to facilitate management of funding costs and interest rate risk. FHLB advances constitute the Association's only source of borrowings, which have fixed rate terms with laddered maturities. Following the conversion, the Association may use additional RP Financial, LC. Page 1.3 borrowings to facilitate leveraging of its higher capital position that will result from the stock offering, in which borrowings would be utilized to fund purchases of investment securities at a positive spread to improve earnings and return on equity. To the extent additional borrowings are utilized by the Association, FHLB advances would likely continue to be the principal source of such borrowings. Home Federal's earnings base is largely dependent upon net interest income and operating expense levels, although sources of non-interest operating income have become a fairly significant contributor to the Association's in recent years. Overall, Home Federal's operating strategy has provided for a relatively strong net interest margin during the past five and one-quarter fiscal years, which has been supported by maintenance of a deposit composition with a relatively high concentration of lower cost checking accounts and greater diversification into higher yielding types of lending particularly with respect to growth of the commercial real estate loan portfolio. The Association's operating expenses are also viewed as being relatively high, which can in part be attributed to a deposit composition that consists of a relatively high concentration of transaction accounts that are more costly to service than time deposits and the Association's mortgage banking operations which incurs compensation and other expenses for purposes of originating and servicing loans that are not reflected on the Association's balance sheet. The Association's high level of operating expenses also results from maintaining a relatively large number of branch offices for the size of its deposit base, which can be attributed to the low population density of some of the markets served that limits the ability to grow deposits without geographic expansion of the branch network. The post-conversion business plan of the Association is expected to continue to focus on products and services which have facilitated Home Federal's recent growth. Specifically, Home Federal will continue to be an independent community-oriented financial institution with a commitment to local real estate and non-mortgage financing with operations funded by retail deposits, borrowings, equity capital and internal cash flows. In addition, the Association will emphasize pursuing further diversification into commercial real estate and consumer loans, as well as expansion and diversification of other products and services. The Association's Board of Directors has elected to convert to the stock form of ownership to improve the competitive position of Home Federal. The capital realized from the RP Financial, LC. Page 1.4 stock offering will increase the operating flexibility and overall financial strength of Home Federal, as well as support the expansion of the Association's strategic focus of providing competitive community banking services in its local market area. The additional capital realized from stock proceeds will increase liquidity to support funding of future loan growth and other interest-earning assets. Home Federal's higher capital position resulting from the infusion of stock proceeds will also serve to reduce interest rate risk, through enhancing the Association's interest-earning-assets-to-interest-bearing-liabilities ("IEA/IBL") ratio. The additional funds realized from the stock offering will provide an alternative funding source to deposits and borrowings in meeting the Association's future funding needs, which may facilitate a reduction in Home Federal's funding costs. Additionally, Home Federal's higher equity-to-assets ratio will also better position the Association to take advantage of expansion opportunities as they arise. Such expansion would most likely occur through the establishment or acquisition of additional banking offices or customer facilities that would provide for further penetration in the markets currently served by the Association or nearby surrounding markets. The Association will also be bettered position to pursue growth through acquisition of other financial service providers following the conversion, given its strengthened capital position and its ability to offer stock as consideration for an acquisition. At this time, the Association has no specific plans for expansion other than through establishing additional branches. The projected use of proceeds are highlighted below. o Home Federal Bancorp. The Company is expected to retain up to 50% of the net offering proceeds. At present, funds at the Company level, net of the loan to the ESOP, are expected to be primarily invested initially into short-term investment grade securities. Over time, the funds may be utilized for various corporate purposes, possibly including acquisitions, infusing additional equity into the Association, repurchases of common stock, and the payment of regular and/or special cash dividends. o Home Federal. Approximately 50% of the net conversion proceeds will be infused into the Association in exchange for all of the Association's newly issued stock. Cash proceeds (i.e., net proceeds less deposits withdrawn to fund stock purchases) infused into the Association are anticipated to become part of general operating funds, and are expected to be primarily utilized to fund loan growth. Overall, it is the Association's objective to pursue growth that will serve to increase returns, while, at the same time, growth will not be pursued that could potentially compromise RP Financial, LC. Page 1.5 the overall risk associated with Home Federal's operations. The Association has acknowledged that it intends to operate with excess capital in the near term, operating with a below market return on equity ("ROE"), until such time as the new capital can be leveraged in a safe and sound manner over an extended period of time. Balance Sheet Trends - -------------------- Table 1.1 shows the Association's historical balance sheet data for the past five and one-quarter fiscal years. From September 30, 1999 through December 31, 2003, Home Federal's assets increased at a 14.1% annual rate. Asset growth was largely the result of loan growth, which facilitated a shift in the Association's interest-earning asset composition towards a higher concentration of loans. Asset growth has been funded with a combination of deposits and borrowings, as well as retained earnings. A summary of Home Federal's key operating ratios for the past five and one-quarter fiscal years are presented in Exhibit I-3. Home Federal' loans receivable portfolio increased at a 17.7% annual rate from fiscal year end 1999 through December 31, 2003, with the portfolio exhibiting positive growth throughout the period. The Association's higher loan growth rate compared to its asset growth rate served to increase the loans-to-assets ratio from 70.5% at fiscal year end 1999 to 80.4% at December 31, 2003. Home Federal's historical emphasis on 1-4 family lending is reflected in its loan portfolio composition, as 65.1% of total loans receivable consisted of 1-4 family permanent mortgage loans at December 31, 2003. Trends in the Association's loan portfolio composition over the past five and one-quarter fiscal years show that the concentration of 1-4 family permanent mortgage loans comprising total loans increased from a low of 58.9% at fiscal year end 1999 to a high of 66.3% at year fiscal year end 2003. The slightly lower ratio of 1-4 family permanent mortgage loans maintained at December 31, 2003 was the result of shrinkage experienced in the portfolio, as Home Federal's loan volume for 1-4 family permanent mortgage loans declined sharply during the quarter ended December 31, 2003. Over the past five and one-quarter years lending diversification by the Association has emphasized origination of commercial real estate loans, with the level of permanent multi-family/commercial real estate loans comprising total loans increasing from 15.8% at fiscal year end 1999 to 24.6% at December 31, 2003. Comparatively, over the same time period, construction and land loans RP Financial, LC. Page 1.6 Table 1.1 Home Federal Savings and Loan Association of Nampa Historical Balance Sheets (Amount and Percent of Assets)(1)
At Fiscal Year End September 30, At December 31, Annual ------------------------------------------------------------------------------- -------------- Growth 1999 2000 2001 2002 2003 2003 Rate ------------ ------------ ------------ ------------ ------------- -------------- -------- Amount Pct Amount Pct Amount Pct Amount Pct Amount Pct Amount Pct Pct ------ --- ------ --- ------ --- ------ --- ------ --- ------ --- --- ($000) (%) ($000) (%) ($000) (%) ($000) (%) ($000) (%) ($000) (%) (%) Total Amount of: Assets $271,143 100.0% $325,922 100.0% $382,504 100.0% $416,543 100.0% $450,196 100.0% $474,307 100.0% 14.06% Cash and cash equivalents 7,630 2.8% 9,329 2.9% 9,784 2.6% 9,286 2.2% 11,118 2.5% 12,141 2.6% 11.55% Investment securities 0 0.0% 0 0.0% 7,508 2.0% 2,508 0.6% 5,440 1.2% 5,440 1.1% NM Mortgage-backed securities 56,332 20.8% 47,524 14.6% 37,388 9.8% 44,325 10.6% 24,425 5.4% 42,848 9.0% -6.23% Loans receivable, net 191,267 70.5% 247,903 76.1% 298,752 78.1% 331,019 79.5% 377,695 83.9% 381,574 80.4% 17.65% FHLB stock 3,516 1.3% 3,757 1.2% 4,019 1.1% 5,267 1.3% 6,533 1.5% 6,615 1.4% 16.03% Deposits 209,302 77.2% 232,747 71.4% 266,316 69.6% 279,772 67.2% 301,273 66.9% 304,755 64.3% 9.24% Borrowings 28,785 10.6% 54,498 16.7% 73,394 19.2% 91,008 21.8% 96,527 21.4% 116,735 24.6% 39.02% Equity 26,731 9.9% 31,058 9.5% 32,866 8.6% 34,961 8.4% 40,399 9.0% 41,444 8.7% 10.87% Full service offices 9 13 15 14 14 15
- --------------------- (1) Ratios are as a percent of ending assets. Sources: Home Federal's prospectus, audited financial statements and RP Financial calculations. RP Financial, LC. Page 1.7 declined from 12.8% to 3.8% of total loans and consumer loans declined from 11.5% to 6.7% of total loans. Commercial business lending is not an area of lending emphasis for the Association, with such loans ranging from a high of 1.2% of total loans at fiscal year ends 2000 and 2001 to a low of 0.44% of total loans at fiscal year end 2003. The intent of the Association's investment policy is to provide adequate liquidity and to generate a favorable return within the context of supporting Home Federal's overall credit and interest rate risk objectives. It is anticipated that proceeds retained at the holding company level will primarily be invested into investments with short-term maturities. Over the past five and one-quarter fiscal years, the Association's level of cash and investment securities (inclusive of FHLB stock) has declined from a high of 24.9% of assets at fiscal year end 1999 to a low of 10.6% of assets at fiscal year end 2003. As of December 31, 2003, cash and investments maintained by the Association equaled 14.1% of assets. Mortgage-backed securities comprise the most significant component of the Association's investment portfolio, with the portfolio consisting of mortgage-pass-through certificates that are guaranteed or insured by Fannie Mae or Freddie Mac. Mortgage-backed securities are generally purchased as a means to deploy excess liquidity at more favorable yields than other investment alternatives that are consistent with Home Federal's investment philosophy. The Association's investment in mortgage-backed securities has emphasized purchases of securities with fixed rate terms of more than ten years. The Association's investment in mortgage-backed securities totaled $42.8 million at December 31, 2003 and all but $1.0 million of the portfolio was classified as held to maturity. As of December 31, 2003, the fair value of the held to maturity mortgage-backed securities portfolio was $956,000 above the book value of the portfolio. Beyond the Association's investment in mortgage-backed securities, the only other investments held by Home Federal at December 31, 2003 consisted of an adjustable rate mortgage fund ($5.4 million) and FHLB stock ($6.6 million). The adjustable rate mortgage fund, which is maintained as available for sale, had a gross unrealized loss of $28,000 at December 31, 2003. The Association also maintained cash and cash equivalents of $12.1 million as of December 31, 2003, which equaled 2.6% of assets. Exhibit I-4 provides historical detail of the Association's investment portfolio. RP Financial, LC. Page 1.8 The Association also maintains an investment in bank-owned life insurance ("BOLI") policies, which cover the lives of some of the Association's officers and directors. The purpose of the investment is to provide funding for employee and director benefit plans. The life insurance policies earn tax-exempt income through cash value accumulation and death proceeds. As of December 31, 2003, the cash surrender value of the Association's BOLI equaled $9.7 million. Over the past five and one-quarter fiscal years, Home Federal's funding needs have been substantially met through retail deposits, internal cash flows, borrowings and retained earnings. From fiscal year end 1999 through December 31, 2003, the Association's deposits increased at an annual rate of 9.2%. Positive deposit growth was sustained throughout the period covered in Table 1.1, although the Association's utilization of borrowings increased at a faster rate than its deposit growth. Accordingly, deposits as a percent of assets declined from 77.2% at fiscal year end 1999 to 64.3% at December 31, 2003. Transaction and savings accounts equaled 51.6% of the Association's total deposits at year December 31, 2003, versus a comparable ratio of 50.1% at year end 2001. Growth of transaction and saving deposits has been sustained by growth of demand deposits, which equaled $75.5 million at December 31, 2003 and accounted for 48.1% of the Association's total transaction and savings accounts. Borrowings serve as an alternative funding source for the Association to address funding needs for growth and to support control of deposit costs. Borrowings have become a more prominent funding source for the Association during the past five and one-quarter fiscal years, increasing from 10.6% of assets at fiscal year end 1999 to 24.6% of assets at December 31, 2003. The Association's use of borrowings has generally been limited to FHLB advances. The Association held $116.7 million of FHLB advances at December 31, 2003, which have laddered terms of up to ten years. Since year end 1999, retention of earnings translated into an annual capital growth rate of 10.9% for the Association. Asset growth slightly outpaced the Association's equity growth rate, as Home Federal's equity-to-assets ratio declined from 9.9% at fiscal year end 1999 to 8.7% percent at December 31, 2003. All of the Association's capital is tangible capital, and the Association maintained capital surpluses relative to all of its regulatory capital requirements at December 31, 2003. The addition of stock proceeds will serve to strengthen Home Federal's RP Financial, LC. Page 1.9 capital position and competitive posture within its primary market area, as well as possibly support expansion into other nearby markets if favorable growth opportunities are presented. At the same time, as the result of the Association's relatively high pro forma capital position, Home Federal's ROE can be expected to be below industry averages following its conversion. Income and Expense Trends - ------------------------- Table 1.2 shows the Association's historical income statements for the past five fiscal years and for the twelve months ended December 31, 2003. The Association reported positive earnings over the past five and one-quarter fiscal years, ranging from a low of 0.50% of average assets during fiscal 2001 to a high of 1.45% of average assets during fiscal 2000. Net interest income and operating expenses represent the primary components of Home Federal's core earnings. Non-interest operating income is also a significant contributor to the Association's core earnings and has been a source of earnings growth. The amount of loan loss provisions established over the past five years has varied, but in general have not been a significant factor in the Association's earnings. Gains realized from the sale of fixed rate loans have increased in recent years, reflecting an increase in the demand for longer term fixed rate loans. The peak earnings posted in fiscal 2000 was supported by a one time gain realized from the sale of a property. Home Federal maintained a healthy net interest margin throughout the period shown in Table 1.2, which has been supported by factors such as the Association's maintenance of a relatively high concentration of lower cost transaction accounts, implementation of a lending strategy that has increased the concentration of higher yielding commercial real estate loans in the loan portfolio and maintenance of a strong position that has provided for a favorable ratio of interest-earning assets relative to interest-bearing liabilities. Over the past five and one-quarter fiscal years, the Association's net interest income to average assets ratio has ranged from a low of 3.37% during fiscal 2001 to a high of 3.88% during fiscal 2002 and fiscal 2003. For the twelve months ended December 31, 2003, the Association's net interest income to average assets ratio equaled 3.75%. The improvement in the Association's net interest income ratio has been supported by the declining interest rate environment, reflecting the more immediate impact that changes in interest rates have on the Association's interest-bearing liabilities as compared to its RP Financial, LC. Page 1.10 Table 1.2 Home Federal Savings and Loan Association of Nampa Historical Income Statements (Amount and Percent of Avg. Assets)(1)
For the Fiscal Year Ended September 30, -------------------------------------------------------------------------------------- For the 12 Months 1999 2000 2001 2002 2003 Ended 12/31/03 --------------- --------------- --------------- --------------- --------------- --------------- Amount Pct Amount Pct Amount Pct Amount Pct Amount Pct Amount Pct ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ($000) (%) ($000) (%) ($000) (%) ($000) (%) ($000) (%) ($000) (%) Interest Income $17,964 7.24% $22,438 7.51% $26,514 7.41% $26,904 6.77% $26,896 6.06% $26,506 5.85% Interest Expense (8,451) -3.41% (11,023) -3.69% (14,480) -4.05% (11,465) -2.88% (9,705) -2.19% (9,527) -2.10% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Net Interest Income $ 9,513 3.83% $11,415 3.82% $12,034 3.37% $15,439 3.88% $17,191 3.88% $16,979 3.75% Provision for Loan Losses (575) -0.23% (600) -0.20% (748) -0.21% (277) -0.07% (615) -0.14% (765) -0.17% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Net Interest Income after Provisions $ 8,938 3.60% $10,815 3.62% $11,286 3.16% $15,162 3.81% $16,576 3.74% $16,214 3.58% Other Income 4,378 1.76% 4,586 1.54% 6,033 1.69% 5,091 1.28% 10,144 2.29% 9,931 2.19% Operating Expense (9,079) -3.66% (10,641) -3.56% (14,594) -4.08% (17,178) -4.32% (18,885) -4.26% (18,629) -4.11% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Net Operating Income $ 4,237 1.71% $ 4,760 1.59% $ 2,725 0.76% $ 3,075 0.77% $ 7,835 1.77% $ 7,516 1.66% Gains and Non-Operating Income Net gain(loss) on sale of loans $ 501 0.20% $ 341 0.11% $ 286 0.08% $ 676 0.17% $ 1,044 0.24% $ 974 0.21% Gain on sale of property 0 0.00% 1,316 0.44% 0 0.00% 0 0.00% 0 0.00% 0 0.00% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Net Non-Operating Income 501 0.20% 1,657 0.55% 286 0.08% 676 0.17% 1,044 0.24% 974 0.21% Net Income Before Tax $ 4,738 1.91% $ 6,417 2.15% $ 3,011 0.84% $ 3,751 0.94% $ 8,879 2.00% $ 8,490 1.87% Income Taxes (1,766) -0.71% (2,085) -0.70% (1,223) -0.34% (1,644) -0.41% (3,423) -0.77% (3,248) -0.72% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Net Income (Loss) $ 2,972 1.20% $ 4,332 1.45% $ 1,788 0.50% $ 2,107 0.53% $ 5,456 1.23% $ 5,242 1.16% Adjusted Earnings Net Income Before Ext. Items $ 2,972 1.20% $ 4,332 1.45% $ 1,788 0.50% $ 2,107 0.53% $ 5,456 1.23% $ 5,242 1.16% Addback: Non-Operating Losses 0 0.00% 0 0.00% 0 0.00% 0 0.00% 0 0.00% 0 0.00% Deduct: Non-Operating Gains (501) -0.20% (1,657) -0.55% (286) -0.08% (676) -0.17% (1,044) -0.24% (974) -0.21% Tax Effect Non-Op. Items(2) 196 0.08% 648 0.22% 112 0.03% 264 0.07% 408 0.09% 381 0.08% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ Adjusted Net Income $ 2,667 1.08% $ 3,323 1.11% $ 1,614 0.45% $ 1,695 0.43% $ 4,820 1.09% $ 4,649 1.03%
- --------------------- (1) Ratios are as a percent of average assets. (2) Assumes tax rate of 39.1%. Sources: Home Federal's prospectus, audited financial statements and RP Financial calculations. RP Financial, LC. Page 1.11 less rate sensitive interest-earning assets. Home Federal's yield-cost spread increased from 3.29% during fiscal 2001 to 3.93% during fiscal 2003, as a 157 basis point decline in the yield earned on interest-earning assets was more than offset by a 221 basis decline in the cost of interest-bearing liabilities. More recently, the Association has experienced some compression of its yield-cost spread, as the loss of yield income resulting from accelerated repayments of 1-4 family loans and mortgage-backed securities is no longer being offset by a comparable reduction in funding costs. In particular, the Association's ability to realize further reductions in core deposit costs is limited, since current rates paid on those accounts have already been reduced to near bottom levels. For the three month period ended December 31, 2003, the Association's interest rate spread declined to 3.70%. The Association's historical net interest rate spreads and yields and costs are set forth in Exhibits I-3 and I-5. Non-interest operating income has been a significant contributor to the Association's earnings in recent years, ranging from a low of 1.28% of average assets in fiscal 2002 to a high of 2.29% of average assets in fiscal 2003. For the twelve months ended December 31, 2003, non-interest operating income equaled 2.19% of average assets. Growth of non-interest operating income has been mostly realized through increased fees and service charges generated from transaction deposits and other products and services offered to retail customers, as the Association has implemented a strategy of aggressively marketing its checking account products and other fee-oriented products and services. Service charges and fees, which account for the major portion of the Association's non-interest operating income increased from $4.8 million in fiscal 2001 to $8.3 million for the twelve months ended December 31, 2003. The lower level of non-interest operating income reported in fiscal 2002 was related to impairment charges incurred on the mortgage servicing asset, which resulted in a loss on mortgage servicing rights of $1.0 million during fiscal 2002. Operating expenses represent the other major component of the Association's earnings, ranging from a low of 3.56% of average assets during fiscal 2000 to a high of 4.32% of average assets during fiscal 2002. For the twelve months ended December 31, 2003, the Association's operating expense to average assets ratio equaled 4.11%. The Association's relatively high operating expense ratio reflects expenses associated with generating a high level of non-interest operating income, which includes servicing a high level of transaction accounts and servicing RP Financial, LC. Page 1.12 loans that are sold to the secondary market. The Association's high operating expense ratio is reflective of the higher staffing needs required for its operations compared to a more traditional thrift that generates a lower level of non-interest operating income. As of December 31, 2003, the Association's ratio of assets per full time equivalent employee equaled $2.1 million versus a comparable measure of $4.5 million for all publicly-traded thrifts. Upward pressure will be placed on the Association's operating expense ratio following the stock offering, due to expenses associated with operating as a publicly-traded company, including expenses related to the stock benefit plans. At the same, the increase in capital realized from the stock offering will increase the Association's capacity to leverage operating expenses through pursuing a more aggressive growth strategy. Overall, the general trends in the Association's net interest margin and operating expense ratio since fiscal 1999 reflect a decline in the Association's core earnings, as indicated by the Association's expense coverage ratio (net interest income divided by operating expenses). Home Federal's expense coverage ratio equaled 1.05 times in fiscal 1999, versus a comparable ratio of 0.91 times for the twelve months ended December 31, 2003. The decline in the expense coverage ratio was the result of both a decline in the net interest income ratio and an increase in the operating expense ratio. Similarly, Home Federal's efficiency ratio (operating expenses, net of amortization of intangibles, as a percent of the sum of net interest income and other operating income) of 65.5% in fiscal 1999 was more favorable than the 69.2% efficiency ratio maintained for the twelve months ended December 31, 2003. Over the past five and one-quarter years, maintenance of generally favorable credit quality measures has served to limit the amount of loss provisions established during the period. Loan loss provisions established by the Association ranged from a low of 0.07% of average assets during fiscal 2002 to a high of 0.23% of average assets during fiscal 1999. For the twelve months ended December 31, 2003, loan loss provisions established by the Association equaled $765,000 or 0.17% of average assets. As of December 31, 2003, the Association maintained valuation allowances of $2.1 million, equal to 0.56% of net loans receivable and 344.8% of non-performing loans. Exhibit I-6 sets forth the Association's loan loss allowance activity during the past five and one-quarter fiscal years. RP Financial, LC. Page 1.13 The Association records gains on the sale of loans from the sale of fixed rate loan originations to the secondary market. Most loans are sold with servicing retained. Gains realized from the sale of loans were a larger source of earnings in 2002 and 2003, as historically low mortgage rates supported a significant increase in the Association's lending volume for longer term 1-4 family fixed rate loans. Gains on the sale of loans equaled 0.17% of average assets in fiscal 2002 and 0.24% of average assets in fiscal 2003. For the twelve months ended December 31, 2003, gains on the sale of loans equaled 0.21% of average assets. Except for gains on the sale of loans, the only other gain recorded during the past five and one-quarter years was a $1.3 million gain on the sale of a property in fiscal 2000 equal to 0.44% of average assets. The gains on the sale of property is viewed as a non-recurring income item, while gains generated from the sale of fixed rate loan originations have been an ongoing activity for the Association particularly in the prevailing low interest rate environment. However, gains realized through secondary market activities are subject to a certain degree of volatility as well, given the dependence of such gains on the interest rate environment and resulting demand for longer term fixed rate loans. The Association's effective tax rate ranged from a low of 32.5% in fiscal 2000 to a high of 43.8% in fiscal 2002 and equaled 38.3% for the twelve months ended December 31, 2003. As set forth in the prospectus, the Association's effective statutory tax rate equals 39.1%. Interest Rate Risk Management - ----------------------------- The Association's balance sheet is liability-sensitive in the short-term (less than one year) and, thus, the net interest margin will typically be adversely affected during periods of rising and higher interest rates. As of December 31 , 2003, the Net Portfolio Value ("NPV") analysis provided by the OTS indicated that a 2.0% instantaneous and sustained increase in interest rates would result in a 21.9% decline in the Association's NPV and a 1.8% decline in NPV as a percent of portfolio value assets (see Exhibit I-7). The Association pursues a number of strategies to manage interest rate risk, particularly with respect to seeking to limit the repricing mismatch between interest rate sensitive assets and liabilities. The Association manages interest rate risk from the asset side of the balance sheet RP Financial, LC. Page 1.14 through selling originations of 1-4 family fixed rate loans with terms of more than 20 years and diversifying into other types of lending beyond 1-4 family permanent mortgage loans, which consists primarily of short-term and adjustable rate loans. As of December 31, 2003, of the Association's total loans due after December 31, 2004, ARM loans comprised 34.2% of those loans (see Exhibit I-8). On the liability side of the balance sheet, management of interest rate risk has been pursued through utilizing fixed rate FHLB advances with laddered maturities out to ten years and emphasizing growth of lower cost and less interest rate sensitive transaction and savings accounts. Transaction and savings accounts comprised 51.6% of the Association's deposits at December 31, 2003. The infusion of stock proceeds will serve to further limit the Association's interest rate risk exposure, as most of the net proceeds will be redeployed into interest-earning assets and the increase in the Association's capital will lessen the proportion of interest rate sensitive liabilities funding assets. Lending Activities and Strategy - ------------------------------- Home Federal's lending activities have traditionally emphasized 1-4 family permanent mortgage loans and such loans continue to comprise the largest component of the Association's loan portfolio. Beyond 1-4 family loans, lending diversification by the Association has emphasized commercial real estate, multi-family, construction, land and consumer loans. To a lesser extent, the Association's lending activities include commercial business loans. Going forward, the Association's lending strategy is to place a greater emphasis on the origination of commercial real estate loans and consumer loans, particularly home equity loans; however, the origination of 1-4 family permanent mortgage loans is expected to remain as the Association's most prominent lending activity. It is anticipated that growth of the 1- 4 family portfolio will be slowed somewhat by the sale of a large portion of fixed rate originations, thereby providing for a gradual shift in the Association's loan portfolio composition towards a higher concentration of commercial real estate loans. Exhibit I-9 provides historical detail of Home Federal's loan portfolio composition over the past five and one-quarter fiscal years and Exhibit I-10 provides the contractual maturity of the Association's loan portfolio by loan type as of December 31, 2003. RP Financial, LC. Page 1.15 Home Federal originates both fixed rate and adjustable rate 1-4 family permanent mortgage loans, retaining all ARM loans and selling most fixed rate loans with terms of more than 20 years. The Association currently retains most fixed rate loans with terms of 20 years or less. Home Federal offers ARM loans that adjust every one, three, five, seven or ten years and are indexed to the comparable term U.S. Treasury Constant Maturity Index ("CMT"). After the initial repricing period, ARM loans convert to a one-year ARM loan for the balance of the mortgage term. The substantial portion of the Association's 1-4 family permanent mortgage loans are underwritten to secondary market standards specified by Fannie Mae or Freddie Mac. As of December 31, 2003, the Association's 1-4 family permanent mortgage loan portfolio totaled $248.6 million or 64.5% of total loans outstanding. Construction loans originated by the Association consist of loans to finance the construction of 1-4 family residences, as well as multi-family and commercial real estate properties. The Association's 1-4 family construction lending activities consist of construction financing for construction/permanent loans as well as financing for speculative loans that are extended to builders. Construction/permanent loans are offered on comparable terms as 1-4 family permanent mortgage loan rates and require payment of interest only during the construction period. Speculative loans for the construction of 1-4 family properties are floating rate loans equal to the prime rate as published in The Wall Street Journal plus a margin of 1.0% to 1.25%. Commercial real estate and multi-family construction loans are generally originated as construction/permanent loans and are subject to the same underwriting criteria as required for permanent mortgage loans, as well as submission of completed plans, specifications and cost estimates related to the proposed construction. Loans for the construction of commercial real estate and multi-family loans are extended up to a loan-to-value ("LTV") ratio of 80.0% based on the lesser of the appraised value of the property or cost of construction. Commercial real estate and multi-family construction loans are prime-based loans, in which the margin applied to the prime rate is based on the degree of risk associated with the loan. Land loans constitute a minor area of lending diversification for the Association consisting substantially of properties that will be used for residential and commercial development. Land loans are typically prime-based loans that require payment of interest only RP Financial, LC. Page 1.16 for terms of up to three years. As of December 31, 2003, Home Federal's outstanding balance of construction and land loans totaled $14.5 million or 3.8% of total loans outstanding. The balance of the mortgage loan portfolio consists of commercial real estate and multi-family loans, which are substantially collateralized by properties in the Treasure Valley region of Idaho. Home Federal originates commercial real estate and multi-family loans up to a maximum LTV ratio of 80.0% and requires a minimum debt-coverage ratio of 1.2 times. Commercial real estate and multi-family loans are generally extended as five-year ARMs tied to the comparable term CMT with amortization terms of up to 25 years. In light of the higher credit risk associated with commercial real estate and multi-family loans, the margin applied to the CMT for such loans is higher compared to 1-4 family loans. Properties securing the commercial real estate and multi-family loan portfolio include hotels, office buildings, warehouses, retail properties, mini-storage facilities, medical and professional buildings, a mobile home dealership, churches and apartment buildings. Growth of commercial real estate lending is currently an area of lending emphasis for the Association. Growth will be supported by the increase in capital provided by conversion proceeds, as the Association's higher capital position will increase its loans-to-one borrower limit and, thereby, provide for increased flexibility with respect to retaining larger credits. As of December 31, 2003, the Association's largest commercial real estate loan on one property had an outstanding balance of $4.0 million and is secured by a hotel property located in Valley County which is north of the Boise metropolitan area. The loan was performing in accordance with its terms at December 31, 2003. As of December 31, 2003, the Association's balance of commercial real estate and multi-family loans totaled $94.8 million equal to 24.6% of the total loan portfolio. Diversification into non-mortgage lending consists primarily of consumer loans and, to a lesser extent, commercial business loans. Home equity lines of credit accounted for $21.2 million or 82.9% of the Association's consumer loan portfolio at December 31, 2003. Home equity lines of credit are tied to the prime rate as published in The Wall Street Journal and the Association will lend up to maximum LTV ratio of 89.9% of the combined balance of the home equity line of credit and the first lien. The balance of the consumer loan portfolio consists primarily of installment loans extended directly to the end borrower. The consumer loan portfolio also includes small balances of loans on deposits, home improvement loans and RP Financial, LC. Page 1.17 overdraft lines of credit. As of December 31 2003, the Association's consumer loan portfolio, totaled $25.6 million equal to 6.7% of total loans outstanding. Commercial business loans represent a minor area of lending diversification for the Association and will not be emphasized as a source of loan growth going forward. Commercial business loans are generally offered as floating rate loans indexed to the prime rate as published in The Wall Street Journal, which are extended to local businesses for purposes of working capital and other general business purposes. The commercial business loan portfolio includes modest balances of both secured and unsecured loans. As of December 31, 2003, Home Federal's outstanding balance of commercial business loans totaled $1.7 million equal to 0.5% of total loans outstanding. Exhibit I-11 provides a summary of the Association's lending activities over the past three and one-quarter fiscal years. The Association's lending volume increased significantly from fiscal 2001 to fiscal 2003, which was supported by increased originations of 1-4 family permanent mortgage loans. Originations of 1-4 family permanent mortgage loans increased from $114.2 million in fiscal 2001 to $289.2 million in fiscal 2003, as borrowers took advantage of historically low mortgage rates to finance new home purchases or to refinance their existing mortgages. During the past three fiscal years, originations of 1-4 family permanent loans accounted for 70.3% of the total loans originated by the Association. Commercial real estate and multi-family permanent loans represented the second highest source of originations during the three year period, with originations of those loan types accounting for 7.9% of total loans originated. While the Association's lending volume surged higher in 2003, loan growth was less significant than the pick-up in loan volume as loan repayments and loan sales increased as well. For the quarter ended December 31, 2003, the Association's lending volume reflected a sharp decline from the comparable year ago period. The decline in loan volume was mostly attributable to a significant decline in refinancing volume, which resulted in originations of 1-4 family permanent mortgage loans declining from $91.5 million during the three months ended December 31, 2002 to $18.0 million during the three months ended December 31, 2003. The decline in 1-4 family lending volume was partially offset by increased originations of commercial real and multi-family loans, with such originations increasing from $3.1 million RP Financial, LC. Page 1.18 during the three months ended December 31, 2002 to $12.0 million during the three months ended December 31, 2003. Asset Quality - ------------- The Association's 1-4 family lending emphasis has generally supported favorable credit quality measures. Over the past five and one-quarter fiscal years, Home Federal's balance of non-performing assets ranged from a low of 0.02% of assets at fiscal year end 1999 to a high of 0.97% of assets at fiscal year end 2001. The Association held $616,000 of non-performing assets at December 31, 2003, equal to 0.13% of assets. The higher ratio of non-performing assets maintained at fiscal year end 2001 was attributable to increases experienced in the balances of non-accruing 1-4 family permanent mortgage loans and non-accruing 1-4 family construction loans. As shown in Exhibit I-12, the Association's balance of non-performing assets at December 31, 2003 consisted of $616,000 of non-accruing loans, with $601,000 of the non-accruing loan balance consisting of loans secured by 1-4 family residences. To track the Association's asset quality and the adequacy of valuation allowances, Home Federal has established detailed asset classification policies and procedures which are consistent with regulatory guidelines. Detailed asset classifications are reviewed monthly by senior management and the Board. Additionally, the Association has retained an independent consulting firm to perform an annual review of the loan portfolio. Pursuant to these procedures, when needed, the Association establishes additional valuation allowances to cover anticipated losses in classified or non-classified assets. The Association's asset liability committee reviews the adequacy of the loan loss allowance quarterly. As of December 31, 2003, the Association maintained valuation allowances of $2.1 million, equal to 0.56% of net loans receivable and 344.8% percent of non-performing loans. Funding Composition and Strategy - -------------------------------- Deposits have consistently accounted for the substantial portion of the Association's interest-bearing funding composition and at December 31, 2003 deposits equaled 72.3% percent of Home Federal's interest-bearing funding composition. Exhibit I-13 sets forth the RP Financial, LC. Page 1.19 Association's deposit composition for the past three and one-quarter fiscal years and Exhibit I-14 provides the interest rate and maturity composition of the CD portfolio at December 31, 2003. Transaction and savings deposits account for the largest portion of the Association's deposit base, which in aggregate equaled $157.1 million or 51.6% of total deposits at December 31, 2003. Factors contributing to the Association's relatively high level of core deposits include aggressive marketing of "totally-free" checking accounts, training of branch personnel to be sales focused, and effective solicitation of medical savings accounts. Medical savings accounts are similar to traditional IRAs, in that interest earned on the account is not taxable provided that the funds in that account are use to pay for medical expenses. The low interest rate environment is also believed to have contributed to the increase in transaction and savings accounts maintained by the Association, as the general decline in CD rates has increased depositor preference to hold funds in liquid transaction accounts. CDs comprise the balance of the Association's deposits, equaling $147.6 million or 48.4% of total deposits at December 31, 2003. As of December 31, 2003, 37.8% of the Association's CDs were scheduled to mature in one year or less. As of December 31, 2003, jumbo CDs (CD accounts with balances of $100,000 or more) amounted to $29.1 million or 19.7% of total CDs. Home Federal does not maintain any brokered CDs. Borrowings serve as an alternative funding source for the Association to support management of funding costs and interest rate risk. Borrowings held by the Association consist of FHLB advances with laddered terms of up to ten years. As of December 31, 2003, the Association maintained $116.7 million of FHLB advances. Exhibit I-15 provides further detail of Home Federal's borrowing activities during the past three and one-quarter fiscal years. Following the stock offering, the Association may add borrowings for purposes of leveraging the balance sheet, in which borrowings would be utilized to fund purchases of investment securities at a positive spread to improve ROE. To the extent additional borrowings are obtained by the Association, FHLB advances would likely continue to be the primary source of borrowings utilized. Subsidiaries and Other Activities - --------------------------------- The Association maintains one wholly-owned subsidiary, Idaho Home Service RP Financial, LC. Page 1.20 Corporation, which has been inactive since 2000. Home Federal does have one full time broker on staff to provide investment services to customers of the Association, which are offered through a third party affiliation. Services provided by the broker include the sale of annuities, mutual funds, equities and bonds. Legal Proceedings - ----------------- Home Federal is involved in routine legal proceedings occurring in the ordinary course of business which, in the aggregate, are believed by management to be immaterial to the financial condition of the Association. RP Financial, LC. Page 2.1 II. MARKET AREA Introduction - ------------ Headquartered in Nampa, Idaho the Association maintains eight stand-alone branch locations, five Wal-Mart branch locations, one Hispanic Cultural Center office and two loan centers. The Association's branch offices serve the Treasure Valley region in southwestern Idaho, which includes the counties of Ada, Canyon, Elmore and Gem. The city of Boise is located in Ada County, where the Association maintains its largest branch presence with seven locations. Home Federal maintains five branch locations in Canyon County, including the main office in Nampa, and one branch office each in the counties of Elmore and Gem. Exhibit II-1 provides information on the Association's office facilities. The Association's primary market area is viewed as mostly rural in nature, as indicated by low population density and relative isolation from major metropolitan areas. Boise is the most populous and most urban of the markets that are served by the Association. The regional economy is well diversified, in which government, healthcare, manufacturing, hi-tech, call centers and construction provide major sources of employment. Agriculture and food processing also continue to be prominent components of the economy in southwestern Idaho. The Association's competitive environment includes other thrift institutions, as well as commercial banks, credit unions and other financial services companies, some of which have a regional or national presence. Future business and growth opportunities will be partially influenced by economic and demographic characteristics of the markets served by the Association, particularly the future growth and stability of the regional economy, demographic growth trends, and the nature and intensity of the competitive environment for financial institutions. These factors outlined herein have been taken into account regarding their relative impact on value. RP Financial, LC. Page 2.2 National Economic Factors - ------------------------- The future success of the Company's operations is partially dependent upon various national and local economic trends. Over the past year, the performance of the national economy has been mixed. March 2003 employment data signaled that the economic recovery was faltering, as the U.S. economy suffered a worse-than-expected decline in payrolls in March. Notwithstanding the loss of jobs in March, the U.S. unemployment rate for March remained steady at 5.8%. Overall, the national economy grew at a 1.6% annualized rate in the first quarter, as growth in consumer spending slowed and companies cut both capital spending and inventory restocking. The beginning of the second quarter of 2003 provided mixed economic signals. Initial jobless claims hit a one-year high in late-April, but consumer sentiment also edged higher in April. Despite the improvement in consumer sentiment, which was expected to support an increase in spending, the outlook for job growth remained dim. Job losses continued in April for the third month in a row and the national unemployment rate rose to 6.0% in April. The manufacturing sector also continued to struggle in April, as industrial production declined for the second straight month and factories were operating at their lowest rate in 20 years. Comparatively, economic data for May exhibited some positive signs, as a regional manufacturing report showed factory expansion and May consumer sentiment improved from April. Factory orders and retail sales also increased in May, but business investment and the labor market remained weak. Despite growing expectations for a rebound in the economy, the manufacturing sector continued to contract in June. Job losses concentrated in the manufacturing sector pushed the nation's unemployment rate to 6.4% in June, the highest level in more than nine years. The housing market remained a bright spot in the economy during the second quarter, as low mortgage rates continued to fuel strong demand for purchases of new and existing homes. The national economy showed signs of strengthening at the beginning of the third quarter of 2003, as the U.S. economy grew at a stronger-than-expected 3.1% annualized rate in the second quarter. Second quarter growth was fueled by brisk consumer and business spending, as well as a surge in defense expenditures. Manufacturing activity increased for the second straight RP Financial, LC. Page 2.3 month in August and retail sales were stronger in August as well. However, despite the apparent improvement in the U.S. economy, the number of employed fell in August for the seventh consecutive month. The August unemployment rate of 6.1% reflected a slight decline from the July rate of 6.2%, which was attributable to contraction in the size of the labor force as opposed to jobs being added. However, employment data for September reflected a more promising outlook for the economy, as non-farm payrolls rose for the first time in eight months. The national unemployment rate for September remained at 6.1%, as the increase in jobs was offset by a larger increase in new labor force entrants. Despite higher mortgage rates, sales of new and existing homes were strong in September. Third quarter GDP growth of 8.2% and data reflecting that the recovery was starting to translate into gains in employment provided further evidence that the national economy was gaining momentum. Job growth pushed the national unemployment rate down to 6.0% in October and 5.9% in November. Employment gains were aided by a pick-up in manufacturing activity, which was attributable to a surge in new orders. Despite the pick-up in economic activity, inflation remained low as core consumer prices fell in November for the first time since 1982. The December national unemployment rate unexpectedly dropped to a 14-month low of 5.7%; however, the decline was attributable to workers exiting the labor force rather than new jobs beings created. Other economic data for December indicated that the economic recovery was intact, as industrial production increased and consumer confidence rose to its highest level since late-2000. Residential construction also picked up in December, helping to make 2003 the best year for homebuilders since 1978. The U.S. economy grew at a 4.1% annual rate in the fourth quarter of 2003, which was supported by an increase in business investment. While fourth quarter GDP growth slowed considerably from the third quarter growth rate, GDP growth for the third and fourth quarters was the strongest back-to-back quarterly growth since 1984. A strong increase in U.S. industrial production in January 2004 provided another indication that the economic recovery was on track. Factory activity continued to rise in January and non-manufacturing grew for a tenth consecutive month in January 2004. The U.S. unemployment rate fell to a two-year low of 5.6% in January, as the pace of job growth picked-up. However, consumer confidence slipped in February, as RP Financial, LC. Page 2.4 hiring activity continued to lag the pace of the economic expansion. Employment data for February showed that jobs were added but well below expectations and the unemployment rate was unchanged at 5.6%. In terms of interest rate trend over the past year, signs of a stalling economic recovery and a sell-off in equities pulled U.S. Treasury yields to their lowest level since 1958 in early-March 2003. Comparatively, interest rates moved higher in mid-March, as stocks rallied sharply higher on expectations of a quick and decisive U.S. led strike on Iraq. The Federal Reserve left rates unchanged at its mid-March meeting, signaling uncertainty of the current strength of the economy due to the Iraq conflict. Bond prices strengthened in late-March, as weak economic data and fears that the war in Iraq could be longer and more difficult than initially anticipated served to push the yield on the 10-year Treasury note back below 4.0%. Treasury prices moved lower at the beginning of the second quarter of 2003, as the bond market ignored weak economic data and focused mainly on news of U.S. war successes in Iraq that sparked a rally in stocks. Weak economic data provided support for Treasury prices in mid-April, as the yield on the 10-year U.S. Treasury note stabilized at slightly below 4.0% through the end of April. The Federal Reserve concluded to leave short-term interest rates unchanged at its meeting in early-May. However, in a major shift, the central bank signaled that it may cut rates later to ward off the possibility of deflation, which served to boost Treasury prices following the Federal Reserve meeting. Amid more signs of economic sluggishness and growing concerns of deflation, Treasury yields plunged to their lowest levels in 45 years through the end of May and into early-June. Treasury yields declined further in mid-June on news of a shake-up among Freddie Mac's top executives due to accounting concerns and growing expectations that the Federal Reserve would cut rates again. A smaller than hoped for 0.25% rate cut by the Federal Reserve in late-June prompted a sell-off in Treasury issues at the close of the second quarter. The decline in bond prices became more pronounced at the beginning of the third quarter of 2003, with the yield on the 10-year Treasury increasing from 3.56% on July 1, 2003 to 4.43% on July 31, 2003. Investors dumped bonds in favor of stocks during July on growing expectations of an economic recovery that would lead to an end of further rate cuts by the RP Financial, LC. Page 2.5 Federal Reserve. The Federal Reserve kept its interest rate target at a 45-year low of 1.0% at its mid-August meeting and predicted that rates would stay near that level for some time. Treasury yields continued to climb higher through the balance of August, as the U.S. and global economy showed signs of improving and the Dow Jones Industrial Average rose to a 14-month high. However, weak employment data for August provided a boost to the bond market in early-September. U.S. Treasury bonds continued to strengthen through mid-September, as the Federal Reserve left interest rates unchanged and indicated they would remain low in light of government data that showed underlying inflation at a 37-year low. Weaker than expected economic data that showed a decline in consumer confidence and a slow down in manufacturing activity further contributed to the decline in Treasury yields at the close of the third quarter. The decline in interest rates was reversed in the fourth quarter, as data indicating that the economic recovery was strengthening pushed Treasury yields higher during October and early-November 2003. Indications that the Federal Reserve would keep interest rates low and favorable inflation data served to push interest rates lower in mid-November. Treasury yields moved up again in early-December, largely on the basis of economic data that showed an increase in manufacturing activity and the Federal Reserve's more upbeat assessment of the economy. The Federal Reserve concluded its December meeting with no change in the federal funds target rate of 1% and indicated that low interest rate levels could be maintained for a considerable period. Favorable inflation data supported a relatively stable interest rate environment at the close of 2003. At the beginning of January 2004, Treasury prices rallied on news of a weaker than expected December employment report, which showed job creation far below forecasted levels. In late-January, the Federal Reserve concluded to leave short-term interest rates unchanged at a 45-year low of 1%, but dropped its commitment to keep rates low for a considerable period of time. The change in the Federal Reserve's wording pushed Treasury yields higher at the end of January and into early-February. Following the spike-up in bond yields, interest rates eased lower into mid-February as January employment data showed that job growth remained less than robust. Interest rates stabilized during the second half of February, with the yield on 10-year Treasury edging below 4.0% at the end of the month. A weaker than expected employment RP Financial, LC. Page 2.6 report for February sparked a rally in Treasury bonds in early-March, as the lack of meaningful job growth raised expectations that the Federal Reserve would not increase rates anytime soon. As of March 5, 2004, one- and 10-year U.S. government bonds were yielding 1.11% and 3.82%, respectively, versus comparable year ago yields of 1.19% and 3.62%. Exhibit II-2 provides historical interest rate trends from 1991 through March 5, 2004. Market Area Demographics - ------------------------ Demographic growth in the markets served by the Association has been measured by changes in population, number of households and median household income, with trends in those areas summarized by the data presented in Table 2.1. Since 2000, the primary market area served by the Association has exhibited mixed growth characteristics as measured by population and household growth. Except for Elmore County, the primary market area counties recorded stronger population growth rates compared to the state and national growth rates. The strongest population growth has been realized in the counties of Ada and Canyon, which has been spurred by growth that has taken place in the Boise MSA. Gem County is a rural market with a small population base, and, thus, a modest increase in population translated into a relatively high population growth rate. Projected population growth for the primary market area counties is not expected to vary materially from recent historical trends; although, population growth rates for all four of the primary market area counties are projected to be slightly lower over the next five years compared to the first three years of this decade. Growth in households generally paralleled the population growth rates, with Ada County and Canyon County posting the highest household growth rates among the primary market area counties. Median household and per capita income measures for the primary market area counties indicate that Ada County is a relatively affluent market, which can be attributed to the more metropolitan nature of that market and, in particular, the greater concentration of higher paying jobs that are located in Boise. Median household and per capita income measures for Ada County were above the comparable measures for Idaho and the U.S. Comparatively, median household income and per capita income for the other three primary market counties were lower compared to the respective measures for Idaho and the U.S. Median household income increased RP Financial, LC. Page 2.7 Table 2.1 Home Federal Savings & Loan Association Summary Demographic Data
Year Growth Rate ------------------------------------- ------------------------ 2000 2003 2008 2000-2003 2003-2008 -------- -------- -------- --------- --------- Population (000) United States 281,422 291,628 309,303 1.2% 1.2% Idaho 1,294 1,377 1,522 2.1% 2.0% Ada County 301 333 389 3.4% 3.2% Canyon County 131 150 185 4.6% 4.3% Elmore County 29 30 32 1.1% 1.0% Gem County 15 16 18 2.4% 2.0% Households (000) United States 105,480 109,362 117,074 1.2% 1.4% Idaho 470 500 558 2.1% 2.2% Ada County 113 125 148 3.3% 3.4% Canyon County 45 51 64 4.5% 4.4% Elmore County 9 9 10 1.4% 1.3% Gem County 6 6 7 2.2% 2.1% Median Household Income ($) United States $ 42,729 $ 46,615 $ 54,319 2.9% 3.1% Idaho 38,121 41,420 47,440 2.8% 2.8% Ada County 52,713 54,623 58,822 1.2% 1.5% Canyon County 36,020 38,949 43,605 2.6% 2.3% Elmore County 35,378 37,395 41,156 1.9% 1.9% Gem County 34,472 37,362 42,024 2.7% 2.4% Per Capita Income - ($) United States $ 21,587 $ 24,733 4.6% Idaho 17,841 19,938 3.8% Ada County 22,519 25,111 3.7% Canyon County 15,155 16,820 3.5% Elmore County 16,773 18,086 2.5% Gem County 15,340 17,095 3.7% Less Than $25,000 to $50,000 to Median 2003 HH Income Dist.(%) $25,000 50,000 100,000 $100,000 + Age - ----------------------- ------- ------ ------- ---------- --- United States 25.5 27.8 30.5 16.1 36.0 Idaho 27.9 32.7 29.6 9.8 33.6 Ada County 20.4 28.9 35.3 15.5 33.3 Canyon County 29.1 36.1 27.9 6.8 31.0 Elmore County 29.0 40.2 25.3 5.5 29.1 Gem County 32.1 35.0 25.8 7.1 37.9
Source: ESRI Business Information Solutions RP Financial, LC. Page 2.8 in all four of the primary market area counties since 2000, with annual growth rates ranging from a low of 1.2% in Ada County to a high of 2.7% in Gem County. Household income is projected to increase at a slightly higher rate in Ada County over the next five years, versus slightly lower growth rates projected for Canyon County and Gem County. Household income distribution measures further imply that Ada County is a relatively affluent market area, based on the notably higher percentage of households with incomes of $100,000 or more in Ada County. In summary, the demographic characteristics of the primary market area are considered to be conducive for facilitating loan and deposit growth, particularly in markets that serve the Boise MSA. Regional Economy - ---------------- The Association's primary market area has a fairly diversified local economy, with employment in services, wholesale/retail trade, government and manufacturing generally serving as the basis of the local economy in each of the primary market area counties. Agriculture and related industries, which constitute the historical basis of the market area's economy, continue to be a prominent factor throughout the Association's primary market area. Service jobs generally represent the largest employment sector in the primary market area counties, although government jobs constitute the largest employment sector in Elmore County. Jobs are concentrated in the Boise MSA, which includes the counties of Ada and Canyon. Large corporations that are headquartered in the Boise MSA include Micron Technology, Albertsons, Washington Group International, J.R. Simplot Company and Boise Cascade Corporation. Boise is also home to the state's largest higher education facility, Boise State University, which has a student base of more than 18,000. Job growth was realized throughout the primary market area from 1997 through 2001, although some of the rural market area counties have a relatively small employment base and have experienced only modest job growth. The most significant job growth occurred in Ada County, as more than 38,000 jobs were created in Ada County from 1997 through 2001 bringing total employment to more than 236,000 jobs. Job growth in Ada County was primarily realized through jobs added in the service and wholesale/retail sectors. RP Financial, LC. Page 2.9 Comparative unemployment rates for the primary market area counties, as well as for the U.S. and Idaho, are shown in Table 2.2. Unemployment rates for the primary market area counties ranged from a low of 3.7% in Ada County to a high of 6.9% in Canyon County. As of December 2003, among the primary market area counties, only Ada County maintained an unemployment rate that was lower than the comparable Idaho measure of 5.4%. The Idaho unemployment rate for December 2003 matched the U.S. unemployment rate. All four of the primary market area counties, as well as the U.S. and Idaho, maintained lower unemployment rates in December 2003 compared to December 2002. Table 2.2 Unemployment Data Region December 2002 December 2003 ------ ------------- ------------- United States 5.7% 5.4% Idaho 6.1 5.4 Ada County 5.0 3.7 Canyon County 7.4 6.9 Elmore County 9.7 6.3 Gem County 9.9 6.7 Source: U.S. Bureau of Labor Statistics. Deposit Trends - -------------- The Association's retail deposit base is closely tied to the economic fortunes of southwestern Idaho and, in particular, the areas of the region that are nearby to Home Federal's 14 branches. Table 2.3 displays deposit market trends from June 30, 2001 through June 30, 2003 for the counties where the Association maintained branches during that period. Additional deposit data is also presented for Idaho. The data indicates that deposit growth in the Association's primary market area has been generally positive, with three of the five counties shown in Table 2.3 recording an increase in deposits during the two-year period. However, only Ada County's annual deposit growth rate of 12.9% exceed the comparable Idaho growth rate of 6.4%. Similar to the entire state of Idaho, commercial banks maintained a larger market share of deposits than savings institutions in all of the primary market area counties. However, during the RP Financial, LC. Page 2.10 Table 2.3 Home Federal Savings & Loan Association Deposit Summary
As of June 30, -------------------------------------------------------------------------- 2001 2003 ----------------------------------- ---------------------------------- Deposit Market # of Market # of Growth Rate Deposits Share Branches Deposits Share Branches 2001-2003 ------------ ------- -------- ------------ ------- -------- --------- (Dollars in Thousands) (%) State of Idaho $ 11,106,724 100.0% 457 $ 12,576,592 100.0% 468 6.4% Commercial Banks 9,489,114 85.4% 372 10,407,957 82.8% 378 4.7% Savings Institutions 1,617,610 14.6% 85 2,168,635 17.2% 90 15.8% Ada County $ 2,986,698 100.0% 105 $ 3,804,100 100.0% 115 12.9% Commercial Banks 2,582,285 86.5% 81 3,200,089 84.1% 87 11.3% Savings Institutions 404,413 13.5% 24 604,011 15.9% 28 22.2% Home FS&LA 78,838 2.6% 6 106,947 2.8% 7 16.5% Canyon County $ 937,763 100.0% 34 $ 942,473 100.0% 37 0.3% Commercial Banks 630,275 67.2% 22 608,745 64.6% 26 -1.7% Savings Institutions 307,488 32.8% 12 333,728 35.4% 11 4.2% Home FS&LA 147,323 15.7% 4 154,153 16.4% 4 2.3% Elmore County $ 114,967 100.0% 8 $ 124,262 100.0% 8 4.0% Commercial Banks 87,969 76.5% 5 81,042 65.2% 5 -4.0% Savings Institutions 26,998 23.5% 3 43,220 34.8% 3 26.5% Home FS&LA 11,822 10.3% 2 14,303 11.5% 1 10.0% Gem County $ 123,581 100.0% 4 $ 122,911 100.0% 4 -0.3% Commercial Banks 104,228 84.3% 3 100,694 81.9% 3 -1.7% Savings Institutions 19,353 15.7% 1 22,217 18.1% 1 7.1% Home FS&LA 19,353 15.7% 1 22,217 18.1% 1 7.1% Jerome County $ 138,042 100.0% 7 $ 136,624 100.0% 8 -0.5% Commercial Banks 123,616 89.5% 5 117,817 86.2% 5 -2.4% Savings Institutions 14,426 10.5% 2 18,807 13.8% 3 14.2% Home FS&LA 835 0.6% 1 2,220 1.6% 1 63.1%
Source: FDIC RP Financial, LC. Page 2.11 period covered in Table 2.3, savings institutions experienced an increase in deposit market share in all five of counties shown in Table 2.3. The Association completed the sale of its Jerome County branch in March 2004, which was located in a Wal-Mart and had only a very modest balance of deposits. In all four of the counties that are currently served by the Association's branches, the Association recorded an increase in deposits and an increase in deposit market share from June 30, 2001 through June 30, 2003. Home Federal's largest holding of deposits is maintained in Canyon County, where the Association is headquartered. The Association's $154.2 million of deposits at the Canyon County branches represented a 16.4% market share of thrift and bank deposits at June 30, 2003. Home Federal's largest branch presence is in Ada County, where the Association maintained its second largest holding of deposits but only a 2.8% market share of total deposits. The Association's comparatively lower market share of deposits in Ada County highlights the presence of significantly larger competitors, as well as the higher total number of bank and thrift competitors operating in the Boise MSA. Comparatively, the more rural markets served by the branches in Elmore County and Gem County translated into significantly fewer competitors and a higher market share for the Association. Pursuant to the Association's strategic plan, Home Federal will evaluate opportunities to increase deposit market share through acquisitions of financial institutions and at the same time will continue to evaluate opportunities to build deposit market share through establishing de novo branches in existing and complementary markets that are currently served by its branch network. Competition - ----------- The Association faces notable competition in both deposit gathering and lending activities, including direct competition with several financial institutions that primarily have a local or regional presence. Securities firms and mutual funds also represent major sources of competition in raising deposits. In many cases, these competitors are also seeking to provide some or all of the community-oriented services as Home Federal. With regard to lending RP Financial, LC. Page 2.12 competition, the Association encounters the most significant competition from the same institutions providing deposit services. In addition, the Association competes with mortgage companies, independent mortgage brokers, and credit unions in originating mortgage loans. Table 2.4 lists the Association's largest competitors in each of the four counties currently served by its branches, based on deposit market share as noted parenthetically. The Association's deposit market share and market rank are also provided in Table 2.4. Table 2.4 Home Federal Savings & Loan Association Market Area Deposit Competitors Location Name - -------- ---- Ada County U.S. Bancorp. (27.8%) Wells Fargo & Co. (22.0%) Washington Federal Inc. (6.3%) Home Federal (2.8%) - Rank of 12 Canyon County Wells Fargo & Co. (22.3%) U.S. Bancorp (15.2%) Washington Federal Inc.(11.0%) Home Federal (16.4%) - Rank of 2 Elmore County Wells Fargo & Co. (32.9%) U.S. Bancorp (23.6%) Washington Mutual Inc. (23.3%) Home Federal (11.5%) - Rank of 4 Gem County Wells Fargo & Co. (48.6%) U.S. Bancorp (25.0%) KeyCorp (8.4%) Home Federal (18.1%) - Rank of 3 Sources: SNL Financial and FDIC. RP Financial, LC. Page 3.1 III. PEER GROUP ANALYSIS This chapter presents an analysis of Home Federal's operations versus a group of comparable companies (the "Peer Group") selected from the universe of all publicly-traded savings institutions. The primary basis of the pro forma market valuation of Home Federal is provided by these public companies. Factors affecting the Association's pro forma market value such as financial condition, credit risk, interest rate risk, and recent operating results can be readily assessed in relation to the Peer Group. Current market pricing of the Peer Group, subject to appropriate adjustments to account for differences between Home Federal and the Peer Group, will then be used as a basis for the valuation of Home Federal's to-be-issued common stock. Peer Group Selection - -------------------- The Peer Group selection process is governed by the general parameters set forth in the regulatory valuation guidelines. Accordingly, the Peer Group is comprised of only those publicly-traded savings institutions whose common stock is either listed on a national exchange (NYSE or AMEX), or is NASDAQ listed, since their stock trading activity is regularly reported and generally more frequent than non-publicly traded and closely-held institutions. Non-listed institutions are inappropriate since the trading activity for thinly-traded or closely-held stocks is typically highly irregular in terms of frequency and price and thus may not be a reliable indicator of market value. We have also excluded from the Peer Group those companies under acquisition or subject to rumored acquisition, mutual holding companies and recent conversions, since their pricing ratios are subject to unusual distortion and/or have limited trading history. A recent listing of the universe of all publicly-traded savings institutions is included as Exhibit III-1. Ideally, the Peer Group, which must have at least 10 members to comply with the regulatory valuation guidelines, should be comprised of locally or regionally-based institutions with comparable resources, strategies and financial characteristics. There are approximately 195 fully-converted publicly-traded thrift institutions nationally and, thus, it is typically the case that the Peer Group will be comprised of institutions with relatively comparable characteristics. To the extent that differences exist between the converting institution and the Peer Group, valuation RP Financial, LC. Page 3.2 adjustments will be applied to account for the differences. From the universe of publicly-traded thrifts, we selected 13 institutions with characteristics similar to those of Home Federal. In the selection process, we applied two "screens" to the universe of all public companies: o Screen #1. Northwest institutions with assets between $350 million and $1 billion and equity-to-assets ratios of greater than 10.0%. Seven companies met the criteria for Screen #1 and six were included in the Peer Group: Evertrust Financial Group of WA, FirstBank NW Corp. of WA, Heritage Financial Corp. of WA, Horizon Financial Corp. of WA, Riverview Bancorp of WA and Timberland Bancorp of WA. Rainier Pacific Financial Group of WA was excluded from the Peer Group due to the recency of its conversion, which was completed in October 2003. Exhibit III-2 provides financial and public market pricing characteristics of all publicly-traded Northwest based thrifts. o Screen #2. Midwest institutions with assets between $350 million and $1 billion and equity-to-assets ratios of greater than 10.0%. Seven companies met the criteria for Screen #2 and all seven were included in the Peer Group: Chesterfield Financial of IL, FSF Financial Corp. of MN, First Federal Bankshares of IA, Lincoln Bancorp of IN, Peoples Bancorp of IN, Wayne Savings Bancorp of OH and Western Ohio Financial Corp. of OH. Exhibit III-3 provides financial and public market pricing characteristics of all publicly-traded Midwest based thrifts. Table 3.1 shows the general characteristics of each of the 13 Peer Group companies and Exhibit III-4 provides summary demographic and deposit market share data for the primary market areas served by each of the Peer Group companies. While there are expectedly some differences between the Peer Group companies and Home Federal, we believe that the Peer Group companies, on average, provide a good basis for valuation subject to valuation adjustments. The following sections present a comparison of Home Federal's financial condition, income and expense trends, loan composition, interest rate risk and credit risk versus the Peer Group as of the most recent publicly available date. A summary description of the key characteristics of each of the Peer Group companies is detailed below. o Chesterfield Financial of IL. Selected due to high equity-to-assets ratio and favorable credit quality measures. o Evertrust Financial Group of WA. Selected due to Northwest regional market area, comparable size of branch network, comparable loans-to-assets ratio, similar interest-bearing funding composition, comparable net interest margin, relatively high level of RP Financial, LC. Page 3.3 [GRAPHIC OMITTED] RP Financial, LC. Page 3.4 operating expenses, lending diversification emphasis on commercial real estate loans and favorable credit quality measures. o FSF Financial Corp. of MN. Selected due to comparable asset size, comparable size of branch network, similar interest-bearing funding composition, comparable return on assets, relatively high level of non-interest operating income and relatively high level of operating expenses. o First Federal Bankshares of IA. Selected due to comparable size of branch network, similar interest-bearing funding composition, relatively high level of non-interest operating income, relatively high level of operating expenses and lending diversification emphasis on commercial real estate loans. o FirstBank NW Corp. of WA. Selected due to Northwest regional market area, similar interest-bearing funding composition, relatively high level of operating expenses and favorable credit quality measures. o Heritage Financial Corp. of WA. Selected due to Northwest regional market area, similar interest-earning asset composition, relatively high level of operating expenses, lending diversification emphasis on commercial real estate loans and favorable credit quality measures. o Horizon Financial Corp. of WA. Selected due to Northwest regional market area, comparable size of branch network, lending diversification emphasis on commercial real estate loans and favorable credit quality measures. o Lincoln Bancorp of IN. Selected due to lending diversification emphasis on commercial real estate loans and favorable credit quality measures. o Peoples Bancorp of IN. Selected due to comparable asset size, comparable size of branch network, comparable return on assets and favorable credit quality measures. o Riverview Bancorp of WA. Selected due to Northwest regional market area, comparable asset size, comparable size of branch network, comparable return on assets, relatively high level of non-interest operating income, relatively high level of operating expenses, lending diversification emphasis on commercial real estate loans and favorable credit quality measures. o Timberland Bancorp of WA. Selected due to Northwest regional market area, comparable asset size, comparable size of branch network, high equity-to-assets ratio, relatively high level of operating expenses and lending diversification emphasis on commercial real estate loans. o Wayne Savings Bancorp of OH. Selected due to comparable lending emphasis on 1-4 family loans and favorable credit quality measures. o Western Ohio Financial Corp. of OH. Selected due to similar interest-bearing funding composition, comparable lending emphasis on 1-4 family loans, lending diversification emphasis on commercial real estate loans and favorable credit quality measures. RP Financial, LC. Page 3.5 In aggregate, the Peer Group companies maintain a higher level of capital than the industry average (12.87% of assets versus 10.78% for all public companies), generate higher earnings as a percent of average assets (1.01% ROAA versus 0.85% for all public companies), and generate a slightly lower return on equity (8.17% ROE versus 8.95% for all public companies). Overall, the Peer Group's average P/B ratio and average P/E multiple were below and comparable to the respective averages for all publicly-traded thrifts. All Publicly-Traded Peer Group --------------- ---------- Financial Characteristics (Averages) ------------------------------------ Assets ($Mil) $ 2,489 $ 553 Market capitalization ($Mil) $ 447 $ 101 Equity/assets (%) 10.78% 12.87% Return on assets (%) 0.85% 1.01% Return on equity (%) 8.95% 8.17% Pricing Ratios (Averages)(1) ------------------------- Price/earnings (x) 18.08x 18.71x Price/book (%) 167.69% 142.83% Price/assets (%) 18.37% 18.25% (1) Based on market prices as of March 5, 2004. Ideally, the Peer Group companies would be comparable to Home Federal in terms of all of the selection criteria, but the universe of publicly-traded thrifts does not provide for an appropriate number of such companies. However, in general, the companies selected for the Peer Group were fairly comparable to Home Federal, as will be highlighted in the following comparative analysis. Financial Condition - ------------------- Table 3.2 shows comparative balance sheet measures for Home Federal and the Peer Group. Home Federal's and the Peer Group's ratios reflect balances as of December 31, 2003, unless otherwise indicated for the Peer Group companies. Home Federal's equity-to-assets ratio of 9.5% was below the Peer Group's average net worth ratio of 12.9%. However, the Association's pro forma capital position will increase with the addition of stock proceeds and RP Financial, LC. Page 3.6 [GRAPHIC OMITTED] RP Financial, LC. Page 3.7 will exceed the Peer Group's ratio following the conversion. Tangible equity-to-assets ratios for the Association and the Peer Group equaled 9.5% and 12.0%, respectively, as goodwill and intangibles maintained by the Peer Group equaled 0.9% off assets. The increase in Home Federal's pro forma capital position will be favorable from a risk perspective and in terms of future earnings potential that could be realized through leverage and lower funding costs. At the same time, the Association's higher pro forma capitalization will also result in a relatively low return on equity. Both the Association's and the Peer Group's capital ratios reflected capital surpluses with respect to the regulatory capital requirements, with the Peer Group's ratios currently exceeding the Association's ratios. On a pro forma basis, the Association's surpluses will likely be more significant than indicated for the Peer Group. The interest-earning asset compositions for the Association and the Peer Group were somewhat similar, with loans constituting the bulk of interest-earning assets for both Home Federal and the Peer Group. Home Federal's loans-to-assets ratio of 80.4% was above the comparable Peer Group ratio of 70.7%. Comparatively, Home Federal's cash and investments-to assets ratio of 14.2% was lower than the comparable Peer Group measure of 24.0%. Overall, Home Federal's interest-earning assets amounted to 94.6% of assets, which approximated the Peer Group's ratio of 94.7%. Home Federal's funding liabilities reflected a funding strategy that was somewhat similar to that of the Peer Group's funding composition. The Association's deposits equaled 64.3% of assets, which was below the comparable Peer Group ratio of 72.8%. Comparatively, borrowings accounted for a higher portion of the Association's interest-bearing funding composition, as indicated by borrowings-to-assets ratios of 24.6% and 13.4% for Home Federal and the Peer Group, respectively. Total interest-bearing liabilities maintained by the Association and the Peer Group, as a percent of assets, equaled 88.9% and 86.2%, respectively. Following the increase in capital provided by the net proceeds of the conversion offering, the Association's ratio of interest-bearing liabilities as a percent of assets will be less than the Peer Group's ratio. A key measure of balance sheet strength for a thrift institution is its IEA/IBL ratio. Presently, the Peer Group's IEA/IBL ratio is stronger than the Association's ratio, based on respective ratios of 109.9% and 106.4%. The additional capital realized from stock proceeds RP Financial, LC. Page 3.8 should serve to provide Home Federal with an IEA/IBL ratio that exceeds the Peer Group's ratio, as the increase in capital provided by the infusion of conversion proceeds will serve to lower the level of interest-bearing liabilities funding assets and will be primarily deployed into interest-earning assets. The growth rate section of Table 3.2 shows annual growth rates for key balance sheet items. Home Federal's growth rates are based on annualized growth for the 15 months ended December 31, 2003, while the Peer Group's growth measures are based on annual growth for the twelve months ended December 31, 2003 or the most recent period available. Home Federal's assets increased at an 11.0% annualized rate, versus a 4.5% asset growth rate posted by the Peer Group. Home Federal's asset growth was mostly realized through loan growth, which was supplemented with less significant growth of cash and investments. Similarly, asset growth for the Peer Group was mostly realized through loan growth and, to a lesser extent, growth of cash and investments. Overall, the Association's asset growth measures would tend to indicate greater earnings growth potential relative to the Peer Group's asset growth measures. Additionally, Home Federal's future asset growth potential will be enhanced by the increased leverage capacity that will result from the infusion of net conversion proceeds into capital. Fairly comparable increases in the Association's balances of deposits and borrowings funded asset growth, which translated into a higher borrowings growth rate in light of the lower balance of borrowings maintained relative to deposits. The Peer Group's growth rates for deposits and borrowings were lower than the comparable growth rates indicated for the Association. Capital growth rates posted by the Association and the Peer Group equaled 14.6% and 2.3%, respectively. Factors contributing to the Association higher capital growth rate included its lower level of capital as well as retention of all of its earnings. Comparatively, despite recording a higher return on assets than the Association, the Peer Group's capital growth rate was slowed by dividend payments as well as stock repurchases. The increase in capital realized from stock proceeds, as well as possible dividend payments and stock repurchases, will depress the Association's capital growth rate following the stock offering. RP Financial, LC. Page 3.9 Income and Expense Components - ----------------------------- Table 3.3 displays comparable statements of operations for Home Federal and the Peer Group, based on earnings for the twelve months ended December 31, 2003 unless indicated otherwise for the Peer Group companies. For the period shown in Table 3.3, Home Federal and the Peer Group reported net income to average assets ratios of 1.16% and 1.01%, respectively. The comparable returns indicated for Association and the Peer Group resulted from the Association's stronger net interest margin and higher level of non-interest operating income being offset by the Peer Group's lower level of operating expenses. Net gains and loss provisions were fairly comparable factors in the Association's and the Peer Group's earnings. Net interest income represents the primary source of earnings for the Association and the Peer Group, equaling 3.75% and 3.51% of average assets, respectively. The Association maintained both a higher interest income ratio and a higher interest expense ratio in comparison to the Peer Group's ratios. The Association's higher interest income ratio was supported by maintaining a higher yield on interest earning assets (6.32% versus 5.86% for the Peer Group), which was supported by the Association's interest-earning asset mix that reflected a higher concentration of loans in comparison to the Peer Group. The slightly lower interest expense ratio posted by the Peer Group was facilitated by maintaining a lower ratio of interest-bearing liabilities as a percent of assets, as well as by maintaining a slightly lower cost of funds than the Association (2.40% versus 2.53% for the Association). Following the Association's conversion, the increase in capital to be realized from the infusion of conversion proceeds and the resultant decline in the level of interest-bearing liabilities funding assets should negate the Peer Group's current advantage with respect to maintaining a lower interest expense ratio. In another key area of core earnings strength, the Association maintained a significantly higher level of operating expenses than the Peer Group. For the period covered in Table 3.3, the Association and the Peer Group reported operating expense to average assets ratios of 4.11% and 2.90%, respectively, inclusive of amortization of goodwill and other intangibles. In general, the Association's higher operating expense ratio is reflective of its strategy to broaden products and services offered to its customers, its deposit composition which consist of a relatively high concentration of transaction accounts that are more costly to service than time deposits and its RP Financial, LC. Page 3.10 [GRAPHIC OMITTED] RP Financial, LC. Page 3.11 more significant mortgage banking operations. Consistent with the Association's higher operating expense ratio and more diversified operations, Home Federal maintained a comparatively higher number of employees relative to its asset size. Assets per full time equivalent employee equaled $2.1 million for the Association, versus a comparable measure of $3.6 million for the Peer Group. On a post-offering basis, the Association's operating expenses can be expected to increase with the addition of stock benefit plans and expenses related to operating as a publicly-traded company, with such expenses already impacting the Peer Group's operating expenses. At the same time, Home Federal's capacity to leverage operating expenses will be greater than the Peer Group's leverage capacity following the increase in capital realized from the infusion of net stock proceeds. When viewed together, net interest income and operating expenses provide considerable insight into a thrift's earnings strength, since those sources of income and expenses are typically the most prominent components of earnings and are generally more predictable than losses and gains realized from the sale of assets or other non-recurring activities. In this regard, as measured by their expense coverage ratios (net interest income divided by operating expenses), the Association's earnings strength was less than the Peer Group's. For the twelve months ended December 31, 2003, Home Federal's and the Peer Group's expense coverage ratios equaled 0.91x and 1.21x, respectively. An expense coverage ratio of greater than 1.0x indicates that an institution is able to sustain pre-tax profitability without having to rely on non-interest sources of income. Sources of non-interest operating income were a larger contributor to Home Federal's earnings, with such income amounting to 2.19% and 0.78% of Home Federal's and the Peer Group's average assets, respectively. The Association's higher level of non-interest operating income is supported by income generated through service fees and charges. Taking non-interest operating income into account in comparing the Association's and the Peer Group's earnings, Home Federal's efficiency ratio of 69.2% was slightly less favorable than the Peer Group's efficiency ratio of 67.4%. Loan loss provisions had a fairly comparable impact on the Association's and the Peer Group's earnings, with loss provisions established by Home Federal and the Peer Group equaling RP Financial, LC. Page 3.12 0.17% and 0.12% of average assets, respectively. The level of loan loss provisions established by the Association and the Peer Group were indicative of their generally favorable credit quality measures. Net gains were a comparable factor in the Association's and the Peer Group's earnings, equaling 0.21% and 0.23% of average assets for the Association and the Peer Group, respectively. Typically, gains and losses generated from the sale of assets are viewed as earnings with a relatively high degree of volatility and, thus, are substantially discounted in the evaluation of an institution's core earnings. In the case of Home Federal, the gains were derived through selling fixed rate loans into the secondary market, which is considered to be an ongoing activity for the Association particularly during periods of low interest rates. Likewise, the gains recorded by the Peer Group were supported by gains derived from the sale of fixed rate loans as an ongoing activity. Accordingly, such gains warrant some consideration as a core earnings factor for the Association and the Peer Group, but are still viewed as a more volatile source of income than income generated through the net interest margin and non-interest operating income. Taxes had a slightly larger impact on the Association's earnings, as Home Federal and the Peer Group posted effective tax rates of 38.3% and 32.1%, respectively. Loan Composition - ---------------- Table 3.4 presents data related to the loan composition of Home Federal and the Peer Group. In comparison to the Peer Group, the Association's loan portfolio composition reflected a higher concentration in the aggregate of 1-4 family permanent mortgage loans and mortgage-backed securities than maintained by the Peer Group (61.4% of assets versus 32.1% for the Peer Group). A higher concentration of 1-4 family primarily accounted for the Association's higher ratio, while the Association also maintained a slightly higher ratio of mortgage-backed securities. Loans serviced for others equaled 53.7% and 11.0% of the Association's and the Peer Group's assets, respectively, thereby indicating the greater influence of mortgage banking activities on the Association's operations. The Association's higher balance of loans serviced for others translated into a higher ratio of servicing intangibles, as servicing assets equaled 0.67% and 0.06% of the Association's and the Peer Group's assets, respectively. RP Financial, LC. Page 3.13 [GRAPHIC OMITTED] RP Financial, LC. Page 3.14 Diversification into higher risk and higher yielding types of lending was more significant for the Peer Group, largely on the basis of the Peer Group's higher concentration of construction and land loans. Commercial real estate/multi-family loans represented the most significant area of lending diversification for the Association (20.0% of assets), followed by consumer loans (5.4% of assets). Similarly, commercial real estate/multi-family loans represented the most significant area of lending diversification for the Peer Group (22.9% of assets) followed by construction and land loans (10.5% of assets). In comparison to Home Federal, the Peer Group's loan composition also reflected higher concentrations of commercial business loans (2.6% of assets) and consumer loans (5.5% of assets). Beyond commercial real estate and consumer loans, lending diversification for the Association was limited consisting of modest balances of construction and land loans (3.1% of assets) and commercial business loans (0.4% of assets). Overall, the Peer Group's greater degree of lending diversification into higher risk types of lending translated into a higher risk weighted assets-to-assets ratio of 69.1%, versus a comparable ratio of 59.8% maintained by the Association. Interest Rate Risk - ------------------ Table 3.5 reflects various key ratios highlighting the relative interest rate risk exposure of the Association versus the Peer Group companies. In terms of balance sheet composition, Home Federal's interest rate risk characteristics were considered to be slightly less favorable than the Peer Group's. Most notably, Home Federal's lower tangible capital position and lower IEA/IBL ratio indicate a greater dependence on the yield-cost spread to sustain the net interest margin. A lower level of non-interest earning assets also represented an advantage for the Peer Group with respect to capacity to generate net interest income and, in turn, limiting the interest rate risk associated with the balance sheet. On a pro forma basis, the infusion of stock proceeds should provide the Association with comparable or slightly more favorable balance sheet interest rate risk characteristics than currently maintained by the Peer Group, particularly with respect to the increases that will be realized in Association's equity-to-assets and IEA/IBL ratios. To analyze interest rate risk associated with the net interest margin, we reviewed quarterly changes in net interest income as a percent of average assets for Home Federal and the RP Financial, LC. Page 3.15 [GRAPHIC OMITTED] RP Financial, LC. Page 3.16 Peer Group. In general, the more significant fluctuations in the Association's ratios implied there was a greater degree of interest rate risk associated with its net interest income compared to the Peer Group's, based on the interest rate environment that prevailed during the period covered in Table 3.5. The stability of the Association's net interest margin should be enhanced by the infusion of stock proceeds, as interest rate sensitive liabilities will be funding a lower portion of Home Federal's assets and the proceeds will be substantially deployed into interest-earning assets. Credit Risk - ----------- Overall, the Association's credit risk exposure appears to be slightly less than the Peer Group's, based on the Association's lower ratios of non-performing loans and non-performing assets and higher reserve coverage ratios as a percent of non-performing loans and non-performing assets. As shown in Table 3.6, the Association's ratio of non-performing assets and accruing loans that are more than 90 days past due equaled 0.13% of assets, which was below the comparable Peer Group ratio of 0.65%. Non-performing loans equaled 0.16% of the Association's loans compared to 0.76% for the Peer Group. The Association maintained a higher level of loss reserves as a percent of non-performing loans (344.8% versus 262.2% for the Peer Group), while the Peer Group maintained higher reserves as a percent of loans (1.00% versus 0.56% for the Association). The Peer Group's higher credit risk exposure was also implied by higher net charge-offs, as net charge-offs for the twelve month period equaled 0.11% and 0.04% of the Peer Group's and the Association's respectively. Summary - ------- Based on the above analysis, RP Financial concluded that the Peer Group forms a reasonable basis for determining the pro forma market value of Home Federal. Such general characteristics as asset size, capital position, interest-earning asset composition, funding composition, core earnings measures, loan composition, credit quality and exposure to interest rate risk all tend to support the reasonability of the Peer Group from a financial standpoint. RP Financial, LC. Page 3.17 [GRAPHIC OMITTED] RP Financial, LC. Page 3.18 Those areas where differences exist will be addressed in the form of valuation adjustments to the extent necessary. RP Financial, LC. Page 4.1 IV. VALUATION ANALYSIS Introduction - ------------ This chapter presents the valuation analysis and methodology, prepared pursuant to the regulatory valuation guidelines, and valuation adjustments and assumptions used to determine the estimated pro forma market value of the common stock to be issued in conjunction with the Association's conversion transaction. Appraisal Guidelines - -------------------- The OTS written appraisal guidelines specify the market value methodology for estimating the pro forma market value of an institution pursuant to a mutual-to-stock conversion. Pursuant to this methodology: (1) a peer group of comparable publicly-traded institutions is selected; (2) a financial and operational comparison of the subject company to the peer group is conducted to discern key differences; and (3) a valuation analysis in which the pro forma market value of the subject company is determined based on the market pricing of the peer group as of the date of valuation, incorporating valuation adjustments for key differences. In addition, the pricing characteristics of recent conversions, both at conversion and in the aftermarket, must be considered. RP Financial Approach to the Valuation - -------------------------------------- The valuation analysis herein complies with such regulatory approval guidelines. Accordingly, the valuation incorporates a detailed analysis based on the Peer Group, discussed in Chapter III, which constitutes "fundamental analysis" techniques. Additionally, the valuation incorporates a "technical analysis" of recently completed stock conversions, including closing pricing and aftermarket trading of such offerings. It should be noted that these valuation analyses cannot possibly fully account for all the market forces which impact trading activity and pricing characteristics of a particular stock on a given day. The pro forma market value determined herein is a preliminary value for the Association's to-be-issued stock. Throughout the conversion process, RP Financial will: (1) RP Financial, LC. Page 4.2 review changes in the Association's operations and financial condition; (2) monitor the Association's operations and financial condition relative to the Peer Group to identify any fundamental changes; (3) monitor the external factors affecting value including, but not limited to, local and national economic conditions, interest rates, and the stock market environment, including the market for thrift stocks; and (4) monitor pending conversion offerings (including those in the offering phase) both regionally and nationally. If material changes should occur prior to closing the offering, RP Financial will evaluate if updated valuation reports should be prepared reflecting such changes and their related impact on value, if any. RP Financial will also prepare a final valuation update at the closing of the offering to determine if the prepared valuation analysis and resulting range of value continues to be appropriate. The appraised value determined herein is based on the current market and operating environment for the Association and for all thrifts. Subsequent changes in the local and national economy, the legislative and regulatory environment, the stock market, interest rates, and other external forces (such as natural disasters or major world events), which may occur from time to time (often with great unpredictability) may materially impact the market value of all thrift stocks, including Home Federal's value, or Home Federal's value alone. To the extent a change in factors impacting the Association's value can be reasonably anticipated and/or quantified, RP Financial has incorporated the estimated impact into its analysis. Valuation Analysis - ------------------ A fundamental analysis discussing similarities and differences relative to the Peer Group was presented in Chapter III. The following sections summarize the key differences between the Association and the Peer Group and how those differences affect the pro forma valuation. Emphasis is placed on the specific strengths and weaknesses of the Association relative to the Peer Group in such key areas as financial condition, profitability, growth and viability of earnings, asset growth, primary market area, dividends, liquidity of the shares, marketing of the issue, management, and the effect of government regulations and/or regulatory reform. We have also considered the market for thrift stocks, in particular new issues, to assess the impact on value of Home Federal coming to market at this time. RP Financial, LC. Page 4.3 1. Financial Condition ------------------- The financial condition of an institution is an important determinant in pro forma market value, because investors typically look to such factors as liquidity, capital, asset composition and quality, and funding sources in assessing investment attractiveness. The similarities and differences in the Association's and the Peer Group's financial conditions are noted as follows: o Overall A/L Composition. Loans funded by retail deposits were the primary components of both Home Federal's and the Peer Group's balance sheets. The Association's interest-earning asset composition exhibited a higher concentration of loans, while the Peer Group's loan portfolio composition exhibited a greater degree of diversification into higher risk and higher yielding types of loans. Overall, the Peer Group's asset composition provided for a higher risk weighted assets-to-assets ratio than maintained by the Association. Home Federal's funding composition reflected a lower level of deposits and a higher level of borrowings than the comparable Peer Group ratios. Overall, as a percent of assets, the Association maintained a comparable level of interest-earning assets and a higher level of interest-bearing liabilities, which provided for a higher IEA/IBL ratio for the Peer Group. After factoring in the impact of the net conversion proceeds, the Association's IEA/IBL ratio will be as strong or stronger than the Peer Group's ratio. For valuation purposes, RP Financial concluded that no adjustment was warranted for the Association's overall asset/liability composition. o Credit Quality. Both the Association's and the Peer Group's credit quality measures were indicative of fairly limited credit risk exposure. However, in general, the Association's credit quality measures were considered to be more favorable than the Peer Group's. The Association maintained a lower non-performing assets-to-assets ratio and a lower non-performing loans-to-loan ratio than the comparable Peer Group ratios. Loss reserves as a percent of non-performing assets were stronger for the Association, while the Peer Group maintained a stronger reserve coverage ratio as a percent of loans. Overall, in comparison to the Peer Group, the Association's measures tended to imply a more limited degree of credit exposure and, thus, RP Financial concluded that a slight upward adjustment was warranted for the Association's credit quality. o Balance Sheet Liquidity. The Peer Group operated with a higher level of cash and investment securities relative to the Association (24.0% of assets versus 14.2% for the Association). Following the infusion of stock proceeds, the Association's cash and investments ratio is expected to increase as the proceeds retained at the holding company level will be initially deployed into investments. The Peer Group's future borrowing capacity was considered to be slightly greater than the Association's, in light of the higher level of borrowings currently maintained by the Association. However, both the Association and the Peer Group were considered to have ample borrowing capacities. Overall, balance RP Financial, LC. Page 4.4 sheet liquidity for the Association was considered to be comparable to the Peer Group and, thus, RP Financial concluded that no adjustment was warranted for the Association's balance sheet liquidity. o Funding Liabilities. Retail deposits served as the primary interest-bearing source of funds for the Association and the Peer Group, with borrowings being utilized to a greater degree by the Association. The Association's overall funding composition provided for a slightly higher cost of funds than maintained by the Peer Group. In total, the Association maintained a higher level of interest-bearing liabilities than the Peer Group, which was attributable to Home Federal's lower capital position. Following the stock offering, the increase in the Association's capital position should provide Home Federal with a comparable or lower level of interest-bearing liabilities than maintained by the Peer Group. Overall, RP Financial concluded that no adjustment was warranted for Home Federal's funding composition. O Capital. The Peer Group operates with a higher equity-to-assets ratio than the Association. However, following the mutual-to-stock conversion, Home Federal's pro forma capital position will likely exceed the Peer Group's equity-to-assets ratio. The Association's higher pro forma capital position will result in greater leverage potential and reduce the level of interest-bearing liabilities utilized to fund assets. At the same time, the Association's more significant capital surplus will likely result in a depressed ROE. Overall, RP Financial concluded that a slight upward adjustment was warranted for the Association's capital position. On balance, Home Federal's balance sheet strength was considered to be more favorable than Peer Group's, as implied by the more favorable credit quality and capital characteristics of the Association's pro forma balance sheet. Accordingly, we concluded that a slight upward valuation adjustment was warranted for the Association's financial condition. 2. Profitability, Growth and Viability of Earnings ----------------------------------------------- Earnings are a key factor in determining pro forma market value, as the level and risk characteristics of an institution's earnings stream and the prospects and ability to generate future earnings heavily influence the multiple the investment community will pay for earnings. The major factors considered in the valuation are described below. o Reported Earnings. The Association's reported earnings were comparable to the Peer Group's on a ROAA basis (1.16% of average assets versus 1.01% for the Peer Group). A stronger net interest margin and a higher level of non-interest operating income represented earnings advantages for the Association, which was partially offset by the Peer Group's lower level of operating expenses. Loss RP Financial, LC. Page 4.5 provisions and net gains were comparable factors in the Association's and the Peer Group's earnings. Reinvestment of stock proceeds into interest-earning assets will serve to increase the Association's earnings, with the benefit of reinvesting proceeds expected to be somewhat offset by higher operating expenses associated with operating as a publicly-traded company and the implementation of stock benefit plans. Overall, the Association's higher ROAA warranted a slight upward adjustment for this earnings factor. o Core Earnings. Both the Association's and the Peer Group's earnings were derived largely from recurring sources, including net interest income, operating expenses, and non-interest operating income. In these measures, the Association operated with a higher net interest margin, a higher operating expense ratio and a higher level of non-interest operating income. The Association's higher net interest margin and higher level of operating expenses translated into a lower expense coverage ratio (0.91x versus 1.21x for the Peer Group). Likewise, due to the Association's higher level of operating expenses, the Peer Group's efficiency ratio was more favorable than the Association's (67.6% versus 69.2% for the Association). Loss provisions had a slightly larger impact on the Association's earnings and the Peer Group's effective tax rate was lower than the Association's. Overall, these measures, as well as the expected earnings benefits the Association should realize from the redeployment of stock proceeds into interest-earning assets, indicated that the Association's and the Peer Group's core earnings were comparable and no adjustment was warranted for the Association's core earnings. o Interest Rate Risk. Quarterly changes in the Association's and the Peer Group's net interest income to average assets ratios indicated that a higher degree of volatility was associated with the Association's net interest margin. Other measures of interest rate risk, such as capital ratios, IEA/IBL ratios, and the level of non-interest earning assets-to-total assets were more favorable for the Peer Group, thereby indicating a lower dependence on the yield-cost spread to sustain net interest income. On a pro forma basis, the infusion of stock proceeds can be expected to provide the Association with equity-to-assets and IEA/ILB ratios that are as strong or stronger than maintained by Peer Group, as well as enhance the stability of the Association's net interest margin through the reinvestment of stock proceeds into interest-earning assets. Accordingly, RP Financial concluded that the interest rate risk exposure associated with Home Federal's pro forma earnings was similar to the Peer Group's and no adjustment was warranted for valuation purposes. o Credit Risk. Loan loss provisions were a slightly larger factor in the Association's earnings, but were not considered to be significant for either the Association or the Peer Group. In terms of future exposure to credit quality related losses, lending diversification into higher risk types of loans was greater for the Peer Group. The Association's and the Peer Group's credit quality measures indicated the Association maintained a lower level of non-performing assets and a higher level of reserves as a percent of non-performing assets. Overall, RP Financial concluded that the credit risk associated with Home RP Financial, LC. Page 4.6 Federal's and the Peer Group's earnings were comparable and no adjustment was warranted for this factor. o Earnings Growth Potential. Several factors were considered in assessing earnings growth potential. First, the Association's historical growth was stronger than the Peer Group's. Second, the infusion of stock proceeds will increase the Association's earnings growth potential with respect to leverage capacity, as the Association's pro forma leverage capacity should be greater than the Peer Group's. Lastly, the Association's more diversified operations into areas that generate non-interest operating income provides greater earnings growth potential and sustainability of earnings during periods when net interest margins come under pressure as the result of higher interest rates. Overall, the Association's earnings growth potential appears to be slightly more favorable than the Peer Group's, and, thus, we concluded that a slight upward adjustment was warranted for this factor. o Return on Equity. As the result of the significant increase in capital that will be realized from the infusion of net conversion proceeds into the Association's, equity, the Association's return on equity will be well below the comparable averages for the Peer Group and all publicly-traded thrifts. In view of the lower capital growth rate that will be imposed by Home Federal's lower ROE, we concluded that a moderate downward adjustment was warranted for the Association's ROE. On balance, the more favorable earnings growth potential associated with Home Federal's earnings and the Association's slightly higher reported earnings were partially offset by the Peer Group's higher return on equity. Accordingly, RP Financial concluded that a slight upward valuation adjustment was warranted for the Association's profitability, growth and viability of earnings. 3. Asset Growth ------------ Home Federal's asset growth was stronger than the Peer Group's for the period covered in our comparative analysis (11.0% growth versus 4.5% growth for the Peer Group). On a pro forma basis, the Association's tangible equity-to-assets ratio will be above the Peer Group's tangible equity-to-assets ratio, indicating greater leverage capacity for the Association. The demographic characteristics of the primary market areas served by the Association and the Peer Group companies do not represent a decisive advantage for either the Association of the Peer Group with respect to supporting lending and deposit growth opportunities. On balance, we believe a slight upward adjustment was warranted for this factor. RP Financial, LC. Page 4.7 4. Primary Market Area ------------------- The general condition of an institution's market area has an impact on value, as future success is in part dependent upon opportunities for profitable activities in the local market served. Home Federal's primary market area for deposits and loans is considered to be where the Association maintains a branch presence in the counties of Ada, Canyon, Elmore and Gem. A diversified and growing economy has translated into favorable demographic growth for the Association's primary market area, particularly in the Boise metropolitan area. At the same time, the Association also serves markets that are sparsely populated and are somewhat rural in nature, which limits growth opportunities in those markets. Overall, the demographic and economic characteristics of the local market area are considered to be favorable with respect to limiting credit risk exposure. While the outward expansion of the Boise metropolitan is viewed as an attractive characteristic of the Association's primary market area, it has also fostered a highly competitive environment among financial institutions that serve the Boise metropolitan area which increases the cost of growth in that market. Overall, the markets served by the Peer Group companies were viewed as having favorable growth characteristics. The primary markets served by the Peer Group companies have on average experienced an increase in population since 2000 and, on average, population growth in those markets is projected to continue over the next five years. The Peer Group companies serve more populous and slower growing markets than the primary market area served by the Association. The average deposit market share maintained by the Peer Group companies was comparable to the Association's market share of deposits in Canyon County. In general, the degree of competition faced by the Peer Group companies was viewed as being comparable to the Association's competitive environment. Summary demographic and deposit market share data for the Association and the Peer Group companies is provided in Exhibit III-3. As shown in Table 4.1, December 2003 unemployment rates for the majority of the markets served by the Peer Group companies were slightly lower than the unemployment rate reflected for Canyon County. On balance, we concluded that no adjustment was appropriate for the Association's market area. RP Financial, LC. Page 4.8 Table 4.1 Market Area Unemployment Rates Home Federal and the Peer Group Companies (1) December 2003 County Unemployment ------ ------------ Home Federal - ID Canyon 6.9% The Peer Group -------------- Chesterfield Financial - IL Cook 6.6% Evertrust Financial - WA Snohomish 7.3 FSF Financial - MN McLeod 4.4 First Federal Bankshares - IA Woodbury 5.1 First Bank NW Corp. - WA Asotin 5.0 Heritage Financial Corp. - WA Thurston 5.0 Horizon Financial Corp. - WA Whatcom 5.4 Lincoln Bancorp - IN Hendricks 4.0 Peoples Bancorp - IN De Kalb 6.1 Riverview Bancorp - WA Clark 8.4 Timberland Bancorp - WA Grays Harbor 8.5 Wayne Savings Bancorp - OH Wayne 4.4 Western Ohio Financial - OH Clark 6.0 (1) Unemployment rates are not seasonally adjusted. Source: U.S. Bureau of Labor Statistics. 5. Dividends --------- At this time the Association has not established a dividend policy. Future declarations of dividends by the Board of Directors will depend upon a number of factors, including investment opportunities, growth objectives, financial condition, profitability, tax considerations, minimum capital requirements, regulatory limitations, stock market characteristics and general economic conditions. All 13 of the Peer Group companies pay regular cash dividends, with implied dividend yields ranging from 1.22% to 4.57%. The average dividend yield on the stocks of the Peer Group institutions was 2.60% as of March 5, 2004, representing an average earnings payout ratio of 51.0% of core earnings. As of March 5, 2004, approximately 89% of all publicly-traded thrifts had adopted cash dividend policies (see Exhibit IV-1) exhibiting an average yield of RP Financial, LC. Page 4.9 1.97% and an average payout ratio of 34.78%. The dividend paying thrifts generally maintain higher than average profitability ratios, facilitating their ability to pay cash dividends. While the Association has not established a definitive dividend policy prior to converting, the Association will have the capacity to pay a dividend comparable to the Peer Group's average dividend yield based on pro forma earnings and capitalization. On balance, we concluded that no adjustment was warranted for purposes of the Association's dividend policy. 6. Liquidity of the Shares ----------------------- The Peer Group is by definition composed of companies that are traded in the public markets, and all of the Peer Group members trade on the NASDAQ National Market system. Typically, the number of shares outstanding and market capitalization provides an indication of how much liquidity there will be in a particular stock. The market capitalization of the Peer Group companies ranged from $56.2 million to $198.1 million as of March 5, 2004, with average and median market values of $100.5 million and $92.7 million, respectively. The shares issued and outstanding to the public shareholders of the Peer Group members ranged from approximately 1.7 million to 10.4 million, with average and median shares outstanding of 4.6 million and 3.9 million. The Association's pro forma market value will be comparable to the Peer Group average, while shares outstanding for the Association will be in the upper end or above the range of shares outstanding maintained by the individual Peer Group companies. Like all of the Peer Group companies, the Association's stock will be quoted on the NASDAQ National Market System following the conversion. Overall, we anticipate that the Association's conversion stock will have a comparable trading market as the Peer Group companies on average and, therefore, concluded no adjustment was necessary for this factor. 7. Marketing of the Issue ---------------------- We believe that three separate markets need to be considered for thrift stocks such as Home Federal coming to market: (1) the after-market for public companies, in which trading activity is regular and investment decisions are made based upon financial condition, earnings, capital, ROE, dividends and future prospects; (2) the new issue market in which converting RP Financial, LC. Page 4.10 thrifts are evaluated on the basis of the same factors, but on a pro forma basis without the benefit of prior operations as a publicly-held company and stock trading history; and (3) the thrift acquisition market for thrift franchises in Idaho and the Northwest region of the U.S. All of these markets were considered in the valuation of the Association's to-be-issued stock. A. The Public Market ----------------- The value of publicly-traded thrift stocks is easily measurable, and is tracked by most investment houses and related organizations. Exhibit IV-1 provides pricing and financial data on all publicly-traded thrifts. In general, thrift stock values react to market stimuli such as interest rates, inflation, perceived industry health, projected rates of economic growth, regulatory issues and stock market conditions in general. Exhibit IV-2 displays historical stock market trends for various indices and includes historical stock price index values for thrifts and commercial banks. Exhibit IV-3 displays historical stock price indices for thrifts only. In terms of assessing general stock market conditions, the performance of the overall stock market has been mixed over the past year. War fears and the uncertain outlook for the economy pulled stocks lower through most of February 2003 and into early-March, as blue chip stocks dropped to a five-month low during the first week of March. Comparatively, the commencement of war with Iraq produced a rally in the stock market, amid initial expectations that a conflict in Iraq would end quickly. However, the rally was not sustained, as stocks declined at the close of the first quarter on renewed worries about the economy and fears that the war in Iraq could be longer and more difficult than investors had initially anticipated. Stocks rebounded at the start of the second quarter on news of U.S. war successes in Iraq. As investors shifted their focus from the war to first quarter earnings, the broader stock market settled into a narrow trading in mid-April 2003 and then rallied higher through the end of April and into early-May. Generally better than expected first quarter earnings and increasing investor optimism that the end of the war with Iraq would lead to a recovery in the economy and improved corporate profits supported the rally. Technology stocks posted the strongest gains during the rally, as the NASDAQ Composite Index ("NASDAQ") moved to a five-month high in early-May. The broader stock market sustained a positive trend through the second half of May RP Financial, LC. Page 4.11 and into early-June 2003, as the Dow Jones Industrial Average ("DJIA") moved above 9000 on investor optimism that low interest rates, the tax-cut plan and improving consumer confidence would boost the economy. After experiencing a mild set back following an earnings warning from Motorola and news of a shake-up in Freddie Mac's top management due to accounting concerns, the stock market recovered in mid-June on growing expectations that the Federal Reserve would cut rates further to stimulate the economy. Stocks eased lower at the close of the second quarter largely on profit taking. The broader stock market surged higher at the beginning of the third quarter of 2003 on growing optimism about the economy and the sustainability of the bull market. The NASDAQ posted a 14-month high in early-July, before declining slightly on profit taking and disappointing economic data related to an increase in jobless claims. Generally upbeat second quarter earnings and more signs of an economic upturn provided for a positive trend in the broader stock market in mid- and late-July, as the DJIA posted its fifth straight monthly gain. Economic data that showed a strengthening economy, particularly in the manufacturing sector, sustained the upward momentum in stocks through August and into-early September, as the DJIA and NASDAQ posted respective 14-month and 16-month highs. Stocks retreated following the release of August employment data which showed further job losses, but then recovered in mid-September as the Federal Reserve indicated that it would not raise rates in the near term. Weaker than expected numbers for consumer confidence and manufacturing activity pulled the boarder market lower at the close of the third quarter, which ended a streak of six monthly gains in the DJIA. Comparatively, at the start of the fourth quarter stocks showed renewed strength, as optimism about third quarter earnings and employment data for September provided a boost to stocks. In mid-October, the DJIA and the NASDAQ hit 16- and 19-month highs, respectively, primarily on the basis of some favorable third quarter earnings reports. The broader stock market rally cooled in mid-October, as the result of profit taking and the posting of some less favorable third quarter earnings by some of the bellwether technology and manufacturing stocks. Indications that the economic recovery was gaining momentum, including an annualized GDP growth rate of 8.2% in the third quarter, as well as the Federal Reserve's statement that it would not raise its target interest rates for a considerable period, supported a stock market rally during RP Financial, LC. Page 4.12 late-October and into early-November. Despite upbeat economic news, including employment data that showed the size of the U.S. workforce increased in October, stocks edged lower in mid-November on profit taking and concerns over increased terrorism in the Middle East. In late-November and early-December 2003, positive economic news such as improved third quarter corporate profits and a strong start to the Christmas shopping season provided a boost to stocks. Stocks continued to move higher at the close of 2003, as key sectors of the economy continued to show signs of strengthening. Year end momentum in the stock market was sustained at the beginning of 2004, reflecting generally favorable fourth quarter earnings and an increase in consumer confidence. Profit taking and slower than expected GDP growth in the fourth quarter of 2003 caused stocks to falter in late-January. However, aided by January employment data that showed jobs were added and a decline in the national unemployment rate to 5.6%, the broader stock market moved higher during the first half of February. Stocks generally declined during the balance of February and into early-March, reflecting valuation concerns following a year of strong gains and weaker than expected job growth during February. As an indication of the general trends in the nation's stock markets over the past year, as of March 5, 2004, the DJIA closed at 10595.55, an increase of 36.9% from one year ago and the NASDAQ closed at 2047.63, an increase of 56.9% from one year ago. The Standard & Poors 500 Index closed at 1156.86 on March 5, 2004, an increase of 39.6% from one year ago. The market for thrift stocks has been mixed during the past twelve months, but, in general, thrift stocks have appreciated in conjunction with the broader market. Thrift issues traded in a narrow range throughout February 2003 and into mid-March, thereby outperforming the broader market. The stronger performance exhibited by thrift stocks continued to be supported by the relatively low risk characteristics associated with residential lenders, as well as the general earnings benefit of operating in a low interest rate environment with a relatively steep yield curve. Thrift stocks remained fairly stable at close of the first quarter, exhibiting far less volatility compared to the boarder stock market that produced dramatic day-to-day swings as investors reacted to the most recent news on the war's direction. RP Financial, LC. Page 4.13 Financial stocks eased higher at the beginning of the second quarter, as positive news on the war with Iraq lifted stocks in general. First quarter earnings that were generally in-line with expectations sustained the positive trend in thrift issues through early-May, as thrift stocks participated in the broader stock market rally. With the exception of acquisition-related price movements, thrift stocks settled into a narrow trading range in mid-May. Thrift stocks participated in the broader stock market rally in late-May and the first half of June 2003, largely on the basis of recent deal activity in the thrift sector and some favorable economic data. Freddie Mac's management shake-up had a negative ripple effect throughout the thrift sector, but the pullback was only temporary as thrift issues recovered in conjunction with the broader stock market. Profit taking pulled the thrift sector lower in late-June. However, thrift issues recovered modestly at the close of the second quarter, which was supported by merger speculation following New York Community Bancorp's announced acquisition of Roslyn Bancorp. The rally in the broader stock market combined with acquisition speculation in certain regional markets lifted thrift issues higher at the beginning of the third quarter of 2003. Thrift issues traded in a narrow range through most of July, reflecting mixed earnings in the sector. Higher mortgage rates and strength in technology stocks pushed thrift stocks lower in early-August, as investors rotated into sectors that were expected to benefit from an economic recovery. After edging higher in mid-August, thrift stocks eased lower at the end of August on expectations that interest rates would continue to move higher as the economic recovery gained momentum. Merger activity and acquisition speculation in the thrift sector provided a boost to thrift prices in early-September. After easing lower into mid-September on data that showed a slow down in refinancing activity, thrift stocks strengthened following the Federal Reserve's decision to leave interest rates unchanged at its mid-September meeting. After following the broader stock market lower in late-September 2003, thrift issues posted solid gains at the beginning of the fourth quarter. A rally in the broader stock market and acquisition activity were noteworthy factors that supported the positive trend in thrift stocks. Following a two week run-up, thrift stocks declined in mid-October on profit taking and a pullback in the broader market. Merger activity, most notably Bank America's announced acquisition of FleetBoston Financial Corp., along with strength in the broader market, provided for gains in the thrift sector during late-October. The positive trend in thrift stocks carried into RP Financial, LC. Page 4.14 early-November, reflecting expectations of improving net interest margins and more consolidation of thrifts. Thrifts stocks eased lower in mid-November in conjunction with the decline in the broader market. In late-November and early-December 2003, thrift stocks followed the broader market higher and then stabilized at the close of the fourth quarter. After trading in a narrow range at the beginning of 2004, thrift issues trended higher in late-January and the first half of February. The positive trend was supported by further consolidation in the thrift sector, including GreenPoint Financial's agreement to sell to North Fork Bancorp, as well as generally favorable fourth quarter earnings. Indications that interest rates would continue to remain low provided further support to thrift prices. Thrift stocks followed the broader market lower in mid-February, before recovering in late-February following a dip in long term Treasury yields. On March 5, 2004, the SNL Index for all publicly-traded thrifts closed at 1,621.5, an increase of 49.4% from one year ago. B. The New Issue Market -------------------- In addition to thrift stock market conditions in general, the new issue market for converting thrifts is also an important consideration in determining the Association's pro forma market value. The new issue market is separate and distinct from the market for seasoned stock thrifts in that the pricing ratios for converting issues are computed on a pro forma basis, specifically: (1) the numerator and denominator are both impacted by the conversion offering amount, unlike existing stock issues in which price change affects only the numerator; and (2) the pro forma pricing ratio incorporates assumptions regarding source and use of proceeds, effective tax rates, stock plan purchases, etc. which impact pro forma financials, whereas pricing for existing issues are based on reported financials. The distinction between pricing of converting and existing issues is perhaps no clearer than in the case of the price/book ("P/B") ratio in that the P/B ratio of a converting thrift is at a discount to book value whereas in the current market for existing thrifts the P/B ratio often reflects a premium to book value. Therefore, it is appropriate to also consider the market for new issues, both at the time of the conversion and in the aftermarket. Thrift offerings completed in 2003 and in the first quarter of 2004 have generally been well received, although the total number of offerings completed have been somewhat limited. RP Financial, LC. Page 4.15 As shown in Table 4.2, two second-step conversion offerings and one mutual holding company offering were completed during the past three months. The second-step conversion offerings are considered to be less relevant for our analysis. In general, second-step conversions tend to be priced (and trade in the aftermarket) at a higher P/B ratio than standard conversions. We believe investors take into consideration the generally more leveraged pro forma balance sheets of second-step companies, their track records as public companies prior to conversion, and their generally higher pro forma ROE measures relative to standard conversions in pricing their common stocks. Accordingly, Cheviot Financial's pro forma pricing on a fully-converted basis was considered to be the most relevant for purposes of a comparative analysis to the Association's standard conversion pro forma pricing. Cheviot Financial's fully-converted pro forma price/tangible book ratio at closing equaled 81.9% and pro forma core price/earnings ratio equaled 42.1 times. Based on Cheviot Financial's closing market price as of March 5, 2004, it was trading at a fully-converted P/TB ratio of 97.0%. C. The Acquisition Market ---------------------- Also considered in the valuation was the potential impact on Home Federal's stock price of recently completed and pending acquisitions of other savings institutions operating in Idaho. As shown in Exhibit IV-4, between the beginning of 2000 through year-to-date 2004, there were five acquisitions of thrifts based in the Northwest region of the U.S., none of which were based in Idaho. There are no acquisitions currently pending of Northwest based savings institutions. The recent acquisition activity in the regional market area may imply a certain degree of acquisition speculation for the Association's stock. To the extent that acquisition speculation may impact the Association's offering, we have largely taken this into account in selecting companies which operate in markets that have experienced a comparable level of acquisition activity as the Association's market and, thus, are subject to the same type of acquisition speculation that may influence Home Federal's trading price. However, since converting thrifts are subject to a three-year regulatory moratorium from being acquired, acquisition speculation in Home Federal's stock would tend to be less compared to the more seasoned stocks of the Peer Group companies. RP Financial, LC. Page 4.16 [GRAPHIC OMITTED] RP Financial, LC. Page 4.17 * * * * * * * * * * * In determining our valuation adjustment for marketing of the issue, we considered market conditions in general and trends in the overall thrift market, including the new issue market and the acquisition market for thrifts in the Northwest region of the U.S. Taking these factors and trends into account, RP Financial concluded that a slight upward adjustment was appropriate in the valuation analysis for purposes of marketing of the issue. 8. Management ---------- Home Federal's management team appears to have experience and expertise in all of the key areas of the Association's operations. Exhibit IV-5 provides summary resumes of Home Federal's Board of Directors and senior management. While the Association does not have the resources to develop a great deal of management depth, given its asset size and the impact it would have on operating expenses, management and the Board have been effective in implementing an operating strategy that can be well managed by the Association's present organizational structure as indicated by the financial characteristics of the Association. Home Federal currently does not have any senior management positions that are vacant. Similarly, the returns, capital positions, and other operating measures of the Peer Group companies are indicative of well-managed financial institutions, which have Boards and management teams that have been effective in implementing competitive operating strategies. Therefore, on balance, we concluded no valuation adjustment relative to the Peer Group was appropriate for this factor. 9. Effect of Government Regulation and Regulatory Reform ----------------------------------------------------- In summary, as a fully-converted SAIF-insured institution, Home Federal will operate in substantially the same regulatory environment as the Peer Group members -- all of whom are adequately capitalized institutions and are operating with no apparent restrictions. Exhibit IV-6 reflects the Association's pro forma regulatory capital ratios. On balance, no adjustment has been applied for the effect of government regulation and regulatory reform. RP Financial, LC. Page 4.18 Summary of Adjustments - ---------------------- Overall, based on the factors discussed above, we concluded that the Association's pro forma market value should reflect the following valuation adjustments relative to the Peer Group:
Key Valuation Parameters: Valuation Adjustment ------------------------ -------------------- Financial Condition Slight Upward Profitability, Growth and Viability of Earnings Slight Upward Asset Growth Slight Upward Primary Market Area No Adjustment Dividends No Adjustment Liquidity of the Shares No Adjustment Marketing of the Issue Slight Upward Management No Adjustment Effect of Government Regulations and Regulatory Reform No Adjustment
Valuation Approaches - -------------------- In applying the accepted valuation methodology promulgated by the OTS and adopted by the FDIC, i.e., the pro forma market value approach, we considered the three key pricing ratios in valuing Home Federal's to-be-issued stock -- price/earnings ("P/E"), price/book ("P/B"), and price/assets ("P/A") approaches -- all performed on a pro forma basis including the effects of the conversion proceeds. In computing the pro forma impact of the conversion and the related pricing ratios, we have incorporated the valuation parameters disclosed in Home Federal's prospectus for reinvestment rate, the effective tax rate, offering expenses and stock benefit plan assumptions (summarized in Exhibits IV-7 and IV-8). In our estimate of value, we assessed the relationship of the pro forma pricing ratios relative to the Peer Group and the recent conversions. RP Financial's valuation placed an emphasis on the following: o P/E Approach. The P/E approach is generally the best indicator of long-term value for a stock. Given the similarities between the Association's and the Peer Group's earnings composition and overall financial condition, the P/E approach was carefully considered in this valuation. At the same time, since reported earnings for both the Association and the Peer Group included certain non-recurring items, we also made adjustments to earnings to arrive at core earnings RP Financial, LC. Page 4.19 estimates for the Association and the Peer Group and resulting price/core earnings ratios. o P/B Approach. P/B ratios have generally served as a useful benchmark in the valuation of thrift stocks, particularly in the context of an initial public offering, as the earnings approach involves assumptions regarding the use of proceeds. RP Financial considered the P/B approach to be a useful indicator of pro forma value taking into account the pricing ratios under the P/E and P/A approaches. We have also modified the P/B approach to exclude the impact of intangible assets (i.e., price/tangible book value or "P/TB"), in that the investment community frequently makes this adjustment in its evaluation of this pricing approach. o P/A Approach. P/A ratios are generally a less reliable indicator of market value, as investors typically assign less weight to assets and attribute greater weight to book value and earnings - we have also given less weight to the assets approach. Furthermore, this approach as set forth in the regulatory valuation guidelines does not take into account the amount of stock purchases funded by deposit withdrawals, thus understating the pro forma P/A ratio. At the same time, the P/A ratio is an indicator of franchise value, and, in the case of highly capitalized institutions, high P/A ratios may limit the investment community's willingness to pay market multiples for earnings or book value when ROE is expected to be low. The Association will adopt Statement of Position ("SOP") 93-6, which will cause earnings per share computations to be based on shares issued and outstanding excluding unreleased ESOP shares. For purposes of preparing the pro forma pricing analyses, we have reflected all shares issued in the offering, including all ESOP shares, to capture the full dilutive impact, particularly since the ESOP shares are economically dilutive, receive dividends and can be voted. However, we did consider the impact of the adoption of SOP 93-6 in the valuation. Based on the application of the three valuation approaches, taking into consideration the valuation adjustments discussed above, RP Financial concluded that, as of March 5, 2004, the pro forma market value of Home Federal's conversion stock was $90,000,000 at the midpoint, equal to 9,000,000 shares at $10.00 per share. 1. Price-to-Earnings ("P/E"). The application of the P/E valuation method requires calculating the Association's pro forma market value by applying a valuation P/E multiple to the pro forma earnings base. In applying this technique, we considered both reported earnings and a recurring earnings base, that is, earnings adjusted to exclude any one-time non-operating items, plus the estimated after-tax earnings benefit of the reinvestment of the net proceeds. The RP Financial, LC. Page 4.20 Association's reported earnings equaled $5.242 million for the twelve months ended December 31, 2003. In deriving Home Federal's core earnings, the only adjustment made to reported earnings was to eliminate gains on the sale of loans equal to $974,000 for the twelve month period. As shown below, on a tax effected basis, assuming an effective marginal tax rate of 39.1% for the loan sale gains eliminated, the Association's core earnings were determined to equal $4.649 million for the twelve months ended December 31, 2003. (Note: see Exhibit IV-9 for the adjustments applied to the Peer Group's earnings in the calculation of core earnings). Amount ------ ($000) Net income $5,242 Gain on sale of loans(1) (593) ------ Core earnings estimate $4,649 (1) Tax effected at 39.3%. Based on the Association's reported and estimated core earnings, and incorporating the impact of the pro forma assumptions discussed previously, the Association's pro forma reported and core P/E multiples at the $90.0 million midpoint value equaled 18.27 times and 20.78 times, respectively, which provided for discounts of 2.4% and 3.0% relative to the Peer Group's average reported and core earnings multiples of 18.71 times and 21.42 times, respectively (see Table 4.3). At the top of the super range, the Association's reported and core P/E multiples of 24.67 times and 28.13 times reflected premiums of 31.9% and 31.3% relative to the comparable P/E multiples for the Peer Group. 2. Price-to-Book ("P/B"). The application of the P/B valuation method requires calculating the Association's pro forma market value by applying a valuation P/B ratio to Home Federal's pro forma book value. The pre-conversion reported book value for Home Federal equaled $41.4 million and consisted entirely of tangible capital. Based on the $90.0 million midpoint valuation, Home Federal's pro forma P/B and P/TB ratios both equaled 75.73%. In comparison to the average P/B and P/TB ratios for the Peer Group of 142.83% and 156.82%, respectively, the Association's ratios reflected a discount of 47.0% on a P/B basis and a discount of 51.7% on a P/TB basis. At the top of the super range, the Association's P/B and P/TB ratios both equaled 82.8% and reflected discounts of 42.1% and 47.2% relative to the comparable P/B RP Financial, LC. Page 4.21 [GRAPHIC OMITTED] RP Financial, LC. Page 4.22 and P/TB ratios for the Peer Group. RP Financial considered the discounts under the P/B approach to be reasonable in light of the Association's significantly lower pro forma return on equity and the Association's resulting P/E multiples. 3. Price-to-Assets ("P/A"). The P/A valuation methodology determines market value by applying a valuation P/A ratio to the Association's pro forma asset base, conservatively assuming no deposit withdrawals are made to fund stock purchases. In all likelihood there will be deposit withdrawals, which results in understating the pro forma P/A ratio which is computed herein. At the midpoint of the valuation range, Home Federal's value equaled 16.31% of pro forma assets. Comparatively, the Peer Group companies exhibited an average P/A ratio of 18.25%, which implies a 10.6% discount has been applied to the Association's pro forma P/A ratio. Comparison to Recent Conversions - -------------------------------- As indicated at the beginning of this chapter, RP Financial's analysis of recent conversion offering pricing characteristics at closing and in the aftermarket has been limited to a "technical" analysis and, thus, the pricing characteristics of recent conversion offerings can not be a primary determinate of value. Particular focus was placed on the P/TB approach in this analysis, since the P/E multiples do not reflect the actual impact of reinvestment and the source of the stock proceeds (i.e., external funds vs. deposit withdrawals). The two second-step conversion offerings completed within the past three months closed at an average P/TB ratio of 137.2% and on average appreciated 9.8% during the first week of trading. Cheviot Financial's recent mutual holding company offering closed at a fully-converted P/TB ratio of 81.9% and appreciated 33.5% during the first week of trading. In comparison to Cheviot Financial's closing P/TB ratio, the Association's pro forma P/TB ratio of 75.73%at the midpoint value reflects an implied discount of 7.5%. At the top of the super range, the Association's P/TB ratio of 82.77% approximated Cheviot Financial's closing P/TB ratio. In comparison to Cheviot Financial's current aftermarket fully-converted P/TB ratio of 97.0%, the Association's P/TB ratio at the appraised midpoint value reflects a discount of 21.9% and a discount of 14.7% at the top of the super range. RP Financial, LC. Page 4.23 Valuation Conclusion - -------------------- Based on the foregoing, it is our opinion that, as of March 5, 2004, the estimated aggregate pro forma market value of the shares to be issued immediately following the conversion was $90,000,000 at the midpoint. Pursuant to conversion guidelines, the 15% offering range indicates a minimum value of $76,500,000 and a maximum value of $103,500,000. Based on the $10.00 per share offering price, this valuation range equates to an offering of 7,650,000 at the minimum and 10,350,000 at the maximum. In the event the appraised value is subject to an increase, the offering range may be increased up to a super maximum value of $119,025,000 without requiring a resolicitation. The comparative pro forma valuation calculations relative to the Peer Group are shown in Table 4.3 and are detailed in Exhibit IV-7 and Exhibit IV-8.