UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended September 30, 2006

Commission file number 000-51028

FIRST BUSINESS FINANCIAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

Wisconsin		39-1576570
(State or jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
401 Charmany Drive Madison, WI		53719
(Address of Principal Executive Offices)		(Zip Code)

(608) 238-8008

Telephone number

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

Yes þ      No o

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

Large accelerated filer o      Accelerated filer o      Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o      No þ

The number of shares outstanding of the registrant’s sole class of common stock, par value $0.01 per share, on October 31, 2006 was 2,493,580 shares.

 

 

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FIRST BUSINESS FINANCIAL SERVICES, INC.
INDEX – FORM 10-Q

		Page
PART I. — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005			3
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2006 and 2005			4
Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income for the Nine Months Ended September 30, 2006 and 2005			5
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005			6
Notes to Unaudited Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations			19
Financial Condition			25
Asset Quality			26
Liquidity and Capital Resources			28
Item 3. Quantitative and Qualitative Disclosures about Market Risk			31
Item 4. Controls and Procedures			32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			33
Item 1A. Risk Factors			33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			33
Certification of Chairman of the Board and CEO
Certiifcation of Sr. VP and CFO
Section 1350 Certifications

		Page
Item 3. Defaults upon Senior Securities			33
Item 4. Submission of Matters to Vote of Security Holders			33
Item 5. Other Information			33
Item 6. Exhibits			33
SIGNATURES			34

PART I. Financial Information

Item 1. – Financial Statements

Consolidated Balance Sheets

		(unaudited)
		September 30,				December 31,
		2006				2005
		(In Thousands, Except Share Data)
Assets
Cash and due from banks		$	13,292			$	16,568
Short-term investments			5,536				139
Cash and cash equivalents			18,828				16,707
Securities available-for-sale, at fair value			95,260				92,055
Loans and leases receivable, net:
Held for sale			100				—
Held for investment			576,884				532,716
Leasehold improvements and equipment, net			1,084				1,155
Cash surrender value of bank-owned life insurance			13,308				12,856
Investment in Federal Home Loan Bank stock, at cost			2,127				2,898
Goodwill and other intangibles			2,825				2,852
Accrued interest receivable and other assets			9,389				8,010
Total assets		$	719,805			$	669,249
Liabilities and Stockholders’ Equity
Deposits		$	604,794			$	567,464
Securities sold under agreement to repurchase			832				713
Federal Home Loan Bank and other borrowings			51,423				39,045
Junior subordinated debentures			10,310				10,310
Accrued interest payable and other liabilities			7,936				9,874
Total liabilities			675,295				627,406
Commitments and contingencies			—				—
Stockholders’ Equity:
Preferred stock, $10 par value, 10,000 Series A shares and 10,000 Series B shares authorized, none issued and outstanding			—				—
Common stock, $.01 par value, 8,000,000 shares authorized, 2,511,695 and 2,456,754 shares issued, 2,489,080 and 2,435,008 outstanding in 2006 and 2005, respectively			25				24
Additional paid-in capital			22,965				22,712
Retained earnings			23,441				21,085
Accumulated other comprehensive loss			(1,391	)			(1,469	)
Treasury stock (22,615 and 21,746 shares in 2006 and 2005, respectively), at cost			(530	)			(509	)
Total stockholders’ equity			44,510				41,843
Total liabilities and stockholders’ equity		$	719,805			$	669,249

See accompanying Notes to Unaudited Consolidated Financial Statements.

Unaudited Consolidated Statements of Income

		Three Months Ended,								Nine Months Ended,
		September 30,								September 30,
		2006				2005				2006				2005
		(In Thousands, Except Share Data)
Interest income:
Loans and leases		$	11,097			$	8,514			$	31,415			$	23,768
Securities income:
Taxable			1,026				818				2,974				2,281
Short-term investments			42				44				123				146
Total interest income			12,165				9,376				34,512				26,195
Interest expense:
Deposits			6,571				4,444				18,087				11,559
Notes payable and other borrowings			617				334				1,616				768
Junior subordinated debentures			260				238				762				700
Total interest expense			7,448				5,016				20,465				13,027
Net interest income			4,717				4,360				14,047				13,168
Provision for loan and lease losses			413				53				484				118
Net interest income after provision for loan and lease losses			4,304				4,307				13,563				13,050
Non-interest income:
Service charges on deposits			186				202				563				630
Credit, merchant and debit card fees			51				36				129				117
Loan fees			181				166				472				444
Gain on sale of 50% owned joint venture			—				—				—				973
Increase in cash surrender value of bank-owned life insurance			154				101				452				282
Trust and investment services fee income			361				258				1,022				784
Change in fair value of interest rate swaps			(68	)			(198	)			(239	)			75
Net cash settlement of interest rate swaps			74				(26	)			92				(78	)
Other			65				52				183				148
Total non-interest income			1,004				591				2,674				3,375
Non-interest expense:
Compensation			2,508				2,170				7,524				6,525
Occupancy			247				226				743				715
Equipment			117				109				364				347
Data processing			228				208				673				603
Marketing			237				233				657				627
Professional fees			331				249				913				875
Other			465				355				1,309				1,179
Total non-interest expense			4,133				3,550				12,183				10,871
Income before income tax expense			1,175				1,348				4,054				5,554
Income tax expense			309				432				1,252				1,889
Net income		$	866			$	916			$	2,802			$	3,665
Earnings per share:
Basic		$	0.35			$	0.38			$	1.13			$	1.52
Diluted			0.35				0.37				1.13				1.49
Dividends declared per share			0.06				—				0.18				0.115

See accompanying Notes to Unaudited Consolidated Financial Statements.

Unaudited Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income

														Accumulated
						Additional								other
		Common				paid-in				Retained				comprehensive				Treasury
		stock				capital				earnings				loss				stock				Total
		(Dollars in thousands, except share data)
Balance at December 31, 2004		$	24			$	22,426			$	16,752			$	(677	)		$	(384	)		$	38,141
Comprehensive income:
Net income			—				—				3,665				—				—				3,665
Unrealized securities losses arising during the period			—				—				—				(689	)			—				(689	)
Unrealized derivatives gains arising during the period			—				—				—				27				—				27
Reclassification adjustment for realized loss on derivatives			—				—				—				180				—				180
Income tax effect			—				—				—				229				—				229
Comprehensive income																							3,412
Cash dividends ($0.115 per share)			—				—				(278	)			—				—				(278	)
Treasury stock purchased (150 shares)			—				—				—				—				(5	)			(5	)
Stock options exercised (6,280 shares)			—				166				—				—				—				166
Balance at September 30, 2005		$	24			$	22,592			$	20,139			$	(930	)		$	(389	)		$	41,436

														Accumulated
						Additional								other
		Common				paid-in				Retained				comprehensive				Treasury
		stock				capital				earnings				loss				stock				Total
		(Dollars in thousands, except share data)
Balance at December 31, 2005		$	24			$	22,712			$	21,085			$	(1,469	)		$	(509	)		$	41,843
Comprehensive income:
Net income			—				—				2,802				—				—				2,802
Unrealized securities losses arising during the period			—				—				—				(14	)			—				(14	)
Unrealized derivatives gains arising during the period			—				—				—				4				—				4
Reclassification adjustment for realized loss on derivatives			—				—				—				86				—				86
Income tax effect			—				—				—				2				—				2
Comprehensive income																							2,880
Share based compensation — restricted shares			1				117				—				—				—				118
Cash dividends ($0.18 per share)			—				—				(446	)			—				—				(446	)
Treasury stock purchased (869 shares)			—				—				—				—				(21	)			(21	)
Stock options exercised (14,314 shares)			—				136				—				—				—				136
Balance at September 30, 2006		$	25			$	22,965			$	23,441			$	(1,391	)		$	(530	)		$	44,510

Unaudited Consolidated Statements of Cash Flows

		Nine Months Ended September 30,
		2006				2005
		(In Thousands)
Operating Activities
Net income		$	2,802			$	3,665
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes, net			276				(1,820	)
Provision for loan and lease losses			484				118
Depreciation, amortization and accretion, net			459				751
Share based compensation			118				—
Change in fair value of interest rate swaps			239				(75	)
Increase in cash surrender value of bank-owned life insurance			(452	)			(282	)
Origination of loans originated for sale			(897	)			(500	)
Sale of loans originated for sale			797				637
Gain on sale of loans originated for sale			(6	)			(3	)
Gain on sale of 50% owned joint venture			—				(973	)
(Increase) decrease in accrued interest receivable and other assets			(1,606	)			183
(Decrease) increase in accrued expenses and other liabilities			(792	)			1,783
Net cash provided by operating activities			1,422				3,484
Investing activities
Proceeds from maturities of available-for-sale securities			16,630				21,540
Proceeds from sale of 50% owned joint venture			—				2,082
Purchases of available-for-sale securities			(19,971	)			(50,072	)
Proceeds from sale of FHLB stock			771				—
(Increase) in investment in FHLB stock			—				(111	)
Net increase in loans and leases			(44,647	)			(31,809	)
Purchases of leasehold improvements and equipment, net			(195	)			(145	)
Net cash used in investing activities			(47,412	)			(58,515	)
Financing activities
Net increase in deposits			37,330				54,063
Net increase (decrease) in FHLB line of credit			6,993				(11,256	)
Repayment of long-term borrowed funds			(5,000	)			—
Proceeds from long-term borrowed funds			11,000				—
Net (decrease) increase in short-term borrowed funds			(497	)			20,195
Termination of interest rate swaps			(1,384	)			—
Exercise of stock options			136				166
Cash dividends			(446	)			(278	)
Purchase of treasury stock			(21	)			(5	)
Net cash provided by financing activities			48,111				62,885
Net increase in cash and cash equivalents			2,121				7,854
Cash and cash equivalents at beginning of period			16,707				8,721
Cash and cash equivalents at end of period		$	18,828			$	16,575
Supplementary cash flow information
Cash paid or credited to accounts:
Interest on deposits and borrowings		$	19,407			$	12,079
Income taxes			2,851				3,142
Non-cash transactions:
Loans transferred to foreclosed properties			—				—

See accompanying Notes to Unaudited Consolidated Financial Statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Principles of Consolidation.

The unaudited consolidated financial statements include the accounts and results of First Business Financial Services, Inc. (“FBFS” or “the Corporation”), and its wholly-owned subsidiaries, First Business Bank (“FBB”), and First Business Bank – Milwaukee (the “Banks”). All significant intercompany balances and transactions have been eliminated in consolidation.

Note 2 – Basis of Presentation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the unaudited consolidated financial statements have been included.

In conformity with GAAP, management of the Corporation is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. Material estimates that could experience significant changes in the near-term include the allowance for loan and lease losses, the value of foreclosed property, lease residuals, derivative financial instruments, hedging activities and accrued and deferred income taxes. The results of operations for the three and nine-month periods ended September 30, 2006 are not necessarily indicative of results that may be expected for any other interim period or the entire fiscal year ending December 31, 2006.

Recent Accounting Changes.

Accounting for Uncertainty in Income Taxes. In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN No. 48”), Accounting for Uncertainty in Income Taxes which is an interpretation of FASB No. 109, Accounting for Income Taxes. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the Corporation’s financial statements. The interpretation applies to situations where there is uncertainty is about the timing of the deduction, the amount of deduction, or the validity of the deduction. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Corporation is in the process of determining if the adoption of FIN No. 48 will have a material effect on the Corporation’s consolidated financial statements.

Fair Value Measurements. In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP and requires enhanced disclosures about fair value measurements. It does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Corporation is in the process of assessing whether it will early adopt SFAS No. 157 as of the first quarter of fiscal 2007 as permitted, and is in the process of determining if the adoption of SFAS No. 157 will have a material effect on the consolidated financial statements of the Corporation.

Accounting for Defined Benefit Pension and Other Postretirement Plans. In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS No. 158”). SFAS No. 158 amends SFAS No. 87, Employers’ Accounting for Pensions, SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions and SFAS No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other

Postretirement Benefits, and other related accounting literature. SFAS No. 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 also requires employers to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Employers with publicly traded equity securities are required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The Corporation is in the process of evaluating the impact the adoption of SFAS No. 158 may have on its consolidated financial statements.

Consideration of the Effects of Prior Year Misstatements on Current Year Financial Statements. In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how to evaluate prior period financial statement misstatements for purposes of assessing their materiality in the current period. If the prior period effect is material to the current period, then the prior period is required to be corrected. Correcting prior year financial statements would not require an amendment of prior year financial statements, but such corrections would be made the next time the company files the prior year financial statements. Upon adoption, SAB 108 allows a one-time transitional cumulative effect adjustment to retained earnings for corrections of prior period misstatements required under this statement. SAB 108 is effective for fiscal years beginning after November 15, 2006. The adoption of SAB 108 is not expected to be material to the Corporation’s consolidated financial statements.

Note 3 – Share Based Compensation.

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (“SFAS No. 123R”) SFAS No. 123R is a revision of SFAS No. 123, Accounting for Stock-based Compensation (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and its related implementation guidance and amends SFAS No. 95, Statement of Cash Flows (“SFAS No. 95”). On January 1, 2006, the Corporation adopted the provisions of SFAS No. 123R using the prospective method. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for equity instruments. SFAS No. 123R requires entities to recognize compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions). SFAS No. 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as prescribed under SFAS No. 95.

Prior to its adoption of SFAS No. 123R, the Corporation followed the intrinsic value method in accordance with APB No. 25 to account for its employee stock options. Accordingly, no compensation expense was recognized under the Corporation’s equity incentive plans, the 1993 plan as amended in 1995 and the 2001 Equity Incentive Plan (“the Plans”). The adoption of SFAS No. 123R resulted in no change in the Corporation’s method of recognizing compensation expense related to previous grants under the Plans.

Equity Incentive Plans.

The Plans are administered by the Compensation Committee of the Board of Directors of FBFS and provide for the grant of equity ownership opportunities through incentive stock options, nonqualified stock options (“stock options”) and restricted stock (“unvested shares”). A maximum of 224,232 common shares are currently authorized for awards under the Plans. As of September 30, 2006, 9,666 shares were available for future grants under the Plans. Shares covered by awards that expire, terminate or lapse will again be available for the grant of awards under the Plans. The Corporation may issue new shares and shares from treasury for shares delivered under the Plans.

In May 2006 the shareholders approved the 2006 Equity Incentive Plan (“the 2006 Plan”). The 2006 Plan is administered by the Compensation Committee of the Board of Directors of FBFS and provides for the

grant of equity ownership opportunities through incentive stock options, unvested shares, restricted stock units and performance shares. A maximum of 200,000 common shares are currently authorized and available for awards under the 2006 Plan.

For the three and nine months ended September 30, 2006, share-based compensation expense included in net income totaled approximately $45,000 and $117,000, respectively. The income tax benefit related to share-based compensation included in net income totaled approximately $17,000 and $44,000 for the three and nine months ended September 30, 2006.

     Stock Options

     Stock options are granted to senior executives and other employees under the Plans. Options generally have an exercise price that is equal to the fair value of the common shares on the date the option is granted. Options granted under the Plans are subject to graded vesting, generally ranging from four to eight years, and have a contractual term of 10 years. For any new awards issued after adoption of SFAS No. 123R provisions, compensation expense is recognized over the requisite service period for the entire award on a straight-line basis. There were no stock options granted during the three and nine months ended September 30, 2006. The Corporation expects that a majority of the outstanding stock options will fully vest.

Stock option activity for the nine months ended September 30, 2006 was as follows:

		For the nine months ended
		September 30,
		2006
										Weighted
										Average
						Weighted				Remaining
						Average				Contractual
		Options				Price				Life (Years)
Outstanding at January 1, 2006			201,532			$	21.06
Granted			—				—
Exercised			(14,314	)			9.50
Forfeited			(19,152	)			21.82
Outstanding at end of period			168,066			$	21.95				6.8
Options exercisable at September 30, 2006			99,086			$	19.79				6.3

The Corporation accounts for stock options FBFS issued prior to October 6, 2005 as a non-public company that are still outstanding under the intrinsic value method of APB No. 25, and related interpretations, under which no compensation cost has been recognized for any periods presented. SFAS No. 123R will be applied prospectively to these equity share options upon modification, repurchase or cancellation of the stock options.

      Restricted Shares

     Under the 2001 and 2006 Equity Incentive Plans, participants may be granted restricted shares, each of which represents an unfunded, unsecured right, which is nontransferable except in the event of death of the participant, to receive a common share on the date specified in the participant’s award agreement. While the restricted shares are subject to forfeiture, the participant may exercise full voting

rights and will receive all dividends and other distributions paid with respect to the restricted shares. The restricted shares granted under this plan are subject to graded vesting. For awards with graded vesting, compensation expense is recognized over the requisite service period of four years for the entire award on a straight-line basis. Restricted share activity for the nine months ended September 30, 2006 was as follows:

		Number of				Weighted Average
		Restricted				Grant-Date
		Shares				Fair Value
Nonvested balance as of January 1, 2006			—			$	—
Granted			43,475				23.17
Vested			—				—
Forfeited			(2,850	)			23.03
Nonvested balance as of September 30, 2006			40,625			$	23.18

As of September 30, 2006, there was approximately $824,000 of deferred compensation expense related to unvested restricted share awards which is expected to be recognized over four years. As of September 30, 2006 there were no restricted shares vested and not delivered.

Note 4 – Goodwill and Other Intangible Assets.

Goodwill is not amortized but is subject to impairment tests on at least an annual basis. No impairment loss was necessary in 2005 or through September 30, 2006. At September 30, 2006, goodwill was $2,689,000. There was no change in the carrying amount of goodwill for the nine months ended September 30, 2006 and 2005, as shown below:

		Nine Months Ended
		September 30,
		2006				2005
		(In Thousands)
Balance at beginning of period		$	2,689			$	2,689
Goodwill acquired			—				—
Balance at end of period		$	2,689			$	2,689

The Corporation has other intangible assets that are amortized, including core deposit intangibles and other intangibles, consisting of a purchased client list from a purchased brokerage/investment business.

Changes in the gross carrying amount, accumulated amortization and net book value of core deposit intangibles and other intangibles were as follows:

		Nine Months Ended
		September 30,
		2006				2005
		(In Thousands)
Core deposit intangibles:
Gross carrying amount		$	145			$	145
Accumulated amortization			(72	)			(47	)
Net book value		$	73			$	98
Additions during the year		$	—			$	—
Amortization during the period			(18	)			(25	)
Other intangibles:
Gross carrying amount		$	120			$	120
Accumulated amortization			(57	)			(45	)
Net book value		$	63			$	75
Additions during the year		$	—			$	—
Amortization during the period			(9	)			(9	)

The following table shows the current period and estimated future amortization expense for amortized intangible assets:

		Core
		Deposit				Other
		Intangibles				Intangibles				Total
		(In Thousands)
Nine months ended September 30, 2006		$	18			$	9			$	27
Estimate for the three months ended December 31, 2006			5				3				8
Estimate for the year ended December 31,
2007			18				12				30
2008			13				12				25
2009			10				12				22
2010			7				12				19
		$	48			$	48			$	96

Note 5 – Securities.

The amortized cost and estimated fair values of securities available-for-sale were as follows (in thousands):

		As of September 30, 2006
						Gross				Gross
						unrealized				unrealized
		Amortized				holding				holding				Estimated
Securities available-for-sale		cost				gains				losses				fair value
		(In Thousands)
U.S. Government corporations and agencies		$	3,255			$	—			$	(53	)		$	3,202
Municipals			185				—				(3	)			182
Collateralized mortgage obligations			93,919				37				(2,080	)			91,876
		$	97,359			$	37			$	(2,136	)		$	95,260

		As of December 31, 2005
						Gross				Gross
						unrealized				unrealized
		Amortized				holding				holding				Estimated
Securities available-for-sale		cost				gains				losses				fair value
		(In Thousands)
U.S. Government corporations and agencies		$	3,264			$	—			$	(80	)		$	3,184
Municipals			275				—				(3	)			272
Collateralized mortgage obligations			90,601				2				(2,004	)			88,599
		$	94,140			$	2			$	(2,087	)		$	92,055

The table below shows the Corporation’s gross unrealized losses and fair value of investments, aggregated by investment category and length of time that individual investments have been in a continuous unrealized loss position at September 30, 2006. Such securities have declined in value due to current interest rate environments and not credit quality and do not presently represent realized losses. The Corporation has the ability to and anticipates that these securities, which have been in a continuous loss position but are not other-than-temporarily impaired, will be kept in the portfolio until the unrealized loss is recovered. If held until maturity, it is anticipated that the investments will be realized with no loss. If the Corporation determines that any of the above securities are deemed other-than-temporarily impaired, the impairment loss will be recognized in the income statement.

A summary of unrealized loss information for investment securities, categorized by security type follows (in thousands):

		As of September 30, 2006
		Less than 12 months								12 months or longer								Total
		Fair Value				Unrealized loss				Fair Value				Unrealized loss				Fair Value				Unrealized loss
		(In Thousands)
U.S. Government corporations and agencies		$	—			$	—			$	3,202			$	53			$	3,202			$	53
Municipals			—				—				182				3				182				3
Collateralized mortgage obligations			18,629				221				66,860				1,859				85,489				2,080
		$	18,629			$	221			$	70,244			$	1,915			$	88,873			$	2,136

The Corporation has not sold any available-for-sale securities for any of the periods shown and has therefore not realized any gains or losses on such transactions.

At September 30, 2006 and December 31, 2005, securities with a fair value of approximately $23,429,000 and $29,700,000, respectively, were pledged to secure public deposits, securities sold under arrangements to repurchase, and borrowings.

Note 6 – Loans and Allowance for Loan and Lease Losses.

Loan and lease receivables consisted of the following (in thousands):

		As of September 30,				As of December 31,
		2006				2005				2004
		(In thousands)
First mortgage loans:
Commercial real estate		$	250,293			$	249,133			$	215,605
Construction			69,823				50,619				41,910
Multi-family			25,960				22,115				17,786
1-4 family			32,649				26,513				22,814
			378,725				348,380				298,115
Commercial business loans			163,226				151,688				136,482
Direct financing leases, net			18,899				17,852				25,583
Second mortgage loans			7,981				8,231				5,563
Credit card and other			15,573				13,579				10,743
			584,404				539,730				476,486
Less:
Allowance for loan and lease losses			7,260				6,773				6,375
Deferred loan fees			160				241				310
		$	576,984			$	532,716			$	469,801

An analysis of the allowance for loan and lease losses is presented below (in thousands):

		Nine Months Ended				Year Ended
		September 30,				December 31,
		2006				2005
		(In Thousands)
Allowance at beginning of period		$	6,773			$	6,375
Charge-offs:
Mortgage			—				—
Commercial			—				—
Lease			—				—
Consumer			—				(10	)
Total charge-offs			—				(10	)
Recoveries:
Mortgage			—				4
Commercial			3				4
Lease			—				—
Consumer			—				—
Total recoveries			3				8
Net recoveries (charge-offs)			3				(2	)
Provision			484				400
Allowance at end of period		$	7,260			$	6,773
Allowance to gross loans and leases			1.24	%			1.25	%

Note 7 – Deposits.

Deposits consisted of the following (in thousands):

		September 30,								December 31,
		2006								2005
						Weighted								Weighted
		Balance				Average Rate				Balance				Average Rate
		(Dollars in Thousands)
Transaction accounts:
Demand deposits		$	43,056				0.00	%		$	46,766				0.00	%
Negotiable order of withdrawal (“NOW”) accounts			49,524				4.19				46,962				2.85
			92,580								93,728
Money market accounts			155,640				4.49				138,442				3.10
Certificates of deposit			356,574				4.53				335,294				3.95
		$	604,794							$	567,464

Note 8 – Borrowings.

Borrowings consisted of the following (in thousands):

		As of September 30,
		2006
						Weighted				Weighted
						Average				Average
		Balance				Balance				Rate
		(Dollars in Thousands)
Fed funds purchased and securities sold under agreement to repurchase		$	21,707			$	12,825				4.97	%
FHLB advances			19,538				17,981				4.78
Junior subordinated debentures			10,310				10,310				9.85
Line of credit			10				4,126				6.88
Subordinated note payable			11,000				5,044				7.40
		$	62,565			$	50,286				6.31	%
Short-term borrowings		$	21,726
Long-term borrowings (due beyond one year)			40,839
		$	62,565

		As of December 31,
		2005
						Weighted				Weighted
						Average				Average
		Balance				Balance				Rate
		(Dollars in Thousands)
Fed funds purchased and securities sold under agreement to repurchase		$	19,463			$	9,021				3.45	%
FHLB advances			12,545				11,427				3.67
Junior subordinated debentures			10,310				10,310				9.18
Line of credit			2,750				2,338				5.39
Subordinated note payable			5,000				5,000				5.75
		$	50,068			$	38,096				5.49	%
Short-term borrowings		$	22,222
Long-term borrowings (due beyond one year)			27,846
		$	50,068

Note 9 – Derivative and Hedging Activities.

Derivative gains and losses reclassified from accumulated other comprehensive income to current period earnings are included in the line item in which the hedged cash flows are recorded. At September 30, 2006 and December 31, 2005 accumulated other comprehensive income included unrealized after tax losses of $4,000 and $8,000, respectively, related to derivatives used to hedge funding cash flows. At September 30, 2006 and December 31, 2005, the fair value of the interest rate swaps designated as cash flow hedges represented unrealized losses of $7,000 and $14,000, respectively. There were no unrealized gains on interest rate swaps which qualify as cash flow hedges as of September 30, 2006 and December 31, 2005. The estimated amount of pre-tax loss expected to be reclassified into earnings from accumulated other comprehensive income due to net expenses on cash flow hedges within the next twelve months is $1,000.

The unrealized holding gains and losses, net of tax effect, included in accumulated other comprehensive income at September 30, 2006 and December 31, 2005, were ($17,000) and ($105,000), respectively. At September 30, 2006 and December 31, 2005, the fair value of other derivatives included in other assets totaled $43,000 and $40,000, respectively. At September 30, 2006 and December 31, 2005, the fair value of other derivatives included in other liabilities totaled $0 and $1,141,000.

The interest rate swap agreements consist of the following:

		As of September 30,														As of December 31,
		2006														2005
		(In thousands)
		Notional				Maturity		Fixed				Variable				Notional				Maturity		Fixed				Variable
		Amount				Date		Rate				Rate				Amount				Date		Rate				Rate
Cash Flow Hedge:
Pay-fixed interest rate swap		$	660			April, 2009			5.24	%			5.04	%		$	789			April, 2009			5.24	%			3.97	%
Other Derivatives:
Pay-fixed interest rate swap			10,000			October, 2006			3.94				5.03				10,000			October, 2006			3.94				4.08
Pay-fixed interest rate swap			10,000			November, 2006			3.75				5.03				10,000			November, 2006			3.75				4.12
Pay-fixed interest rate swap			10,000			December, 2006			4.94				5.39				10,000			December, 2006			4.94				4.50
Callable receive-fixed interest rate swap			—						—				—				10,000			January, 2010			4.25				4.44
Callable receive-fixed interest rate swap			—						—				—				10,000			February, 2010			4.35				4.39
Callable receive-fixed interest rate swap			—						—				—				10,000			February, 2010			4.10				4.42
Callable receive-fixed interest rate swap			—						—				—				10,000			November, 2010			4.00				4.41
Pay-fixed interest rate swap			—						—				—				4,742			June, 2011			5.49				4.20
		$	30,660													$	75,531

As required by SFAS No. 133, the Corporation is amortizing, over the remaining term of the pay-fixed interest rate swap maturing in October 2006, to interest expense the market loss at the date that interest rate swap no longer qualified for cash flow hedge accounting. This swap no longer qualified for hedge accounting treatment because the Corporation did not redesignate a new hedging relationship upon adoption of FIN46R. At September 30, 2006 and December 31, 2005, the balance of the unamortized loss, net of tax effect, on this interest rate swap included in accumulated other comprehensive income is approximately $13,000 and $96,000, respectively.

Note 10 – Earnings Per Share.

Basic earnings per share for the three and nine months ended September 30, 2006 and 2005 have been determined by dividing net income for the respective periods by the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares outstanding plus the effect of dilutive securities. The effect of dilutive securities is computed using the treasury stock method. For the three month periods ended September 30, 2006 and 2005, average anti-dilutive employee stock options totaled 65,323 and 15,750, respectively. For the nine month periods ended September 30, 2006 and 2005, average anti-dilutive employee stock options totaled 65,762 and 12,384, respectively.

		Three Months Ended September 30,
		2006				2005
Numerator:
Net income		$	866,302			$	916,404
Numerator for basic and diluted earnings per share — income available to common stockholders			866,302				916,404
Denominator:
Denominator for basic earnings per share—weighted-average common shares outstanding			2,480,023				2,423,847
Effect of dilutive securities:
Employee stock options			13,232				41,357
Denominator for diluted earnings per share—adjusted weighted-average common shares and assumed conversions			2,493,255				2,465,204
Basic earnings per share		$	0.35			$	0.38
Diluted earnings per share			0.35				0.37

		Nine Months Ended September 30,
		2006				2005
Numerator:		$	2,801,980			$	3,664,539
Net income
Numerator for basic and diluted earnings per share — income available to common stockholders		$	2,801,980			$	3,664,539
Denominator:
Denominator for basic earnings per share—weighted-average common shares outstanding			2,471,825				2,418,679
Effect of dilutive securities:
Employee stock options			16,765				45,190
Denominator for diluted earnings per share—adjusted weighted-average common shares and assumed conversions			2,488,590				2,463,869
Basic earnings per share		$	1.13			$	1.52
Diluted earnings per share			1.13				1.49

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

Cautionary Factors

     This quarterly report on Form 10-Q (“Form 10-Q”) contains or incorporates by reference various forward-looking statements concerning the Corporation’s prospects that are based on the current expectations or beliefs of management. Forward-looking statements may also be made by the Corporation from time to time in other reports and documents as well as oral presentations. When used in written documents or oral statements, the words “anticipate,” “believe,” “estimate,” “expect,” “objective” and similar expressions and verbs in the future tense, are intended to identify forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks, and uncertainties, many of which are beyond the Corporation’s control that could cause the Corporation’s actual results and performance to differ materially from what is expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Corporation: general economic conditions; legislative and regulatory initiatives; increased competition and other effects of deregulation and consolidation of the financial services industry; monetary and fiscal policies of the federal government; deposit flows; disintermediation; the cost of funds; general market rates of interest; interest rates or investment returns on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; general economic developments; acts of terrorism and developments in the war on terrorism; and changes in the quality or composition of loan and investment portfolios. See also Item 1a. Risk Factors discussed in our annual Report on Form 10-K and factors regarding future operations discussed below.

     The following discussion and analysis is presented to assist in the understanding and evaluation of the Corporation’s financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction with such statements, footnotes and data. The presentation focuses on the three and nine months ended September 30, 2006 and the comparable periods in 2005.

Overview

First Business Financial Services, Inc. (“FBFS” or “the Corporation”) is a registered bank holding company incorporated under the laws of the State of Wisconsin and is engaged in the commercial banking business through its wholly-owned banking subsidiaries First Business Bank and First Business Bank – Milwaukee (referred to as “the Banks”). All of the operations of FBFS are conducted through its Banks and certain subsidiaries of First Business Bank. The Corporation operates as a business bank focusing on delivering products and services to small and medium size businesses. The Corporation does not utilize its locations to attract retail customers. FBFS seeks to provide lending and deposit products to local businesses and business executives. To supplement its business banking deposit base, the Corporation utilizes wholesale funding alternatives to fund a portion of the Corporation’s loan and lease portfolio.

Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest and the asset/liability management procedures used by FBFS in responding to such changes. The provision for loan and lease losses is dependent upon the credit quality of loans and leases and management’s assessment of the collectibility of loans and leases under current economic conditions. Non-interest expenses are influenced by the growth of operations, with additional employees necessary to staff such growth. Growth in the number of relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses.

Recent Developments/Financial Highlights

	•		Net income for the three and nine months ended September 30, 2006 decreased $50,000 and $863,000 over the comparable prior year periods due to higher compensation expense as the Corporation continues to hire additional business development staff in order to increase loan and lease receivables, greater provision for loan and lease losses primarily due to the growth in the loan and lease portfolio accompanied by no significant changes in the risk profile of the loan and lease portfolio and the nine month period ended September 30, 2005 included a $973,000 pre-tax gain on the sale of the 50% owned joined venture
	•		Net loans and leases receivable increased 8.3% from December 31, 2005 to $577 million at September 31, 2006
	•		Deposits increased 6.6% to $605 million

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2006 and 2005

     General. Net income for the three and nine months ended September 30, 2006 decreased $50,000 and $863,000 to $866,000 and $2.8 million from $916,000 and $3.7 million for the same periods in 2005. The increase in net interest income of $879,000 for the nine months ended September 30, 2006 was more than offset by an increase of $366,000 in the provision for loan and lease losses, a decrease of $314,000 in the change in fair value of interest rate swaps and an increase in compensation costs of $1.0 million. Additionally, the nine months ended September 30, 2005 included a gain on the sale of the 50% equity investment in a leasing joint venture, m2 Lease Funds, LLC (“m2”), of $973,000. The three months ended September 30, 2006 reflected an increase of $357,000 in net interest income and an increase of $130,000 in the change in fair value of interest rate swaps which were offset by increases in the provision for loan and lease losses of $360,000 and an increase in compensation costs of $338,000. Diluted earnings per share for the three months ended September 30, 2006 decreased to $0.35 from $0.37 for the same period in 2005 largely attributable to the decrease in net income. The annualized returns on average assets and average

stockholders’ equity for the three months ended September 30, 2006 were 0.50% and 7.97%, respectively, as compared to 0.59% and 9.00%, respectively, for the same period in 2005. Diluted earnings per share for the nine months ended September 30, 2006 decreased to $1.13 from $1.49 for the same period in 2005 due to the decrease in net income. The annualized returns on average assets and average stockholders’ equity for the nine months ended September 30, 2006 were 0.55% and 8.74%, respectively, as compared to 0.81% and 12.46%, respectively, for the same periods in 2005.

     Net Interest Income. Net interest income increased $357,000, or 8.2%, to $4.7 million for the three months ended September 30, 2006 from $4.4 million for the same period in 2005. For the nine months ended September 30, 2006, net interest income increased $879,000, or 6.7%, to $14.0 million from $13.2 million for the same period in 2005. The improvement in net interest income for the three and nine months ended September 30, 2006 was due to an increase in average earning assets partially offset by a decrease in net interest margin as compared to the same period in 2005. The net interest margin decreased to 2.84% for the three months ended September 30, 2006 from 2.93% for the same period in 2005. The net interest margin decreased to 2.89% for the nine months ended September 30, 2006 from 3.03% for the same period in 2005. Similarly, there were decreases in the interest rate spread to 2.39% and 2.47% for the three and nine months ended September 30, 2006 from 2.50% and 2.64% for the same three and nine month periods in 2005. The decreases in the net interest margin were the result of the increases in yields paid on interest-bearing liabilities outpacing the increases in yields earned on interest-earning assets and a decrease in net interest earning assets. The increase in rates is reflective of the change in market rates.

     Interest income on interest-earning assets increased $2.8 million to $12.2 million for the three months ended September 30, 2006 as compared to the same period in 2005 driven principally by an increase in average loans and leases outstanding of $61.5 million, an increase of 12.2%, accompanied by an increase in the average yield earned on loans and leases to 7.86% from 6.77% for the three months ended September 30, 2006 in comparison to the same period during 2005.

     For the nine months ended September 30, 2006, interest income on interest-earning assets increased $8.3 million to $34.5 million as compared to the same period in 2005. Interest income on loans and leases increased $7.6 million to $31.4 million from $23.8 million for the same period in 2005. Average loans and leases outstanding increased $57.7 million, or 11.8%, accompanied by an increase in average yield to 7.65% for the nine months ended September 30, 2006, from 6.47% for the same period in 2005.

     The increase in average yields earned on loans and leases for both the three and nine months ended September 30, 2006 was primarily caused by a change in market rates. The average balance of loans and leases increased to $564.5 million for the three months ended September 30, 2006 from $503.0 million for the three months ended September 30, 2005. The increase was driven by growth in mortgage loans which includes commercial real estate, construction, multi-family and 1-4 family loans and commercial loans. For the three months ended September 30, 2006, the average balance of mortgage loans grew $40.5 million, or 12.1%, from $335.7 million to $376.2 million. Average commercial loans increased $23.3 million, or 16.1% to $167.7 million for the three months ended September 30, 2006 from $144.4 million for the same period in 2005. Average leases decreased $2.4 million, or 11.7%, for the three months ended September 30, 2006 in comparison to September 30, 2005. The average balance of loans and leases increased to $547.6 million for the nine months ended September 30, 2006 from $489.9 million as of September 30, 2005. For the nine months ended September 30, 2006, average mortgage loans grew $39.8 million, or 12.3%, from $324.4 million for the nine months ended September 30, 2005 to $364.3 million. Average commercial loans grew $22.2 million, or 15.8%, from $140.2 million for the nine months ended September 30, 2005 to $162.4 million for the nine months ended September 30, 2006. Average leases decreased $4.4 million, or 19.4% for the nine months ended September 30, 2006 in comparison to the nine months ended September 30, 2005. The growth in mortgage and commercial loans has largely been the result of expanding relationships with existing clients and attracting new clients in both of the Banks’ two principal markets.

     Also contributing to the increase in income on interest earning assets was an increase in income on mortgage related securities of $206,000 and $687,000 to $997,000 and $2.9 million for the respective three and nine months ended September 30, 2006 from $791,000 and $2.2 million for the same periods in 2005.