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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
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FORM 10-Q
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Quarterly Report Pursuant to Section 13 or 15(d)
Of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2004
Commission file number 0-15204
National Bankshares, Inc.
(Exact name of registrant as specified in its charter)
State or other jurisdiction of incorporation or organization - Virginia
Internal Revenue Service - Employer Identification No. 54-1375874
101 Hubbard Street, P.O. Box 90002, Blacksburg, VA 24062-9002
(540) 951-6300
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such requirements
for the past 90 days.
Yes _X_ No ___
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b - 2 of the Exchange Act)
Yes _X_ No ___
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 5, 2004
- ------------------------------ --------------------------------
Common Stock, $2.50 Par Value 3,516,502
(This report contains 35 pages)
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18 NATIONAL BANKSHARES, INC. AND SUBSIDIARIES
Form 10-Q
Index
Part I Financial Information
- ---------------------------- Page
Item 1 Financial Statements
Consolidated Balance Sheets, September 30, 2004
(Unaudited) and December 31, 2003 3
Consolidated Statements of Income for the Three Months 5
Ended September 30, 2004 and 2003 (Unaudited)
Consolidated Statements of Income for the Nine Months
Ended September 30, 2004 and 2003 (Unaudited) 7
Consolidated Statements of Changes in
Stockholders' Equity, Nine Months Ended
September 30, 2004 and 2003 (Unaudited) 9
Consolidated Statements of Cash Flows, Nine Months
Ended September 30, 2004 and 2003 (Unaudited) 10
Notes to Consolidated Financial Statements 12
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of Operations 17
Item 3 Quantitative and Qualitative Disclosures about
Market Risk 29
Item 4 Controls and Procedures 29
Part II Other Information
- --------------------------
Item 1 Legal Proceedings 30
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 30
Item 3 Defaults Upon Senior Securities 30
Item 4 Submission of Matters to a Vote of
Security Holders 30
Item 5 Other Information 30
Item 6 Exhibits 30
Signatures 30
Index of Exhibits 30
2
Part I
Financial Information
Item 1. Financial Statements
National Bankshares, Inc. and Subsidiaries
Consolidated Balance Sheets
September 30, 2004 and December 31, 2003
(Unaudited) (Audited)
September 30, December 31,
($ In thousands, except share and per share data) 2004 2003
================== ===================
Assets:
Cash and due from banks $16,206 $11,733
Interest-bearing deposits 5,526 36,220
Securities available for sale 147,590 129,300
Securities held to maturity (fair value
$111,712 in 2004 and $105,026 in 2003) 108,251 100,854
Mortgage loans held for sale 557 714
Loans:
Real estate construction loans 24,209 28,055
Real estate mortgage loans 115,046 87,899
Commercial and industrial loans 241,038 208,997
Loans to individuals 92,665 82,742
------------------ -------------------
Total loans 472,958 407,693
Less unearned income and deferred fees (867) (896)
------------------ -------------------
Loans, net of unearned income
and deferred fees 472,091 406,797
Less allowance for loan losses (5,835) (5,369)
------------------ -------------------
Loans, net 466,256 401,428
------------------ -------------------
Premises and equipment, net 11,738 10,094
Accrued interest receivable 5,153 4,610
Other real estate owned, net 1,010 1,663
Intangible assets and goodwill 17,565 9,958
Other assets 2,761 1,986
------------------ -------------------
Total assets $782,613 $708,560
================== ===================
Liabilities and Stockholders' Equity
Noninterest-bearing demand deposits $101,422 $83,671
Interest-bearing demand deposits 189,712 172,370
Savings deposits 64,199 53,084
Time deposits 334,958 316,253
------------------ -------------------
Total deposits 690,291 625,378
------------------ -------------------
Other borrowed funds 2,214 135
Accrued interest payable 483 489
Other liabilities 2,355 1,917
------------------ -------------------
Total liabilities 695,343 627,919
------------------ -------------------
3
Stockholders' Equity Preferred stock of no par value.
Authorized 5,000,000 shares; none
issued and outstanding --- ---
Common stock of $2.50 par value.
Authorized 10,000,000 shares; issued and
outstanding 3,516,502 shares in 2004 and
3,515,377 in 2003 8,791 8,788
Retained earnings 76,861 70,063
Accumulated other comprehensive income, net 1,618 1,790
----------------- -------------------
Total stockholders' equity 87,270 80,641
----------------- -------------------
Total liabilities and
stockholders' equity $782,613 $708,560
================= ===================
See accompanying notes to the consolidated financial statements.
4
National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
Three Months Ended September 30, 2004 and 2003
(Unaudited)
September 30, September 30,
($ In thousands, except share and per share data) 2004 2003
================== =================
Interest income:
Interest and fees on loans $7,837 $7,495
Interest on interest-bearing deposits 23 43
Interest on federal funds sold 14 5
Interest on securities - taxable 1,654 1,377
Interest on securities - nontaxable 1,313 1,342
------------------ -----------------
Total interest income 10,841 10,262
------------------ -----------------
Interest expense:
Interest on time deposits $100,000 or more 836 710
Interest on other deposits 2,053 2,130
Interest on borrowed funds 15 ---
------------------ -----------------
Total interest expense 2,904 2,840
------------------ -----------------
Net interest income 7,937 7,422
Provision for loan losses 293 435
------------------ -----------------
Net interest income after
provision for loan losses 7,644 6,987
------------------ -----------------
Noninterest income:
Service charges on deposit accounts 824 704
Other service charges and fees 52 65
Credit card fees 480 416
Trust income 274 253
Other income 131 77
Realized securities gains, net 104 7
------------------ -----------------
Total noninterest income 1,865 1,522
------------------ -----------------
Noninterest expense:
Salaries and employee benefits 2,723 2,396
Occupancy and furniture and fixtures 473 416
Data processing and ATM 349 310
Credit card processing 398 324
Intangibles amortization 233 238
Net costs of other real estate owned 37 19
Other operating expenses 1,062 1,001
------------------ -----------------
Total noninterest expense 5,275 4,704
------------------ -----------------
Income before income tax expense 4,234 3,805
Income tax expense 1,019 894
------------------ -----------------
Net income $3,215 $2,911
================== =================
5
Net income per share - basic $0.91 $0.83
================== =================
- diluted 0.91 0.82
================== =================
Weighted average number of common
shares outstanding - basic 3,519,491 3,512,877
================== =================
- diluted 3,536,965 3,534,615
================== =================
Dividends declared per share $--- $---
================== =================
See accompanying notes to consolidated financial statements.
6
National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
Nine Months Ended September 30, 2004 and 2003
(Unaudited)
September 30, September 30,
($ In thousands, except share and per share data) 2004 2003
================== =================
Interest income:
Interest and fees on loans $21,868 $22,766
Interest on interest-bearing deposits 137 180
Interest on federal funds sold 15 16
Interest on securities - taxable 4,648 4,177
Interest on securities - nontaxable 3,987 3,995
------------------ -----------------
Total interest income 30,655 31,134
------------------ -----------------
Interest expense:
Interest on time deposits $100,000 or more 2,294 2,325
Interest on other deposits 5,852 7,248
Interest on borrowed funds 16 1
------------------ -----------------
Total interest expense 8,162 9,574
------------------ -----------------
Net interest income 22,493 21,560
Provision for loan losses 885 1,277
------------------ -----------------
Net interest income after
provision for loan losses 21,608 20,283
------------------ -----------------
Noninterest income:
Service charges on deposit accounts 2,234 1,877
Other service charges and fees 182 206
Credit card fees 1,362 1,210
Trust income 1,105 757
Other income 311 342
Realized securities gains, net 91 3
------------------ -----------------
Total noninterest income 5,285 4,395
------------------ -----------------
Noninterest expense:
Salaries and employee benefits 7,815 7,161
Occupancy and furniture and fixtures 1,337 1,248
Data processing and ATM 913 851
Credit card processing 1,100 949
Intangibles amortization 699 715
Net costs of other real estate owned 149 38
Other operating expenses 2,997 2,878
------------------ -----------------
Total noninterest expense 15,010 13,840
------------------ -----------------
Income before income tax expense 11,883 10,838
Income tax expense 2,772 2,494
------------------ -----------------
Net income $9,111 $8,344
================== =================
7
Net income per share - basic $2.59 $2.38
================== ==================
- diluted 2.57 2.36
================== ==================
Weighted average number of common
shares outstanding - basic 3,517,923 3,512,262
================== ==================
- diluted 3,538,280 3,531,819
================== ==================
Dividends declared per share $0.63 $0.54
================== ==================
See accompanying notes to consolidated financial statements.
8
National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Stockholders' Equity
Nine Months Ended September 30, 2004 and 2003
(Unaudited)
Accumulated
Other
($ In thousands, except per Common Retained Comprehensive Comprehensive
share data) Stock Earnings Income Income Total
============ ============== ================ ================ ===========
Balances, December 31, 2002 $8,778 $62,525 $1,798 $73,101
Net income --- 8,344 --- $8,344 8,344
Dividend ($0.54 per share) --- (1,897) --- --- (1,897)
Exercise of stock options 4 25 --- --- 29
Other comprehensive income, net of tax:
Unrealized gains
on securities
available for sale, net
of income tax $166 --- --- --- (307) ---
Reclass adjustment net
of tax $1 --- --- --- (2) ---
------------ -------------- ---------------- ---------------- -----------
Other comprehensive income --- --- (309) (309) (309)
------------ -------------- ---------------- ---------------- -----------
Comprehensive income --- --- --- $8,035 ---
============ ============== ================ ================ ===========
Balances, September 30, 2003 $8,782 $68,997 $1,489 $79,268
============ ============== ================ ================ ===========
Balances, December 31, 2003 $8,788 $70,063 $1,790 $80,641
Net income --- 9,111 --- $9,111 9,111
Dividends ($0.63 per share) --- (2,216) --- --- (2,216)
Exercise of stock options 16 107 --- --- 123
Other comprehensive income,
net of tax
Unrealized losses on
securities available for
sale, net of income tax
($61) --- --- --- (113) ---
Reclass adjustment net of
income tax ($32) --- --- --- (59) ---
-----
------------ -------------- ---------------- ---------------- -----------
Other comprehensive income --- --- (172) (172) (172)
------------ -------------- ---------------- ---------------- -----------
Comprehensive income --- --- --- $8,939 ---
============ ============== ================ ================ ===========
Common Stock repurchase (13) (204) --- (217)
Balances, September 30,2004 $8,791 $76,861 $1,618 $87,270
============ ============== ================ ================ ===========
See accompanying notes to consolidated financial statements.
9
National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2004 and 2003
(Unaudited)
September 30, September 30,
($In thousands) 2004 2003
=================== =================
Cash flows from operating activities:
Net income $9,111 $8,344
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for loan losses 885 1,277
Depreciation of premises and equipment 727 687
Amortization of intangibles 699 715
Amortization of premiums and accretion of
discount, net 200 383
(Gains) Losses on sales and calls of securities
available for sale, net 27 (1)
(Gains) on calls of securities held to maturity (118) (2)
Losses and writedowns on other real estate owned 111 18
(Increase) decrease in:
Mortgage loans held for sale 157 756
Accrued interest receivable (543) (759)
Other assets 4,567 32
Increase (decrease) in:
Accrued interest payable (6) (184)
Other liabilities 438 (196)
------------------- -----------------
Net cash provided by operating
activities 16,255 11,070
------------------- -----------------
Cash flows from investing activities:
Net increase in federal funds sold --- 1,591
Net decrease in interest-bearing
deposits 30,694 488
Proceeds from calls, principal payments, sales and maturities of
securities available for sale 19,982 19,825
Proceeds from calls, principal payments and maturities of
securities held to maturity 6,933 14,493
Purchases of securities available for sale (20,221) (26,514)
Purchases of securities held to maturity (14,288) (21,839)
Purchases of loan participations (1,114) (2,051)
Collections of loan participations 941 1,292
Net (increase) in loans to customers (26,269) (3,992)
Acquisition of Community National Bank and First National Bank -
Southeast (13,602) ---
Proceeds from disposal of other real estate owned 970 81
Recoveries on loans charged off 174 192
Purchase of premises and equipment (687) (1,331)
Proceeds from disposal of premises and equipment 2 449
------------------- -----------------
Net cash (used in) investing
activities (16,485) (17,316)
------------------- -----------------
10
Cash flows from financing activities:
Net increase (decrease) in other deposits 7,510 16,988
Net increase (decrease) in time deposits (2,576) (7,489)
Net increase(decrease)in other borrowed funds 2,079 (656)
Stock options exercised 123 29
Cash dividends (2,216) (1,897)
Common Stock repurchased (217) ---
------------------- -----------------
Net cash provided by financing
activities 4,703 6,975
------------------- -----------------
Net increase in cash and due from banks 4,473 729
Cash and due from banks at beginning of period 11,733 12,316
------------------- -----------------
Cash and due from banks at end of period $16,206 $13,045
=================== =================
Supplemental disclosure of cash flow information
Cash paid for interest $8,168 $9,758
=================== =================
Cash paid for income taxes $2,576 $2,509
=================== =================
Loans charged to the allowance for loan losses $1,091 $1,059
=================== =================
Loans transferred to other real estate owned $327 $502
=================== =================
Unrealized (losses)on securities available for sale $(265) $(476)
=================== =================
Transactions related to the acquisition of Community National Bank Increase in
assets and liabilities:
Investments $10,052 $---
Loans 40,371 ---
Deposits 59,979 ---
See accompanying notes to consolidated financial statements.
11
National Bankshares, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2004
(Unaudited)
Note (1)
The consolidated financial statements of National Bankshares, Inc.
(Bankshares) and its wholly-owned subsidiaries, The National Bank of Blacksburg
(NBB), Bank of Tazewell County (BTC) and National Bankshares Financial Services,
Inc. (NBFS), (the Company), conform to accounting principles generally accepted
in the United States of America and to general practices within the banking
industry. The accompanying interim period consolidated financial statements are
unaudited; however, in the opinion of management, all adjustments consisting of
normal recurring adjustments which are necessary for a fair presentation of the
consolidated financial statements have been included. The results of operations
for the three and nine months ended September 30, 2004 are not necessarily
indicative of results of operations for the full year or any other interim
period. The interim period consolidated financial statements and financial
information included herein should be read in conjunction with the notes to
consolidated financial statements included in the Company's 2003 Form 10-K.
Note (2) Stock-Based Compensation
At September 30, 2004, the Company had a stock-based employee
compensation plan, which is described more fully in the Company's Form 10-K
dated December 31, 2003. The Company accounts for this plan under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related Interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under the
plan had an exercise price equal to the market value of the underlying common
stock on the date of grant. The following table illustrates the effect on net
income and earnings per share if the Company had applied the fair value
recognition provisions of FASB Statement No. 123, Accounting for Stock-Based
Compensation, to stock-based employee compensation.
Nine months ended Three months ended
September 30, September 30,
---------------------------- --------------------------
($ In thousands, except per share data) 2004 2003 2004 2003
- ---------------------------------------------------- -------------- ------------- ------------- ------------
Net income, as reported $9,111 $8,344 $3,215 $2,911
- ----------------------------------------------------
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards (76) (30) (25) (10)
- ---------------------------------------------------- -------------- ------------- ------------- ------------
Pro forma net income $9,035 $8,314 $3,190 $2,901
- ---------------------------------------------------- -------------- ------------- ------------- ------------
Earnings per share:
Basic-as reported $2.59 $2.38 $0.91 $0.83
-------------- ------------- ------------- ------------
Basic-pro forma $2.57 $2.37 $0.91 $0.83
Diluted-as reported $2.57 $2.36 $0.91 $0.82
-------------- ------------- ------------- ------------
Diluted-pro forma $2.55 $2.35 $0.90 $0.82
- ---------------------------------------------------- -------------- ------------- ------------- ------------
There were no stock options exercised during the third quarter. There
were no stock options granted or forfeited during the period. For the quarter
ended September 30, 2004, $16,500 options were excluded from the calculation of
diluted earnings per share as the effect would have been anti-dilutive.
12
Note (3) Acquisitions
On December 24, 2003, the Company's BTC subsidiary entered into an
agreement to acquire the loans and assume the deposit liabilities of the
Richlands, Virginia branch office of FNB Southeast of Reidsville, North Carolina
(FNB-SE). BTC received approval for this transaction from its primary regulator,
the Federal Reserve Bank, on February 18, 2004. The transaction, which did not
include the purchase of fixed assets, was closed in the second quarter of 2004.
The purchase and assumption added approximately $7.2 million in loans and
approximately $15.0 million in deposits. The Company determined that the
transaction did not constitute the acquisition of a business, and therefore it
has been accounted for under the provisions of SFAS No. 147, Acquisitions of
Certain Financial Institutions.
The Company's NBB subsidiary entered into an agreement with The South
Financial Group of Greenville, South Carolina on February 2, 2004. The contract
provided that NBB would purchase substantially all of the assets and assume all
of the liabilities of The South Financial Group's wholly-owned subsidiary,
Community National Bank located in Pulaski, Virginia (CNB). This transaction
closed in June of 2004 at a purchase price of $12.85 million. It added
approximately $60 million in deposits and approximately $69 million in total
assets. Any goodwill and intangible assets arising from the transaction have
been accounted for under the provisions of SFAS No. 142 Goodwill and other
Intangible Assets. The transaction resulted in the addition of approximately
$6.2 in goodwill and $1.3 million in core deposit intangible.
The results of operations are included in the financial statement from
the date of acquisition.
Note (4) Allowance for Loan Losses, Nonperforming Assets and Impaired Loans
For the periods ended
September 30, December 31,
2004 2003 2003
============== ============== =================
($In thousands, except for % data)
Balance at beginning of period $5,369 $5,092 $5,092
Provision for loan losses 885 1,277 1,691
Loans charged off (1,091) (1,059) (1,660)
Acquisition of CNB 498 --- ---
Recoveries 174 192 246
-------------- -------------- -----------------
Balance at the end of period $5,835 $5,502 $5,369
============== ============== =================
Ratio of allowance for loan losses to the end
of period loans net of unearned income and
deferred fees 1.24% 1.33% 1.32%
============== ============== =================
Ratio of net charge-offs to average loans, net
of unearned income and deferred fees(1)
.28% .28% .34%
============== ============== =================
Ratio of allowance for loan losses to
nonperforming loans(2) 1,220.71% 2,895.79% 1,516.67%
============== ============== =================
(1) Net charge-offs are on an annualized basis.
(2) The Company defines nonperforming loans as total nonaccrual and
restructured loans. Loans 90 days past due and still accruing are
excluded.
13
September 30, December 31,
2004 2003 2003
============= ============ ================
($In thousands, except % data)
Nonperforming Assets:
Nonaccrual loans $478 $190 $354
Restructured loans --- --- ---
------------- ------------ ----------------
Total nonperforming loans 478 190 354
Foreclosed property 1,010 940 1,663
------------- ------------ ----------------
Total nonperforming assets $1,488 $1,130 $2,017
============= ============ ================
Ratio of nonperforming assets to loans, net of
unearned income and deferred fees, plus other
real estate owned .31% .27% .49%
============= ============ ================
Past due 90 days or more and
still accruing $1,121 $2,207 $931
============= ============ ================
Ratio of loans past due 90 days or
more and still accruing to loans, net
of unearned income and deferred fees .24% .53% .23%
============= ============ ================
Total impaired loans $478 $380 $871
============= ============ ================
Impaired loans with a
valuation allowance $64 --- $506
Valuation allowance (64) --- (135)
------------- ------------ ----------------
Impaired loans net of allowance $--- --- $371
============= ============ ================
Impaired loans with no
valuation allowance $414 $380 $365
============= ============ ================
Average recorded investment
in impaired loans $663 $224 $353
============= ============ ================
Income recognized on impaired
loans $--- $19 $66
============= ============ ================
Amount of income recognized
on a cash basis $--- --- ---
============= ============ ================
14
Note (5) Securities
The amortized costs, gross unrealized gains, gross unrealized losses and
fair values for securities available for the sale by major security type as of
September 30, 2004 are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
($ In thousands) Costs Gains Losses Values
----------------- ----------------- ----------------- ------------------
U.S. Treasury $4,041 $51 $21 $4,071
U.S. Government agencies and
corporations 7,836 90 1 7,925
State and political
subdivisions 78,329 2,463 296 80,496
Mortgage-backed
securities 15,859 371 10 16,220
Corporate debt
securities 34,889 674 424 35,139
Federal Reserve Bank stock-
restricted 209 --- --- 209
Federal Home Loan
Bank stock-restricted 1,553 --- --- 1,553
Other securities 1,834 143 --- 1,977
----------------- ----------------- ----------------- ------------------
Total securities
available for sale $144,550 $3,792 $752 $147,590
================= ================= ================= ==================
The amortized costs, gross unrealized gains, gross unrealized losses and
fair values for securities held to maturity by major security type as of
September 30, 2004 are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Costs Gains Losses Values
----------------- ----------------- ----------------- ------------------
U.S. Government agencies and
corporations $15,975 $84 $93 $15,966
State and political
subdivisions 56,660 2,107 18 58,749
Mortgage-backed
securities 3,525 147 1 3,671
Corporate securities 32,091 1,462 227 33,326
----------------- ----------------- ----------------- ------------------
Total securities
held to maturity $108,251 $3,800 $339 $111,712
================= ================= ================= ==================
15
Note (6) Defined Benefit Plan
Components of Net Periodic Benefit Cost
($ in Thousands) Nine Months Ended Three Months Ended
September 30, September 30,
2004 2003 2004 2003
---- ---- ---- ----
Service cost $372 $321 $124 $107
Interest cost 402 375 134 125
Expected return on plan assets (375) (315) (125) (105)
Amortization of prior service cost 6 6 2 2
Recognized net actuarial loss 90 84 30 28
Amortization of transition cost (9) (9) (3) (3)
---------- ---------- ------------ ----------
---------- ---------- ------------ ----------
Net periodic benefit cost $486 $462 $162 $154
========== ========== ============ ==========
Employer Contributions
Bankshares previously disclosed in its financial statements for the year
ended December 31, 2003, an estimated minimum contribution of $623,000 to its
pension plan in 2004. That estimate has since been revised and Bankshares now
expects to contribute $522,000 to the pension plan for 2004. As of September 30,
2004, the Company has made contributions totaling $334,000. Bankshares
anticipates making all required contributions prior to the end of 2004.
Note (7) Recent Accounting Announcements
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No.
105, "Application of Accounting Principles to Loan Commitments" ("SAB 105"). SAB
105 clarifies existing accounting practices relating to the valuation of issued
loan commitments, including interest rate lock commitments ("IRLC"), subject to
SFAS No. 149 and Derivative Implementation Group Issue C13, "Scope Exceptions:
When a Loan Commitment is included in the Scope of Statement 133." Furthermore,
SAB 105 disallows the inclusion of the values of a servicing component and other
internally developed intangible assets in the initial and subsequent IRLC
valuation. The provisions of SAB 105 were effective for loan commitments entered
into after March 31, 2004. The Company has adopted the provisions of SAB 105.
Since the provisions of SAB 105 affect only the timing of the recognition of
mortgage banking income, management does not anticipate that this guidance will
have a material adverse effect on either the Company's consolidated financial
position or consolidated results of operations.
Emerging Issues Task Force Issue No. 03-1 "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments"
("EITF 03-1") was issued and is effective March 31, 2004. The EITF 03-1 provides
guidance for determining the meaning of "other -than-temporarily impaired" and
its application to certain debt and equity securities within the scope of
Statement of Financial Accounting Standards No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS No. 115") and investments
accounted for under the cost method. The guidance requires that investments
which have declined in value due to credit concerns or solely due to changes in
interest rates must be recorded as other-than-temporarily impaired unless the
Company can assert and demonstrate its intention to hold the security for a
period of time sufficient to allow for a recovery of fair value up to or beyond
the cost of the investment which might mean maturity. This issue also requires
disclosures assessing the ability and intent to hold investments in instances in
which an investor determines that an investment with a fair value less than cost
is not other-than-temporarily impaired.
On September 30, 2004, the Financial Accounting Standards Board decided
to delay the effective date for the measurement and recognition guidance
contained in Issue 03-1. This delay does not suspend the requirement to
16
recognize other-than-temporary impairments as required by existing authoritative
literature. The disclosure guidance in Issue 03-1 was not delayed.
EITF No. 03-16, "Accounting for Investments in Limited Liability
Companies was ratified by the Board and is effective for reporting periods
beginning after June 15, 2004." APB Opinion No. 18, "The Equity Method of
Accounting Investments in Common Stock," prescribes the accounting for
investments in common stock of corporations that are not consolidated. AICPA
Accounting Interpretation 2, "Investments in Partnerships Ventures," of Opinion
18, indicates that "many of the provisions of the Opinion would be appropriate
in accounting" for partnerships. In EITF Abstracts, Topic No. D-46, "Accounting
for Limited Partnership Investments," the SEC staff clarified its view that
investments of more than 3 to 5 percent are considered to be more than minor
and, therefore, should be accounted for using the equity method. Limited
liability companies (LLCs) have characteristics of both characteristics of both
corporations and partnerships, but are dissimilar from both in certain respects.
Due to those similarities and differences, diversity in practice exists with
respect to accounting for non-controlling investments in LLCs. The consensus
reached was that an LLC should be viewed as similar to a corporation or similar
to a partnership for purposes of determining whether a non-controlling
investment should be accounted for using the cost method or the equity method of
accounting.
National Bankshares, Inc. and Subsidiaries
(In thousands, except per share data)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The purpose of this discussion is to provide information about the
financial condition and results of operations of National Bankshares, Inc. and
its wholly owned subsidiaries (the Company), which are not otherwise apparent
from the consolidated financial statements and other information included in
this report. Reference should be made to the financial statements and other
information included in this report as well as the 2003 Annual Report on Form
10-K for an understanding of the following discussion and analysis.
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. The Company's actual results could
differ materially from those set forth in the forward-looking statements.
Critical Accounting Policies
General
The Company's financial statements are prepared in accordance with
accounting principles generally accepted in the United States (GAAP). The
financial information contained within our statements is, to a significant
extent, financial information that is based on measures of the financial effects
of transactions and events that have already occurred. A variety of factors
could affect the ultimate value that is obtained when earning income,
recognizing an expense, recovering an asset or relieving a liability. We use
historical loss factors as one factor in determining the inherent loss that may
be present in our loan portfolio. Actual losses could differ significantly from
the historical factors that we use. In addition, GAAP itself may change from one
previously acceptable method to another method. Although the economics of our
transactions would be the same, the timing of events that would impact our
transactions could change.
17
Allowance for Loan Losses
The allowance for loan losses is an estimate of the losses that may be
sustained in our loan portfolio. The allowance is based on two basic principles
of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that
losses be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance.
Our allowance for loan losses has three basic components: the formula
allowance, the specific allowance and the unallocated allowance. Each of these
components is determined based upon estimates that can and do change when actual
events occur. The formula allowance uses a historical loss view as an indicator
of future losses and, as a result, could differ from the loss incurred in the
future. However, since this history is updated with the most recent loss
information, the errors that might otherwise occur are mitigated. The specific
allowance uses various techniques to arrive at an estimate of loss. Historical
loss information, expected cash flows and fair market value of collateral are
used to estimate these losses. The use of these values is inherently subjective
and our actual losses could be greater or less than the estimates. The
unallocated allowance captures losses that are attributable to various economic
events, industry or geographic sectors, whose impact on the portfolio have
occurred but have yet to be recognized in either the formula or specific
allowance.
Core deposit intangibles
Effective January 1, 2002, the Corporation adopted Financial Accounting
Standards Board Statement No. 142, Goodwill and Other Intangible Assets.
Accordingly, goodwill is no longer subject to amortization over its estimated
useful life, but is subject to at least an annual assessment for impairment by
applying a fair value based test. Additionally, Statement 142 requires that
acquired intangible assets (such as core deposit intangibles) be separately
recognized if the benefit of the asset can be sold, transferred, licensed,
rented, or exchanged and amortized over its estimated useful life. Branch
acquisition transactions were outside the scope of the Statement and therefore
any intangible asset arising from such transactions remained subject to
amortization over their estimated useful life.
In October 2002, the Financial Accounting Standards Board issued
Statement No. 147, Acquisitions of Certain Financial Institutions. The Statement
amends previous interpretive guidance on the application of the purchase method
of accounting to acquisitions of financial institutions, and requires the
application of Statement No. 141, Business Combinations, and Statement No. 142
to branch acquisitions if such transactions meet the definition of a business
combination. The provisions of the Statement do not apply to transactions
between two or more mutual enterprises. In addition, the Statement amends
Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to
include in its scope core deposit intangibles of financial institutions.
Accordingly, such intangibles are subject to a recoverability test based on
undiscounted cash flows and to the impairment recognition and measurement
provisions required for other long-lived assets held and used.
An outside evaluation of the intangible assets associated with the recent
CNB acquisition has been conducted. The evaluation recognized as core deposit
intangible approximately $1,354.
Overview
National Bankshares, Inc. (NBI) is a financial holding company located in
Southwest Virginia. It conducts operations primarily through two full-service
banking affiliates, the National Bank of Blacksburg and Bank of Tazewell County.
It also has one nonbanking affiliate, National Bankshares Financial Services,
Inc., which offers investment and insurance products. Net income derived from
the nonbanking affiliate is not significant at this time or for the foreseeable
future. NBI is primarily a community bank holding company.
18
Performance Summary
The following table shows NBI's key performance ratios for the nine months
ended September 30, 2004 and December 31, 2003 and 2002:
September 30, 2004 December 31, 2003 December 31, 2002
- ------------------------------------------------- -------------------- -------------------- ----------------------
Return on average assets 1.64% 1.64% 1.53%
- ------------------------------------------------- -------------------- -------------------- ----------------------
Return on average equity 14.60% 14.77% 14.33%
- ------------------------------------------------- -------------------- -------------------- ----------------------
Net interest margin (1) 4.73% 4.82% 4.74%
- ------------------------------------------------- -------------------- -------------------- ----------------------
Noninterest margin (2) 1.77% 1.81% 1.84%
- ------------------------------------------------- -------------------- -------------------- ----------------------
Basic net earnings per share $2.59 $3.26 $2.85
- ------------------------------------------------- -------------------- -------------------- ----------------------
Fully diluted net earnings per share $2.57 $3.24 $2.84
- ------------------------------------------------- -------------------- -------------------- ----------------------
(1) Net Interest Margin - Year-to-date tax-equivalent net interest income
divided by year-to-date average earning assets.
(2) Noninterest Margin - Noninterest income (including securities gains and
losses) less noninterest expense (excluding the provision for bad debts
and income taxes) divided by average year-to-date assets.
Earnings for the period ending September 30, 2004 were $9,111 up $9.19%
from the same period in 2003. As illustrated in the above table, the return
on average assets continues at the previous year's level. The return on
average equity has declined, in part, because of an increase in capital due
to earnings.
Since the Company pays semi-annual dividends, capital builds in the first and
third quarters, which reduces the return on average equity. In the second and
fourth quarters the payout of capital for dividends has a positive effect.
Unrealized gains and losses on securities available for sale, which can
fluctuate by a substantial amount, can also affect the return on average equity.
The interest margin and noninterest margin have remained relatively stable,
declining 9 basis points and 4 basis points, respectively.
The yield on earning assets declined by 47 basis points while the cost to
fund the earning assets declined by 38 points.
Basic earnings per share were $2.59 for the period ending September 30,
2004 and $2.38 for the period ending September 30, 2003.
Overall profitability indicators remain stable or improving. Management
believes that the current trend will continue in the short term, providing that
interest rates remain stable. Rising interest rates may have an adverse affect
on profitability in the short to intermediate term, especially if such rate
increases move to substantially higher levels in a short period of time. Based
on current information, rate increases are not expected to rise sharply. (See
the discussion on "Net Interest Income" for more information.)
Growth
The following table shows NBI's key growth indicators:
September 30, 2004 December 31, 2003 December 31, 2002
- ------------------ -------------------- ------------------ --------------------
Securities $255,841 $230,154 $219,294
- ------------------ -------------------- ------------------ --------------------
Loans, net 466,256 401,428 404,247
- ------------------ -------------------- ------------------ --------------------
Deposits 690,291 625,378 608,271
- ------------------ -------------------- ------------------ --------------------
Total assets 782,613 708,560 684,935
- ------------------ -------------------- ------------------ --------------------
Bank-owned securities have increased by $25,687 in 2004. Approximately
$10,100 was due to the purchase of substantially all of the assets of the
Community National Bank, Pulaski, VA (CNB) in the latter part of the second
quarter.
Net loans increased by $64,828 in 2004. Loans assumed in the CNB
transaction totaled approximately $40,400 and $7,200 in the purchase and
assumption of certain assets and liabilities of the Richlands, Virginia office
of FNB Southeast (FNB-SE). (See the discussion on "Net Interest Income" for more
details.)
19
Deposits increased in 2004 by $64,913. Deposits acquired in the CNB
transaction were approximately $60,000 and $15,000 in the FNB-SE branch
purchase.
Total assets increased $74,053 in the first nine months of 2004, mostly
because of the CNB and FNB-SE transactions.
Asset Quality
Key asset quality indicators are shown below:
September 30, 2004 December 31,2003 December 31, 2002
- --------------------------------------------- ------------------- ------------------- -------------------
Nonperforming loans $478 $354 $288
- --------------------------------------------- ------------------- ------------------- -------------------
Loans past due over 90 days 1,121 931 977
- --------------------------------------------- ------------------- ------------------- -------------------
Other real estate owned 1,010 1,663 537
- --------------------------------------------- ------------------- ------------------- -------------------
Allowance for loan losses to loans 1.24% 1.32% 1.24%
- --------------------------------------------- ------------------- ------------------- -------------------
Net charge-off ratio .28% .34% .35%
- --------------------------------------------- ------------------- ------------------- -------------------
Asset quality remains good, with only the nonperforming loans category
showing a $12 increase. Management works intensively with delinquent borrowers
to attempt to bring nonperforming loans back to performing status. When these
efforts are unsuccessful, management is moving quickly to liquidate loan
collateral and to institute legal collection activities.
The net charge-off ratio has declined from levels at year-end 2003.
Loans past due ninety days or more were $1,121 at September 30, 2004, up
slightly from the $931 at December 2003 and the $977 at December 31,2002.
Net Interest Income
Net interest income for the period ended September 30, 2004 was $22,493,
an increase of $933 or 4.33%. The net interest margin was 4.73% for the period
ended September 30, 2004 and 4.83% for the period ended September 30, 2003.
During the past two years the Company has benefited from a relatively
long period of low interest rates, which has no recent precedent. The trend
continued into the first half of 2004. In June of 2004, the Federal Reserve
Board raised the federal funds rates 25 basis points, signaling the start of a
higher interest rate environment. Since then additional rate increases have
occurred, with more expected. Many forecasters agree that interest rates will
trend upward in small increments over the next several quarters. However, the
impact of world events, such as but not limited to, oil prices, problems in the
Middle East and terrorist related activities, could negatively impact the
national economy and alter plans for future interest rate increases. If such
events were to occur the Company, together with the entire banking industry,
could be affected to some extent.
The general impact of a rising interest rate scenario on the Company's
balance sheet follows.
Federal Funds Sold and Interest-bearing Deposits - These are overnight
funds used primarily for liquidity purposes. They mature daily and, accordingly,
interest rates change daily, which is advantageous in a period of rising
interest rates. However these funds yield low interest, making other investments
more attractive from an earnings standpoint.
Securities Available for Sale - This category provides a higher level of
earnings than overnight funds and can under certain circumstances be a source of
liquidity and also demonstrate the ability to re-price. While these securities
can be sold to provide liquidity and for interest rate sensitivity purposes,
temporary declines in fair market value due to rising interest rates may make it
unprofitable to sell the securities. In addition, embedded call features may not
be activated during periods of high rates, leaving the Company with a "hold" or
"sell" decision. See page 26 of the Company's 2003 Form 10-K for re-pricing
data.
20
Securities Held to Maturity - Because of its nature, this category of
investments is not necessarily structured to be a source of liquidity or to
moderate interest rate sensitivity. These securities must be held to maturity
except under extenuating circumstances. In a rising rate environment, the
difference in the amount of interest income earned and the cost to fund the
securities decreases. In other words, net interest income from these investments
declines. Embedded call features may not be activated during periods of high
rates. See the Company's 2003 Form 10-K for re-pricing data.
Mortgage Loans Held for Sale - This category is primarily driven by
volume. In periods of low interest rates, mortgage refinancing activity and home
sales tend to accelerate and generate higher revenue levels than are experienced
in times of high interest rates. In the last two years, re-financing activity
has been significant. Recently, however, despite the continuing low rate
environment, activity has declined. This may signal the end to what many have
characterized as a refinancing boom.
Loans - While the low rate environment of the recent past is more
conducive to loan production than periods of extremely high interest rates,
interest rates that are unusually low are a sign of a weak or a recovering
economy. Ideal volumes may in fact be achieved in a more robust economy in which
more moderate rate levels exist. If the economy continues to recover as
forecast, higher loan volumes would have a positive impact on net interest
income.
Of particular concern is the area of loans to individuals, which has
been in a downward trend for several quarters, with the only growth coming from
loans acquired in purchase and assumption transactions. Management believes the
decline is due to several reasons.
o General economic conditions and the lack of employment in portions of
the Company's market area.
o A decline in consumer requests for new car financing because of special
incentives offered by automobile companies.
o Consumers' use of credit cards and home equity lines with higher credit
limits.
o Consumers taking advantage of low mortgage rates to refinance home
mortgages to obtain funds that might otherwise have been borrowed
through a consumer loan.
A reversal of this trend may occur to some extent as economic conditions
change and higher interest rates make mortgage refinancing less appealing.
However, management believes that the automotive related financing offers and
competition from the credit card sector will remain. Since loans to individuals
are generally higher yielding, this trend will not have a favorable effect on
net interest income.
Interest Expense
During periods of rising interest rates, interest-bearing demand
deposits, and to a lesser degree savings deposits, migrate to higher rate,
longer-term time deposits. Generally, as rates climb, more migration occurs.
Given their re-pricing characteristics, interest-bearing demand deposits readily
respond to any interest rate movement. In other words, increases or decreases in
interest expense can occur quite quickly.
With a definite bias towards higher interest rates in the future, it is
expected that the net interest margin will decline, at least temporarily, in
response to rising interest rates. As previously stated, the ultimate impact of
rising interest rates is dependent upon the number of rate increases, the amount
of such and the level to which they ultimately rise is a matter of uncertainty.
Provision and Allowance for Loan Losses
The provision for loan losses for the period ended September 30, 2004
was $885, a decrease of $392 from the September 30, 2003 provision expense of
$1,277.
21
Nonperforming assets at September 30, 2004 were $1,488 and $2,017 at
December 31, 2003. Of the nonperforming assets outstanding at September 30,
2004, $478 was in nonaccrual loans and $1,010 was in foreclosed properties.
Efforts specifically designed to focus on and work intensively with
delinquent borrowers have been undertaken. When these efforts have been
unsuccessful, other more stringent legal collection measures and foreclosures
have been initiated.
Depending on the type of property and/or the circumstances surrounding a
particular credit, the time to deal with each situation may vary widely. Hence,
management cannot predict with any degree of certainty at what point in the
future problems associated with these credits will be resolved. Based on current
information, management believes that the volume of problem credits are at or
near their peak.
Loans ninety days past due and still accruing were $1,121 at September
30, 2004 and $931 at December 31, 2003.
The ratio of the allowance for loan losses to loans net of unearned
income and deferred fees was 1.24% at September 30, 2004, which compares to
1.32% at December 31, 2003.
The annualized ratio of net charge-offs to loans net of unearned income
was .28% at September 30, 2004 and .34% at December 31, 2003.
Noninterest Income
September 30, 2004 September 30, 2003 September 30, 2002
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Service charges on deposits $2,234 $1,877 $1,678
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Other service charges and fees 182 206 202
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Credit card fees 1,362 1,210 1,040
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Trust fees 1,105 757 718
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Other income 311 342 416
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Realized securities gains/losses 91 3 343
- ----------------------------------- ----------------------- ------------------------ ---------------------------
Noninterest income is comprised of several categories. Following is a
description of each, as well as the factors that influence each.
Service charges on deposit accounts consist of a variety of charges
imposed on demand deposits, interest-bearing deposits and savings deposit
accounts. These include, but are not limited to, the following:
o Demand deposit monthly activity fees
o Service charges for checks for which there are
non-sufficient funds or overdraft charges o ATM transaction fees
The principal factors affecting current or future income are:
o Internally generated growth
o Acquisitions of other banks/branches or de novo branches
o Adjustments to service charge structures
In 2003, the Company made certain changes to its service charge
structure. These changes were not in effect in the first quarter of 2003. The
remainder of the increase was due to volume, combined with routine charge-offs.
Revenues are expected to continue to grow if, for no other reason, than the two
recent acquisitions. See the comments under "Acquisitions."
Other service charges and fees consist of several categories. The
primary categories are listed below.
o Fees for the issuance of official checks
o Safe deposit box rent o Income from the sale of customer checks
o Income from the sale of credit life and accident and health insurance
22
Levels of income derived from these categories vary. Fees for the
issuance of official checks and customer check sales tend to grow as the
existing franchise grows and as new offices are added. Fee schedules, while
subject to change, generally do not alone yield a significant or discernable
increase in income when adjusted. The most significant growth in safe deposit
box rent also comes with an expansion of offices. Safe deposit box fee
schedules, which are already at competitive levels, are occasionally adjusted.
Income derived from the sale of credit life insurance and accident and health
insurance varies with loan volumes.
Credit card fees consist of three types of revenues as follows:
o Credit card transaction fees
o Debit card transaction fees
o Merchant fees
In all three cases, volume is critical to growth in income. For debit and
credit cards the number of accounts, whether obtained from internal growth or
by acquisition, is the key factor. Merchant fees also depend on the number of
merchants in the Company's program, as well as the type of business and the
level of transaction discounts associated with them.
Trust income is somewhat dependent upon market conditions and the number
of estate accounts being handled at any given point in time. Financial market
conditions, which affect the value of trust assets managed, can vary, leading
to fluctuations in the related income. Over the past few years and into 2004,
the financial markets have experienced a significant degree of volatility.
Of the $348 increase, approximately $229 was attributable to income from
the settlement of estates. Improvement in market conditions accounts for the
majority of the remaining increase.
The other income category is used for types of income that cannot be
classified with other forms of noninterest income. The category includes such
things as:
o Net gains on the sale of fixed assets
o Rent on foreclosed property
o Income from cash value life insurance
o Other infrequent or minor forms of income
o Revenue from investment and insurance sales
Given the nature of the items included in this category, it is difficult to
determine trends or patterns. Items warranting discussion are usually
non-recurring in nature.
Other income for the first three quarters of 2004 was down $31 when
compared to the first three quarters of 2003. Two items unique to 2003 accounted
for a large part of the decrease. The first was a $40 rebate received by an
affiliate bank from a vendor. The second was a dividend paid to the Company's
financial services affiliate.
Net realized gains on securities at September 30, 2004 were $91 and were
the results of called or sold securities offset by write downs in certain equity
securties.
Noninterest Expense
September 30, 2004 September 30, 2003 September 30, 2002
- --------------------------------- ----------------------- -------------------------- ---------------------------
Salaries and employee benefits $7,815 $7,161 $6,680
- --------------------------------- ----------------------- -------------------------- ---------------------------
Occupancy and furniture and
fixtures 1,337 1,248 1,260
- --------------------------------- ----------------------- -------------------------- ---------------------------
Data processing and ATM 913 851 849
- --------------------------------- ----------------------- -------------------------- ---------------------------
Credit card processing 1,100 949 764
- --------------------------------- ----------------------- -------------------------- ---------------------------
Intangibles and goodwill
amortization 699 715 716
- --------------------------------- ----------------------- -------------------------- ---------------------------
Net costs of other real estate
owned 149 38 139
- --------------------------------- ----------------------- -------------------------- ---------------------------
Other operating expenses 2,997 2,878 2,709
- --------------------------------- ----------------------- -------------------------- ---------------------------
23
Noninterest expense includes several categories. Following is a brief
description of the factors that affect each.
In addition to employee salaries, the salaries and benefits expense
category includes the costs of employment taxes and employee fringe benefits.
Certain of these are:
o Health insurance
o Employee life insurance
o Dental insurance
o Executive compensation plans (1)
o Pension plans (1)
o Employee stock option plan (1)
o Employer FICA
o Unemployment taxes
(1) See the 2003 Form 10-K and the Proxy Statement for the 2004 Annual
Stockholders meeting for further information.
For the first three quarters of 2004, salary and benefits expense was up
$654. Routine salary increases and health insurance cost increases contributed
to the increase.
Of more significance are the recent purchase and assumption
transactions. While the FNB-SE branch acquisition added no employees to the
payroll, the CNB purchase and assumption initially added twenty-one employees.
Because the Company's NBB subsidiary is operating the former CNB office as a
branch office, many former CNB employees were retained in their previous
positions. Some former CNB employees hold jobs that are performed elsewhere at
NBB and they have moved to those positions as the need arose.
Occupancy costs include such items as depreciation expense, maintenance
of the properties, repairs and real estate taxes. This category is most affected
by new property acquisitions resulting from mergers, branch purchases or
construction of new branch facilities. Conversely, expense can be lowered by
branch office consolidations or closures, which though infrequent, have
occurred. On occasion repairs and other expense items can rise to significant
levels, though not frequently. This category increased $89 when the first nine
months of 2004 and 2003 are compared. The CNB purchase and assumption
transaction did not add significantly to this category because it was completed
very near the end of the second quarter.
The Company maintains its own data processing facility and has ATM's at
twenty-two subsidiary bank offices and other locations. Costs to operate these
are reflected in this category and include depreciation, maintenance,
communication lines and certain supplies.
Data processing costs were up $62 when the first half of 2004 is
compared to the same period in 2003. While these cost increases are nominal,
larger increases are expected because of the completion of the two previously
mentioned purchase and assumption transactions. The first purchase and
assumption transaction was quite small and has not greatly impacted data
processing and ATM expense. The second acquisition involved the assets and
liabilities of an existing bank, including assumption of its existing data
processing contract, which will remain until mid 2005. Assumption of this
contract increased monthly costs by approximately $12-$15. While the contract
terminates in mid 2005, no substantial decreases in processing costs are
expected, as the company's primary data processing contract allows for
incremental increases. The Company also added three ATM's at its bank affiliates
during the second quarter of 2004.
Credit card processing includes costs associated with the processing of
credit cards, debit cards and merchant transactions. These expenses are related
to credit card income previously discussed in the "Noninterest Income" section,
and the comments in that section are applicable.
At September 30, 2004 the net cost of other real estate owned was $149.
Expense has risen steadily for the past three years. The September 30, 2004
24
costs are not necessarily indicative of the full year for 2004. Other real
estate owned at September 30, 2004 was $1,010, which compares to $1,663 at
December 31, 2003 and $537 at December 31, 2002. Given the number of
foreclosures, it is likely that higher costs could continue for 2004, possibly
into 2005.
Other operating expenses include all other forms of expense not
classified elsewhere in the Company's statement of income. Included in this
category are such items as stationery and supplies, franchise taxes,
contributions, telephone, postage and other operating costs. Many of the
expenses included in this category are relatively stable or moderately increase
with inflation from year to year. However, there are some items included in the
category, such as other losses and charge-offs and repossession expense, which
can vary from time to time. While many of the items in this category have
identifiable trends, others may have frequent nonrecurring items or items that
occur at no particular frequency. This category was also affected by the recent
acquisitions. Categories such as stationery and supplies, telephone, and postage
all increase when new offices are acquired.
Overall cost for this category increased 4.35%, when the periods ending
September 30, 2004 and September 30, 2003 are compared.
Income Taxes
In 2003 the Company moved from the 34% tax rate to 35%. In addition to
the actual taxes paid, this change affected other areas including the book tax
provision, deferred taxes and tax equivalency calculations.
Balance Sheet
Year-to-date daily averages for the major balance sheet categories are
as follows:
Assets September 30, 2004 December 31, 2003
- ---------------------------------------- ------------------- -----------------
Federal funds sold $351 $1,320
Interest-bearing deposits 17,792 21,958
Securities available for sale 141,575 125,042
Securities held to maturity 107,293 103,962
Mortgage loans held for sale 572 1,159
Real estate construction loans 22,447 29,575
Real estate mortgage loans 104,489 84,363
Commercial and industrial loans 222,008 207,855
Loans to individuals 85,999 90,365
Total Assets $741,743 $697,012
Liabilities and stockholders equity
- ----------------------------------------
Noninterest-bearing demand deposits $89,622 $79,760
Interest-bearing demand deposits 182,949 167,428
Savings deposits 57,459 51,646
Time deposits 324,784 317,989
All other borrowings 482 194
Shareholders' equity $83,372 $77,486
Securities available for sale increased by $16,533 from December 31,
2003, while securities held to maturity increased by $3,331.
As shown in the statement of cash flow, of that increase $10,232 was
attributable to the CNB transaction. During the first three quarters of 2004,
$281 in securities held to maturity were sold. This represents the sale of one
issue and was prompted by credit quality concerns.
25
The mix of loan categories at September 30, 2004 and December 31, 2003 is shown
in the following table.
September 30, 2004 December 31, 2003
- ------------------------------------------ ------------------------- ---------------------------
Construction loans (1) $24,209 $28,055
- ------------------------------------------ ------------------------- ---------------------------
Real estate loans 115,046 87,899
- ------------------------------------------ ------------------------- ---------------------------
Commercial and industrial loans 241,038 208,997
- ------------------------------------------ ------------------------- ---------------------------
Loans to individuals 92,665 82,742
- ------------------------------------------ ------------------------- ---------------------------
(1) All categories shown reflect gross loans at period-end.
The volume of mortgage loans held for sale is directly related to
interest rate levels. Activity generally peaks during periods of low interest
rates, declining as interest rates rise. Period-end balances are not indicative
of volume, as loans are constantly being originated and sold. The balance shown
at period-end reflects only loans held by NBB for which there are purchase
commitments from investors, but which have not yet been funded. At September 30,
2004 there were approximately $3,838 in commitments to extend mortgage loans
outstanding.
Construction loans were $24,209 at September 30, 2004 and $28,055 at
December 31, 2003, a decrease of $3,846. This category tends to fluctuate
because of demand and with the seasons. Demand may vary because of economic
conditions. Completion of construction projects generally occurs within one
year, at which time permanent financing through one of the Company's banking
affiliates or another lender is obtained. Loans for which the Company retains
permanent financing move into the commercial and industrial loan or mortgage
loan categories.
Real estate loans at September 30, 2004 were $115,046, which represents
an increase of $27,147 from December 31, 2003. Loans in this category are for
one-to-four family housing and are loans the banking affiliates elected to
retain rather than sell on the secondary market. Of that increase, approximately
$13.0 million were acquired from CNB and $2.6 million acquired from FNB-SE.
Commercial and industrial loans were $241,038 at September 30, 2004,
which represents an increase of $32,041 from December 31, 2003. Included in this
category are loans for working capital, equipment, commercial real estate and
other loans for legitimate business needs. The CNB transaction accounted for
approximately $14.0 million of this growth and the FNB-SE acquisition $2.4
million. See Footnote 15 of the Company's 2003 Form 10-K for information related
to "Concentrations of Credit". Historically, growth in this category has been
satisfactory, and based on present knowledge, no adverse trends are anticipated.
Loans to individuals increased by $9,923 when September 30, 2004 is
compared to December 31, 2003. Growth attributable to the CNB transaction was
approximately $5.3 million and $2.2 million from FNB-SE. Growth rates in this
category have experienced a downward trend, with most growth observed in this
area being the result of acquisitions. See the comments under the caption "Net
Interest Income" in this report.
At September 30, 2004 total deposits were $690,291 compared to $625,378
at December 31, 2004. Of the $64,913 net increase, approximately $60 million
came from CNB and $15 million from FNB-SE, which were partially offset by
deposit runoff.
Liquidity and Capital Resources
Net cash provided by operating activities was $16,255 for the period
ended September 30, 2004, which compares to $11,070 for the same period the
previous year.
Net cash used in investing activities was $16,485 provided for the
period ended September 30, 2004, and $17,316 used for the period ended September
30, 2003.
The Company used approximately $13,602 in acquisitions, and it had no
acquisitions in 2003.
Net cash provided in financing activities was $4,703 for the period
ending September 30, 2004. The substantial changes in cash used in investing
activities and cash provided by financing activities are due to the CNB and
FNB-SE transactions.
Included in the supplemental cash flow data is interest paid on
deposits, which declined substantially when the periods September 30, 2004 and
26
September 30, 2003 are compared. The decrease is due to a decline in interest
expense due to the lower interest rate environment.
The Company has other available sources of liquidity. They include lines
of credit with a correspondent bank, advances from the Federal Home Loan Bank,
and Federal Reserve Bank discount window borrowings.
Management is unaware of any commitment that would have a material and
adverse effect on liquidity at September 30, 2004.
Total shareholders' equity grew by $6,629 from December 31, 2003 to
September 30, 2004. Earnings net of the change in unrealized gains and losses
for securities available for sale and dividends paid accounted for most of the
increase. Stock options exercised provided $123. During the third quarter the
Company repurchased 5,000 shares of the common stock for $217. The Tier I and
Tier II risk-based capital ratios at September 30, 2004 were 11.96% and 12.99%,
respectively.
Derivatives
The Company is not a party to derivative financial instruments with
off-balance sheet risks such as futures, forwards, swaps and options. The
Company is a party to financial instruments with off-balance sheet risks such as
commitments to extend credit, standby letters of credit, and recourse
obligations in the normal course of business to meet the financing needs of its
customers. Management does not plan any future involvement in high- risk
derivative products. The Company has investments in collateralized mortgage
obligations, structured notes and other similar instruments that are included in
securities available for sale and securities held to maturity. The fair value of
these investments at September 30, 2004 was approximately $2,760. Amortized cost
for these securities was approximately $2,655.
Management Discussion and Analysis of the Financial Condition and results of
operations for the three months ended September 30, 2004.
Performance Summary
The following table shows NBI's performance ratios for the three months ended
September 30, 2004 and September 30, 2003
September September
30,2004 30,2003
- ------------------------------------------ ----------------- ----------------
Return on Average Assets 1.63% 1.66%
- ------------------------------------------ ----------------- ----------------
Return on Average Equity 15.24% 14.78%
- ------------------------------------------ ----------------- ----------------
Net Interest Margin 4.70% 4.86%
- ------------------------------------------ ----------------- ----------------
Basic Net Earnings per Share $0.91 $0.83
- ------------------------------------------ ----------------- ----------------
Fully diluted Net Earnings per Share $0.91 $0.82
- ------------------------------------------ ----------------- ----------------
As can be seen by the above data, these key indicators have been relatively
stable. The return on equity has increased slightly. Earnings per share data
reflects the continued growth in net income.
Following is a comparison of quarter-to-date daily averages for related
categories.
September September
30,2004 30,2003
------------------- ---------------- -----------------
Securities $256,727 $228,794
------------------- ---------------- -----------------
Loans, net 465,806 409,307
------------------- ---------------- -----------------
Deposits 697,119 616,574
------------------- ---------------- -----------------
Total Assets 786,220 697,216
------------------- ---------------- -----------------
27
As can be seen by the above data, the Company has experienced solid growth when
the two quarters are compared. Much of the growth experienced was due to the
acquisition of the FNB-SE branch loans and deposits by the Company's BTC
affiliate that was completed in April of 2004. The CNB transaction that occurred
in the second quarter also had a positive impact on those averages.
Net Income
Net income for the third quarter of 2004 was $3,215 compared to $2,911
for the same period in 2003. This result is a $.09 increase in Diluted Earnings
per Share.
While the FNB-SE transaction had a small unquantifiable effect upon net
income in the third quarter of 2004, the CNB transaction has had a positive
affect, though the exact amount can not be quantified.
Net Interest Income
Net interest income rose by $515 when the third quarters of 2004 and
2003 are compared. Overall interest income increased by $579, while interest
expense increased by $64. The ongoing effect of the low interest rate
environment is apparent. Previous comments in the discussion of year-to-date
"Net Interest Income" section apply.
Provision for Loan Losses
The provision for loan losses was down $142 when the two periods are
compared.
Noninterest Income
Overall noninterest income increased by $343 or 22.54%. Areas
experiencing the greatest change are as follows:
o Service charges on deposits increased $120
o Credit Card processing increased $ 64
o Trust income increased $ 21
General comments made in the year-to-date discussion apply. The
increases in service charges on deposits are attributed in part to deposits
acquired from CNB, which account for $82 of the $120 increase. There were no
material non-routine items in the third quarter of 2004 in credit card
processing or Trust income.
Noninterest Expense
Overall non-interest expense grew by $571 when September 30, 2004 and
September 30, 2003 are compared. Three areas with the greatest increases follow:
o Salaries and employee benefits increased $327
o Credit card processing increased $74
o OREO expense increased $18
General comments made pertaining to salaries and employee benefits made
in the year-to-date discussion apply. In addition, the CNB purchase and
assumption transaction affected this category.
General comments related to credit card processing in the year-to-date
discussion apply. There were no material reportable non-routine transactions.
OREO expense is up. See the year-to-date discussion for additional
comments.
28
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The Company considers interest rate risk to be a significant market risk
and has systems in place to measure the exposure of net interest income to
adverse movement in interest rates. Interest rate shock analyses provide
management with an indication of potential economic loss due to future rate
changes. The following table shows repricing opportunities for the major
categories of assets and liabilities.
INTEREST EARNING ASSETS
1 YEAR 1-5 YEARS >5 YEARS TOTAL
Interest-Bearing Deposits 5,705 --- --- 5,705
Securities AFS 16,646 51,716 76,010 144,372
Securities HTM 7,710 39,982 60,559 108,251
Mortgage Loans HFS 557 --- --- 557
Loans Net of U/E + RE/HFS 143,700 242,552 85,946 472,198
-------------- ------------- ------------ -------------
Total Interest Earning Assets 174,318 334,250 222,515 731,083
============== ============= ============ =============
INTEREST BEARING LIABILITIES
Interest Bearing Demand 191,530 --- --- 191,530
Savings Deposits 64,788 --- --- 64,788
Time Deposits 177,473 135,270 21,626 334,369
Other Borrowings 4,242 --- --- 4,242
-------------- ------------- ------------ -------------
Total Interest Bearing Liabilities 438,033 135,270 21,626 594,929
============== ============= ============ =============
Gap (263,715) 198,980 200,889 136,154
============== ============= ============ =============
============== ============= ============ =============
Cumulative Gap (263,715) (64,735) 136,154
============== ============= ============ =============
Cumulative Gap Ratio 0.40 0.89 1.23 1.23
============== ============= ============ =============
Item 4. Controls and Procedures
Under the supervision and with the participation of management,
including our principal executive officer and principal financial officer, we
have evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report.
Based on that evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. There were no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation.
Disclosure controls and procedures are our controls and procedures that
are designed to ensure that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act is accumulated and
communicated to our management, including our principal executive officer and
principal financial officer, as appropriate, to allow timely decisions regarding
required disclosure.
29
Part II
Other Information
Item 1. Legal Proceedings
None for the nine months ended September 30, 2004.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
See Form 10-Q for the period ended June 30, 2004.
Item 3. Defaults upon Senior Securities
None for the nine months ended September 30, 2004.
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits
See Index of Exhibits.
Signatures
National Bankshares, Inc. has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
DATE: November 8, 2004 NATIONAL BANKSHARES, INC.
/s/JAMES G. RAKES
---------------------
James G. Rakes
Chief Executive Officer
/s/J. ROBERT BUCHANAN
---------------------
J. Robert Buchanan
Chief Financial Officer
(1) Index of Exhibits
Page No. in
Exhibit No. Description Sequential System
----------- ----------- -----------------
3(i) Articles of Incorporation, as amended, of National (incorporated herein by
Bankshares, Inc. reference to Exhibit 3(a) of
the Annual Report on
Form 10-K for fiscal year
ended December 31, 1993)
30
3(i) Articles of Amendment to Articles of Incorporation (incorporated herein by
of National Bankshares, Inc., dated reference to exhibit 3(i) of
April 8, 2003. The Annual Report on Form 10-K
for the fiscal year ended
December 31, 2003)
4(i) Specimen copy of certificate for National (incorporated herein by
Bankshares, Inc. common stock, $2.50 par value reference to Exhibit 4(a) of
the Annual Report on Form 10-K
for fiscal year ended December
31, 1993)
4(i) Article Fourth of the Articles of Incorporation (incorporated herein by
of National Bankshares, Inc. included in reference to Exhibit 4(b)
Exhibit No. of 3(a)) of the Annual Report on Form 10-K
for fiscal year ended December
31, 1993)
10(ii)(B) Computer software license agreement dated June 18, (incorporated herein by
1990, by and between Information Technology, Inc. reference to Exhibit 10(e) of
and The National Bank of Blacksburg the Annual Report on Form 10-K
for fiscal year ended December
31, 1992)
*10(iii)(A) National Bankshares, Inc. 1999 Stock Option Plan (incorporated herein by
reference to Exhibit 4.3 of
the Form S-8, filed as
Registration No. 333-79979
with the Commission on June 4,
1999)
*10(iii)(A) Employment Agreement dated January 2002 between (incorporated herein by
National Bankshares, Inc. and James G. Rakes reference to Exhibit 10(iii)(A)
of Form 10-Q for the period
ended June 30, 2002)
*10(iii)(A) Employment Lease Agreement dated August 14, 2002, (incorporated herein by
between National Bankshares, Inc. and The National reference to Exhibit
Bank of Blacksburg 10(iii)(A)of form 10-Q for the
period ended September 30,
2002)
*10(iii)(A) Change in Control Agreement dated January 5, 2003, (incorporated herein by
between National Bankshares, Inc. and Marilyn B. reference to Exhibit 10 iii (A)
Buhyoff of Form 10-K for the period
ended December 31, 2002)
*10(iii)(A) Change in Control Agreement dated January 8, 2003, (incorporated herein by
between National Bankshares, Inc. and F. Brad reference to Exhibit 10 iii (A)
Denardo of Form 10-K for the period
ended December 31, 2002)
*10(iii)(A) Change in Control Agreement dated June 1, 1998, (incorporated herein by
between Bank of Tazewell County and Cameron L. reference to Exhibit 10 iii (A)
Forester of Form 10-K for the period
ended December 31, 2002)
31
31(i) Section 302 Certification of
Chief Executive Officer Page 32
31(ii) Section 302 Certification of
Chief Financial Officer Page 32
32(i) 18 U.S.C. Section 1350 Certification of Chief
Executive Officer Page 34
32(ii) 18 U.S.C. Section 1350 Certification of Chief
Financial Officer Page 34
* Indicates a management contract or compensatory plan required to be filed
herein.
32