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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
[X ] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended March 31, 2004
Commission File No. 0-16761
HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
West Virginia 55-0650793
- ----------------------------------- --------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
P. O. Box 929
Petersburg, West Virginia 26847
(Address of Principal Executive Offices, Incluing Zip Code)
(304) 257-4111
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirement for the past 90 days. Yes X No
----- -------
Indicate by check mark whether the issuer is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes No X
----- ------
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. As of April 30, 2004,
1,436,874 shares of Common Stock, $5 Par Value
1
HIGHLANDS BANKSHARES, INC.
INDEX
Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Consolidated Statements of Income
Three Months Ended March 31, 2004 and 2003 2
Unaudited Consolidated Balance Sheet March 31, 2004 and
audited Consolidated Balance Sheet December 31, 2003 3
Unaudited Consolidated Statements of Changes in Stockholders' Equity
Three Months Ended March 31, 2004 and 2003 4
Unaudited Consolidated Statements of Cash Flows
Three Months Ended March 31, 2004 and 2003 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 19
Item 4. Controls and Procedures 19
PART II OTHER INFORMATION 20
Item 1. Legal Proceedings 20
Item 2. Changes in Securities 20
Item 3. Defaults upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibit and Reports on Form 8-K 20
SIGNATURES 21
2
Part I Financial Information
Item 1. Financial Statements
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars)
Three Months Ended
March 31,
2004 2003
(unaudited) (unaudited)
Interest Income
Interest and fees on loans $ 4,072 $ 4,226
Interest on federal funds sold 41 59
Interest on time deposits 3 15
Interest and dividends on investment securities
Taxable 179 233
Nontaxable 35 43
------- ------
Total Interest Income 4,330 4,576
------- ------
Interest Expense
Interest on deposits 1,187 1,707
Interest on borrowed money 61 51
------- ------
Total Interest Expense 1,248 1,758
------- ------
Net Interest Income 3,082 2,818
Provision for Loan Losses 195 210
------- ------
Net Interest Income After Loan Losses 2,887 2,608
------- ------
Noninterest Income
Service charges 168 138
Other 166 205
------- ------
Total Noninterest Income 334 343
------- ------
Noninterest Expense
Salaries and employee benefits 1,156 1,085
Equipment and occupancy expense 288 285
Data processing 177 145
Directors Fees 91 58
Legal and Professional Fees 74 50
Other 378 351
------- ------
Total Noninterest Expense 2,164 1,974
------- ------
Income Before Income Taxes 1,057 977
Provision for Income Taxes 345 317
------- ------
Net Income $ 712 $ 660
======= ======
Per Share Data
Net Income $ .50 $ .46
====== ======
Cash Dividends $ . .15 $ .14
====== ======
Weighted Average Common Shares Outstanding 1,436,874 1,436,874
========= =========
The accompanying notes are an integral part of these statements.
3
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands of Dollars)
March 31, December 31,
2004 2003
(unaudited) (audited)
ASSETS
Cash and due from banks - noninterest bearing $ 6,721 $ 7,214
Time deposits in other banks 1,471 1,187
Federal funds sold 20,367 16,718
Securities held to maturity (note 2) 1,363 1,366
Securities available for sale (note 2) 28,151 32,631
Other investments (note 3) 927 933
Loans, net of unearned interest (note 4) 226,197 226,635
Less allowance for loan losses (note 5) (2,533) (2,463)
-------- --------
Net Loans 223,664 224,172
Bank premises and equipment 7,134 7,210
Interest receivable 1,537 1,718
Investments in insurance contracts (note 6) 5,604 5,559
Other assets 2,269 2,460
------- -------
Total Assets $299,208 $301,168
======= =======
LIABILITIES
Deposits:
Noninterest bearing demand deposits $ 36,153 $ 32,936
Interest bearing
Money market and checking 22,849 22,958
Money market savings 16,250 16,953
Savings 33,459 32,187
Time deposits (note 7) 151,634 157,651
------- -------
Total Deposits 260,345 262,685
Borrowed money 5,196 5,295
Accrued expenses and other liabilities 3,606 3,639
------- -------
Total Liabilities 269,147 271,619
------- -------
STOCKHOLDERS' EQUITY
Common stock ($5 par value, 3,000,000 shares
authorized) 7,184 7,184
Surplus 1,662 1,662
Retained earnings 21,223 20,727
Accumulated other comprehensive income (8) (24)
-------- --------
Total Stockholders' Equity 30,061 29,549
------- -------
Total Liabilities and Stockholders' Equity $299,208 $301,168
======= =======
The accompanying notes are an integral part of these statements.
4
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(In Thousands of Dollars)
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
Balances, December 31, 2003 $ 7,184 $ 1,662 $ 20,727 $ (24) $ 29,549
Comprehensive Income
Net income 712 712
Net change in unrealized
appreciation on investment
securities available for sale,
net of taxes 16 16
-------
Total Comprehensive Income 728
Dividends paid (216) (216)
----- ----- ------ ----- ------
Balances, March 31, 2004 $ 7,184 $ 1,662 $ 21,223 $ (8) $ 30,061
======== ======== ========= ====== ======
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
Balances, December 31, 2002 $ 7,184 $ 1,662 $ 19,298 $ 220 $ 28,364
Comprehensive Income
Net income 660 660
Net change in unrealized
appreciation on investment
securities available for sale,
net of taxes (51) (51)
------
Total Comprehensive Income 609
Dividends paid (201) (201)
----- ----- ------ ----- ------
Balances, March 31, 2003 $ 7,184 $ 1,662 $ 19,757 $ 169 $ 28,772
======== ======== ========= ===== ======
The accompanying notes are an integral part of these statements.
5
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
Three Months Ended
March 31,
2004 2003
(unaudited) (unaudited)
Cash Flows from Operating Activities:
Net income $ 712 $ 660
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 161 148
Income from insurance contracts (45) (49)
Net amortization of securities 83 118
Provision for loan losses 195 210
Decrease (increase) in interest receivable 181 (122)
Decrease in other assets 191 53
Increase (decrease) in accrued expenses (32) 510
-------- ------
Net Cash Provided by Operating Activities 1,446 1,528
------- ------
Cash Flows from Investing Activities:
Net change in federal funds sold (3,649) (6,780)
Proceeds from maturities of securities
available for sale 5,877 3,487
Proceeds from maturities of securities
held to maturity 1
Purchase of securities available for sale (1,461) (9,386)
Proceeds from redemption of other investments 6 (173)
Net change in time deposits in other banks (284) (1,532)
Net change in loans 313 562
Purchase of property and equipment (87) (18)
-------- ------
Net Cash Used in Investing Activities 715 (13,839)
------- -------
Cash Flows from Financing Activities:
Increase (decrease) in deposits (2,340) 12,053
Dividends paid in cash (216) (201)
Repayment of borrowed money (98) (130)
-------- ------
Net Cash Provided by (used by) Financing Activities (2,654) 11,722
-------- ------
Net Decrease in Cash and Cash Equivalents (493) (589)
Cash and Cash Equivalents, Beginning of Period 7,214 8,226
------- ------
Cash and Cash Equivalents, End of Period $ 6,721 $ 7,637
======= ======
Supplemental Disclosures:
Cash Paid For:
Income taxes $ 0 $ 0
Interest 1,414 1,761
The accompanying notes are an integral part of these statements.
6
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 ACCOUNTING PRINCIPLES:
The consolidated financial statements conform to U. S. generally
accepted accounting principles and to general industry practices. In
the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments necessary to present
fairly the financial position as of March 31, 2004 and the results of
operations for the three month periods ended March 31, 2004 and 2003.
The notes included herein should be read in conjunction with the
notes to financial statements included in the 2003 annual report on
Form 10-K.
NOTE 2 SECURITIES:
The Company's securities portfolio serves several purposes. Portions
of the portfolio secure certain public and trust deposits while the
remaining portions are held as investments or used to assist the
Company in liquidity and asset liability management.
The amortized cost and market value of securities held to maturity as
of March 31, 2004 and December 31, 2003, are as follows (in
thousands):
2004 2003
Amortized Market Amortized Market
Cost Value Cost Value
Mortgage-backed
securities $ 1 $ 1 $ 2 $ 2
Obligations of states and
political subdivisions 1,362 1,429 1,364 1,435
------ ------ ----- ------
Total $ 1,363 $ 1,430 $1,366 $ 1,437
====== ====== ===== ======
The amortized cost and fair value of securities available for sale
as of March 31, 2004 and December 31, 2003 are as follows (in
thousands):
2004 2003
Amortized Market Amortized Market
Cost Value Cost Value
US Treasury securities and
obligations of US Government
corporations and agencies $ 19,476 $ 19,600 $ 23,132 $ 23,240
Mortgage-backed securities 6,264 6,335 6,686 6,758
Obligations of states and
political subdivisions 2,140 2,184 2,567 2,604
Other investments 32 32 32 29
------ ------ ----- ------
Total $ 27,912 $ 28,151 $ 32,417 $ 32,631
====== ====== ====== ======
7
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 OTHER INVESTMENTS:
Other investments totaling $927,000 include investments in the
Federal Home Loan Bank and other governmental entities whose
transferability is restricted.
NOTE 4 LOANS OUTSTANDING:
A summary of loans outstanding as of March 31, 2004 and December
31, 2003 is as follows (in thousands):
2004 2003
Commercial $ 44,068 $ 42,911
Real estate - construction 6,501 7,552
- mortgages 130,603 129,670
Consumer installment 45,025 46,502
------- -------
Net loans outstanding $226,197 $226,635
======= =======
NOTE 5 ALLOWANCE FOR LOAN LOSSES:
A summary of transactions in the allowance for loan losses for the
three months ended March 31, 2004 and 2003 follows (in thousands):
2004 2003
Balance, beginning of period $ 2,463 $ 1,793
Provisions charged to operating expenses 195 210
Loan recoveries 95 63
Loan charge-offs (220) (150)
-------- -------
Balance, end of period $ 2,533 $ 1,916
======= =======
NOTE 6 INVESTMENT IN INSURANCE CONTRACTS:
Investment in insurance contracts consists of single premium
insurance contracts which have the dual purposes of providing a rate
of return to the Company which approximately equals the Company's
average cost of funds and providing life insurance and retirement
benefits to certain employees. The carrying value of these investments
was $5,604,000 at March 31, 2004 and $5,559,000 at December 31, 2003.
8
NOTE 7 DEPOSITS:
Balances of time deposits over $100,000 and time deposits less than $100,000 at
March 31, 2004 and December 31, 2003 are set forth below (in thousands):
2004 2003
Time deposits over $100,000 $ 44,369 $ 47,345
All other time deposits 107,265 110,306
------- ---------
Total Time Deposits $151,634 $ 157,651
Interest expense for time deposits over $100,000 and time deposits less than
$100,000 for the 3 months ended March 31, 2004 and March 31, 2003 are set forth
below (in thousands):
2004 2003
------ -------
Time deposits over $100,000 $ 350 $ 485
All other time deposits 837 1,221
---- -----
Total Time Deposits $1,187 $1,706
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Critical Accounting Policies
The Company's financial statements are prepared in accordance with accounting
principles generally accepted in the United States ("GAAP"). The financial
statements contained within these statements are, 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 either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could change.
The allowance for loan losses is an estimate of the losses that may be sustained
in the loan portfolio. The allowance is based on two basic principles of
accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS No. 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.
The Company has invested in and owns life insurance polices on key officers. The
policies are designed so that the company recovers the interest expenses
associated with carrying the polices and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits which will be received by the executives at the time of
their retirement is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statementof Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions."
9
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Critical Accounting Policies (continued)
SFAS No. 106 requires that an employers' obligation under a deferred
compensation agreement be accrued over the expected service life of the employee
through their normal retirement date. Assumptions are used in estimating the
present value of amounts due officers after their normal retirement date. These
assumptions include the estimated income to be derived from the investments and
an estimate of the Company's cost of funds in these future periods. In addition,
the discount rate used in the present value calculation will change in future
years based on market conditions.
Recent Accounting Pronouncements
No recent accounting pronouncements had a material impact on the Company's
consolidated financial statements.
Prior Period Adjustment
During the fourth quarter of 2003, the Company, based on new information and
regulatory guidance, made changes to the way it accounts for the life insurance
policies owned by the Company on key officers. These adjustments apply solely to
periods prior to the first quarter of 2003. Beginning balances of certain
financial statements and certain tabular data contained in the Management's
Discussion and Analysis of Financial Condition and Results of Operations in this
quarterly filing on Form 10-Q may have been restated based on these adjustments
as compared to certain previous quarterly filings on Form 10-Q. Information
contained herein should be read in conjunction with the notes to financial
statements included in the 2003 annual report on Form 10-K.
Forward Looking Statements
Certain statements in this report may constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are statements that include projections, predictions,
expectations or beliefs about future events or results or otherwise are not
statements of historical fact. Such statements are often characterized by the
use of qualified words (and their derivatives) such as "expect," "believe,"
"estimate," "plan," "project," or other future events. Although the Company
believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, new products and delivery
systems, inflation, changes in the stock and bond markets, technology, downturns
in the trucking and timber industries, effects of mergers and/or downsizing in
the poultry industry in Hardy County, and consumer spending and savings habits.
The Company does not update any forward-looking statements that may be made from
time to time by or on behalf of the Company.
10
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Overview
Net income of $712,000 in the first quarter of 2004 represents a 7.87% increase
from the first quarter of a year ago. On an annualized basis, return on average
assets was .95% for the first quarter and return on average equity was 9.54%.
Net interest income before provision for loan loss increased 10.69%. Average
balances of loans and total earning assets increased moderately over 2003 levels
while efforts by the company to decrease deposit balances and average rates paid
on deposits contributed to a 3.11% decrease in average balances of interest
bearing deposits and an 85 basis point decline in average rates paid on interest
bearing liabilities.
Due to deterioration in the loan portfolios of the subsidiary banks, the
Company, during the last half of 2003, made a much larger provision for loan
losses than has been historically customary and charged off loans in an amount
significantly greater than historically had been charged-off. During the first
quarter of 2004, increased collection efforts at both subsidiary banks have
caused significant decreases in delinquencies. Total balances of loans over 30
days delinquent, non-accrual, and restructured loans fell 36.53% from December
31, 2003 to March 31, 2004. The Company's provision for loan losses for the
first quarter was down 7.14% compared to the first quarter of 2003. Although
gross charge-offs increased 46.66% and net charge-offs 42.53% compared to 2003,
the Company's ratio of allowance for loan losses to gross loans increased from
1.09% at December 31, 2003 to 1.12% at March 31, 2004.
Other income decreased 2.62% as compared to the first quarter of 2003 in spite
of a 22.08% increase in service charge fees. Income from insurance related
activity fell $17,000 from a year ago as slowing loan demand has impacted
corresponding sales of credit life and accident insurance. Because of the
pending closure of the trust subsidiary, Highlands Bankshares Trust Company,
income from fiduciary activities fell $11,000.
Operations expense increased 9.63% as compared to 2003 as an increase in
salaries due largely to customary pay increases combined with 47.85% and 56.49%
increases in legal and professional fees and directors fees, respectively, drove
a $190,000 overall increase in operations expense.
Net Interest Income
The Company's net interest income rose 9.37% as compared to 2003, despite modest
demand for new loans as compared to recent years, and a slight decrease in the
balance of gross loans as compared to December 31, 2003.
Efforts aimed at reducing deposit balances and the reduction of the Company's
overall cost of funds contributed to this increase in net interest margin.
Average balances of interest bearing deposits fell $7,235,000 as compared to the
first quarter of 2003. Of significant note is the $11,768,000 decrease in
average balance of time deposits, while average balances of comparatively lower
cost money market and savings accounts and interest bearing transaction accounts
increased $4,533,000. Average rates on interest bearing deposits fell 85 basis
points as compared to the first quarter of 2003.
As average balances of interest bearing liabilities fell as compared to the
first quarter of 2003, average balances of earning assets increased. Moderate
increases in average loan balances and Fed Funds sold, and an increase in the
average balances of securities offset a decrease in the average balance of
interest bearing deposits for an overall increase of 1.46% in balances of
earning assets. The Company's loan to deposit ratio stood at 86.88% at March 31,
2004 compared to 86.28% at December 31, 2003 and 83.51% at March 31, 2003.
11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Net Interest Income (continued)
Average yields on taxable securities fell 184 basis points compared to 2003. The
company has traditionally taken a short-term approach toward selection of
securities investments, and this approach has strengthened in recent periods due
to the depressed interest rate environment. Management has been reluctant to
purchase investments with longer term maturities in anticipation of increasing
rates in the coming years. This has caused average yields on securities to
decrease significantly, however with 67.56% of the Company's securities
portfolio maturing within one year and 96.55% maturing within three years,
management feels the Company is well positioned should interest rates rise
within this time frame.
Although demand for new loans over the past twelve months has been sluggish as
compared to recent years, management expects loan demand to remain adequate
enough to maintain current balances or cause balances to increase slightly. If
loan demand remains adequate enough to maintain current balances, and as older,
higher rate time deposits mature and are replaced by lower rate deposits,
management expects net interest margin to remain at current levels or increase
slightly during the coming months.
The table below sets forth an analysis of net interest income for the three
month periods ended March 31, 2004 and March 31, 2003:
Three Months Ended Three Months Ended
March 31, 2004 March 31, 2003
-------------------- --------------------
Average Income/ Average Income/
Balance 2 Expense Rates Balance 2 Expense Rates
Interest Income
Loans $ 226,374 $4,072 7.24% $223,462 $4,226 7.67%
Federal funds sold 19,272 41 .86 21,576 59 1.11
Interest bearing
deposits 1,392 3 .87 5,406 15 1.13
Investments
Taxable 30,597 179 2.35 22,567 233 4.19
Tax exempt 1 3,960 55 5.69 4,525 67 6.00
----- ------ ----- ------ ----- ------
Total Earning
Assets 1 281,595 4,350 6.22 277,536 4,600 6.72
------- ------ ----- ------- ------ -----
Interest Expense
Interest bearing
demand deposits 22,900 19 .33 21,398 49 .93
Savings and
money market 49,710 67 .54 46,679 126 1.09
Time deposits 153,000 1,101 2.89 164,768 1,532 3.77
Other borrowed money 5,244 61 4.68 3,961 51 5.22
----- ----- ---- ------- ------ -----
Total Interest
Bearing
Liabilities $ 230,854 1,248 2.17 $236,806 1,758 3.01
======== ----- ---- ======== ---- -----
Net Interest Margin $ 3,102 $2,842
====== =====
Net Yield on Interest
Earning Assets 1 4.43% 4.15%
====== ====
1 Yields are on a taxable equivalent basis.
2 Balances includes loans in nonaccrual status.
12
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Allowance for Loan Losses
The allowance for loan losses at March 31, 2004 was $2,533,000. This is an
increase of 2.85% over the balance at December 31, 2003. The Company's provision
for loan losses in the first quarter of 2004 was $195,000 compared to $210,000
in 2003.
The allowance for loan losses is an estimate of the losses in the current loan
portfolio. The allowance is based on two 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 loans be identified which have
characteristics of impairment as individual risks, (e.g. the collateral, present
value of cash flows or observable market values are less than the loan balance).
Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County
Bank, determines the adequacy of its allowance for loan losses independently.
Each bank pays particular attention to individual loan performance, collateral
values, borrower financial condition and overall national and local economic
conditions. The determination of an adequate allowance at each bank is done in a
three step process. The first step is to identify problem loans above a certain
threshold and estimated losses are calculated based on collateral values and
projected cash flows. The second step is to identify loans above a certain
threshold which are problem loans due to the borrowers' payment history or
deteriorating financial condition. Losses in this category are determined based
on historical loss rates adjusted for current economic conditions. The final
step is to calculate a loss for the remainder of the portfolio using historical
loss information for each type of loan classification. The determination of
specific allowances and weights is in some part subjective and actual losses may
be greater or less than the amount of the allowance. However, Management
believes that the allowance represents a fair assessment of the losses that
exist in the current loan portfolio.
Both banks classify loans into the following categories: impaired, doubtful,
substandard, special mention and other loans past due 90 days or more and
assigns loss rates to each. Within these categories, Real Estate, Installment
Loans, Commercial Loans and Lines of Credit are assigned a specific loss rate
based on historical losses and management's estimate of losses. The allowance
associated with loans classed as impaired is provided for at 100% of the
identified impairment.
Loans 90 days or more past due and nonaccrual loans are included in one of the
five categories above. Generally, all loans in excess of $250,000 are evaluated
individually as well as any loan regardless of size that is classified as loss,
doubtful, substandard or special mention. This detailed review identifies each
applicable loan for specific impairment and a specific allocation for that
impaired amount is provided for as the first element in the calculation. Rates
assigned each category may vary over time and between the banks as historical
loss rates, loan structure and economic conditions differ and change.
..
The remaining portfolio balances are assigned a loss factor based on the
historical net loss rates. Loss experience per classification varies
significantly based on risk and collateral. Installment and commercial loans
generally have higher loss volumes than secured real estate loans. The net
result creates a low and high range of allocated allowance. The Company's actual
allowance balance is compared to this range and adjusted as deemed necessary.
The required level of the allowance for loan losses is computed quarterly and
the allowance adjusted, if necessary, prior to the issuance of the quarterly
financial statements. All loan losses charged to the allowance are approved by
the boards of directors of each bank at their regular meetings. The allowance is
reviewed for adequacy after considering historical loss rates, current economic
conditions (both locally and nationally) and any known credit problems that have
not been considered under the above formula.
Management has analyzed the potential risk of loss on the Company's loan
portfolio given the loan balances and the value of the underlying collateral and
has recognized losses where appropriate. Nonperforming loans are closely
monitored on an ongoing basis as part of the Company's loan review process. The
ratio of the allowance for loan losses to total loans outstanding was 1.12% at
March 31, 2004 compared to 1.09% at December 31, 2003.
13
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Allowance for Loan Losses (continued)
The following table shows the allocation of loans in the loan portfolio and
the corresponding amounts of the allowance allocated by loan types as of March
31, 2004 and December 31, 2003:
March 31, 2004 December 31, 2003
Loan Allowance Percentage Allowance Percentage
Type Allocation of Loans Allocation of Loans
-------- ------ ------- -------
Commercial $ 791 19% $ 779 19%
Mortgage 831 61% 725 61%
Consumer 756 20% 819 20%
Unallocated 155 140
-------- ------ --- -----
Totals $ 2,533 100% $ 2,463 100%
======= === ===== ===
The following table summarizes the Company's net charge-offs by loan type for
the three months ended March 31, 2004 and March 31, 2003:
Quarter Ended
March 31,
2004 2003
-------- --------
Charge-offs $ (220) $ (150)
Recoveries 95 63
-- --
Total net charge-offs (125) (87)
Components of net charge-offs:
Real estate (23) (8)
Commercial (13) (5)
Consumer (89) (74)
---- -----
Tota $ (125) $ (87)
===== ===
During April of 2004, the Company recognized a loss of $300,000 on a mortgage
loan previously identified as impaired and provided for. The recognition of this
loss did not impact earnings and was charged against the allowance for loan
losses. The loss for this loan was previously provided for in calculating the
adequacy of the allowance for loan losses. The Company expects no further
significant losses related to this loan.
Loan Portfolio
The Company is an active residential mortgage and construction lender and
generally extends commercial loans to small and medium sized businesses within
its primary service area. The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
and northern Pendleton counties in West Virginia and Frederick County, Virginia.
Consistent with its focus on providing community-based financial services, the
Company does not attempt to diversify its loan portfolio geographically by
making significant amounts of loans to borrowers outside of its primary service
area.
The principal economic risk associated with each of the categories of loans in
the Company's portfolio is the creditworthiness of its borrowers. Within each
category, such risk is increased or decreased depending on prevailing economic
conditions. The risk associated with the real estate mortgage loans and
installment loans to individuals varies based upon employment levels, consumer
confidence, fluctuations in value of residential real estate and other
conditions that affect the ability of consumers to repay indebtedness. The risk
associated with commercial, financial and agricultural loans varies based upon
the strength and activity of the local economies of the Company's market areas.
The risk associated with real estate construction loans varies based upon the
supply of and demand for the type of real estate under construction.
14
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Loan Portfolio (continued)
Loans outstanding decreased $438,000 from December 31, 2003 to March 31, 2004, a
decrease of .19%, compared to a decrease of .29% during the first quarter of
2003. The Company has traditionally experienced sluggish loan originations in
the first quarter of any year as farming and logging operations are hampered by
weather conditions and retail borrowing in the first quarter is put on hold
until the spring.
Because of its large impact on the local economy, Management continues to
monitor the economic health of the poultry industry. The Company has direct
loans to poultry growers and the industry is a large employer in the Company's
trade area. Loan requests for poultry house loans or expansion continue to be
presented for approval. In June of 2003, Pilgrim's Pride Corporation announced
the purchase of certain divisions of ConAgra Foods, Inc. including processing
facilities operated by ConAgra in Hardy County. Management anticipates that this
purchase will have no adverse impact on operations of either subsidiary bank or
on the operations of the non-bank subsidiaries.
In recent periods, the Company's loan portfolio has also begun to gain a
concentration in loans collateralized by heavy equipment, particularly in the
trucking and timber industries. In part because of rising fuel costs, and
because of continued stagnant economic conditions, the trucking sector has
experienced a recent downturn. However, the Company has experienced no material
losses related to foreclosures of loans collateralized by heavy equipment. While
close monitoring of this sector is necessary, management expects no significant
losses in the foreseeable future.
Nonperforming loans include nonaccrual loans, loans 90 days or more past due and
restructured loans. Nonaccrual loans are loans on which interest accruals have
been suspended or discontinued permanently. Restructured loans are loans on
which the original interest rate or repayment terms have been changed due to
financial hardship of the borrower.
The following table summarizes the company's non-performing loans as of March
31, 2004 and December 31, 2003.
March 31 December 31,
(in thousands) 2004 2003
---- ----
Non-accrual loans $ 982 $ 1,664
Restructured Loans 631
Loans past due 90 days or more
and still accruing interest 1,084 1,598
Total $ 2,066 $ 3,893
======== ========
Due to increased collection efforts, balances of non-performing loans decreased
46.93% from December 31, 2003 to March 31, 2004. Restructured loans at December
31, 2003 were comprised of two commercial loans for which it was necessary to
refinance in order to recoup timely payment of principal. In neither case were
any principal amounts forgiven. As of March 31, 2004, these loans previously
classified as restructured had timely payments for longer than a twelve month
period and terms were not better than those that would be offered in a
competitive environment, and therefore were no longer classified as
restructured.
15
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Loan Portfolio (continued)
Loans are typically placed on non-accrual status once they have reached certain
levels of delinquency, depending on loan type, and it is no longer reasonable to
expect collection of principal and interest and collateral is insufficient to
cover both principal and interest due. After loans are placed on non-accrual
status, they are returned to accrual status if payment is made current by the
borrower, or are charged off if payment is not made current and management
believes that collection on amounts due is doubtful. Charged-off loans are taken
against the allowance for loan losses. Any subsequent collection or sale of
repossessed collateral is netted against the allowance for loan losses as a
recovery.
Real estate acquired through foreclosure remained unchanged from December 31,
2003 to March 31, 2004. All foreclosed property held as of March 31, 2004 was in
the Company's primary service area. The Company's practice is to value real
estate acquired through foreclosure at the lower of (i) an independent current
appraisal or market analysis less anticipated costs of disposal, or (ii) the
existing loan balance. The Company is actively marketing all foreclosed real
estate and does not anticipate material write-downs in value before disposition.
An inherent risk in the lending of money is that the borrower will not be able
to repay the loan under the terms of the original agreement. The allowance for
loan losses (see subsequent section) provides for this risk and is reviewed
periodically for adequacy. This review also considers concentrations of loans in
terms of geography, business type or level of risk. While lending is
geographically diversified within the service area, the Company does have some
concentration of loans in the area of agriculture (primarily poultry farming),
timber and related industries. Management recognizes these concentrations and
considers them when structuring its loan portfolio. As of March 31, 2004, the
Company did not have any potential problem loans as defined in Guide 3 that
would require disclosure.
Non Interest Expense
Total non-interest expense increased 9.63% for the first three months of 2004 as
compared to 2003.
Expenses of salaries and benefits rose $71,000 (6.51%) due to an increase in
full time equivalent employees, customary salary increases and inflationary
trends of insurance costs. Of the $71,000 increase, approximately 57% was due to
increases in full time equivalent employees and the remainder due to salary
increases and increased insurance costs. Directors fees increased 56.49% over
2003 due largely to an increase in directors fees instituted during the second
quarter of 2003 and an increase in the number of directors at the subsidiary
banks. Legal and professional fees increased 47.85% in large part because of
increased audit expense due to the hiring of an outside accounting firm to
complete internal audit procedures.
Borrowed Money
During the fourth quarter of 2003, the Company obtained a $2,500,000 open line
of credit with another commercial bank. This line of credit was secured by
equity securities in a subsidiary company. This debt instrument was obtained as
both a precautionary and opportunistic device for funding should a future need
arise. There were no advances in 2003 or the first quarter of 2004 from this
line and it is not anticipated that, in the immediate future, any borrowings
from this debt facility will be used to fund operating or liquidity needs.
The Company periodically borrows money from the Federal Home Loan Bank (FHLB).
These borrowings are typically used to fund loan growth but have also been used
to fund renovation of Capon Valley Bank's main office building. Although the
Company has found itself in an extremely favorable liquidity position such that
new loans could be funded through balances of more liquid lower earning assets
such as fed funds sold, the Company during 2003 chose to fund certain larger
fixed rate commercial loans by borrowing from the Federal Home Loan Bank (FHLB).
In borrowing from the FHLB at fixed rates and maturity periods similar to these
larger commercial loans, the Company has attempted to minimize future interest
rate risk.
16
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Discontinuation of Trust Operations
During the fourth quarter of 2003, the Board of Directors of Highlands
Bankshares, Inc. decided to close Highlands Bankshares Trust Company, Inc.
(HBTI) The demand for trust services in the Company's primary and secondary
service areas has been less than anticipated. On a fully consolidated basis,
HBTI contributed the following losses to annual consolidated net income of
Highlands Bankshares, Inc.: $84,223 in 2001, $85,959 in 2002 and $55,721 in 2003
and on a fully consolidated basis HBTI contributed a loss of $41,387 during the
first quarter of 2004. It is anticipated that all trust operations will be
concluded by May 15, 2004.
Liquidity
Operating liquidity is the ability to meet present and future financial
obligations through either the sale or maturity of existing assets or the
acquisition of additional funds through liability management. Liquid assets
include cash, interest bearing deposits with banks, federal funds sold,
investments and loans maturing within one year. The Company's ability to obtain
deposits and purchase funds at favorable rates determines its liability
liquidity. As a result of the Company's management of liquid assets and the
ability to generate liquidity through liability funding, Management believes
that the Company maintains overall liquidity sufficient to satisfy its
depositors' requirements and meet its customers' credit needs.
Additional sources of liquidity available to the Company include, but are not
limited to, loan repayments, the ability to obtain deposits through the
adjustment of interest rates and the purchasing of federal funds. To further
meet its liquidity needs, the Company also maintains lines of credit with
correspondent financial institutions, the Federal Reserve Bank of Richmond and
the Federal Home Loan Bank of Pittsburgh. In the past, growth in deposits and
proceeds from the maturity of investment securities have been sufficient to fund
the net increase in loans.
Historically, the Company's primary need for additional levels of liquidity have
been to fund increases in loan balances. The Company has normally funded
increases in loans through increases in deposits and decreases in secondary
liquidity sources such as balances of Fed Funds sold and balances of securities.
Although total deposit balances have decreased slightly in recent periods, the
Company has substantially maintained or increased levels of these secondary
liquidity resources and does not anticipate that an unexpectedly high level of
loan demand in coming periods would impact liquidity to an extent that the
Company would be required to pay abnormally high premiums above market rates to
obtain deposits.
The parent Company's operating funds, funds with which to pay shareholder
dividends and funds for the exploration of new business ventures have been, in
the past, supplied primarily through dividends paid by subsidiary banks. The
various regulatory authorities impose restrictions on dividends paid by a state
bank. A state bank cannot pay dividends without the consent of the relevant
banking authorities in excess of the total net profits of the current year and
the combined retained profits of the previous two years. As of January 1, 2004,
the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of
approximately $2,634,000 without permission of the regulatory authorities.
17
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Liquidity (continued)
The following table summarizes the dividend limits (in thousands) as of April 1,
2004 for Capon Valley Bank (CVB) and The Grant County Bank (GCB).
Total
2002 2003 2004 Available
Income Dividend Income Dividend Income Dividend For Dividends
------ --------- ------ -------- ------- --------- --------------
CVB $ 1,076 $ 975 $ 475 $ -- $ 238 $ 108 $ 706
GCB 1,627 975 1,801 905 488 108 1,928
Effects of Inflation
Inflation significantly affects industries having high levels of property,
plant and equipment or inventories. Although the Company is not significantly
affected in these areas, inflation does have an impact on the growth of assets.
As assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset ratios.
Traditionally, the Company's earnings and high capital retention levels have
enabled the Company to meet these needs.
The Company's reported earnings results have been minimally affected by
inflation. The different types of income and expense are affected in various
ways. Interest rates are affected by inflation, but the timing and magnitude of
the changes may not coincide with changes in the consumer price index.
Management actively monitors interest rate sensitivity, as illustrated by the
gap analysis shown under the section titled Interest Rate Sensitivity in order
to minimize the effects of inflationary trends on interest rates. Other areas of
noninterest expenses may be more directly affected by inflation.
Capital
The Company seeks to maintain a strong capital base to expand facilities,
promote public confidence, support current operations and grow at a manageable
level. As of March 31, 2004 the Company's total risk based capital ratio was
14.96% which is above the regulatory minimum of 8.0%. The leverage ratio of
total capital to total assets was 9.76% at March 31, 2004 and the tier 1
leverage ratio was 13.76%.
Interest Rate Sensitivity
In conjunction with maintaining a satisfactory level of liquidity,
management must also control the degree of interest rate risk assumed on the
balance sheet. Managing this risk involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals.
At March 31, 2004 the Company had a negative gap position through the first
three months, shifting to a positive gap by the end of one year. With the
largest amount of interest sensitive assets and liabilities repricing within one
year, the Company believes it is in an excellent position to respond quickly to
rapid market rate changes. Early withdrawal of deposits, prepayments of loans
and loan delinquencies are some of the factors that could affect actual versus
expected cash flows. In addition, changes in rates on interest sensitive assets
and liabilities may not be equal, which could result in a change in net interest
margin. While the Company does not match each of its interest sensitive assets
against specific interest sensitive liabilities, it does review its positions
regularly and takes actions to reposition it when necessary.
18
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Interest Rate Sensitivity (continued)
The following table illustrates the Company's sensitivity to interest rate
changes as of March 31, 2004 (in thousands):
More than
5 Years
1 - 90 91 - 365 1 to 3 3 to 5 or Without
Days Days Years Years Maturity Total
EARNING ASSETS
Loans $53,075 $98,126 $50,523 $ 9,599 $14,874 $226,197
Fed funds sold 20,367 20,367
Securities 9,880 10,684 8,825 365 687 30,441
Time deposits in
other
banks 1,171 100 200 1,471
----- ------ ------ ------ ------ ------
Total 84,493 108,910 59,548 9,964 15,561 278,476
------ ------- ----- ------ ------ -------
INTEREST BEARING LIABILITIES
Money market
savings 22,849 22,849
Savings accounts 49,709 49,709
Time deposits
<$100K 16,647 54,015 25,644 10,959 107,265
Time deposits
>$100K 10,556 14,987 10,767 8,059 44,369
Other borrowed
money 93 568 812 1,138 2,585 5,196
----- ------ ------ ------ ------ ------
Total 99,854 69,570 37,223 20,156 2,585 229,388
------- ------ ------ ------- ------- --------
Rate sensitivity GAP (15,361) 39,340 22,325 (10,192) 12,975 49,088
Cumulative GAP (15,361) (23,979) 46,304 36,112 49,088
Ratio of cumulative
interest sensitive
assets to cumulative
interest sensitive
liabilities 84.62% 114.15% 122.41% 115.92% 121.40%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
19
Item 3. Quantitative and Qualitative Disclosures About Market Risk
This information is incorporated herein by reference from Item 2,
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers
such as Highlands Bankshares, Inc. that file periodic reports under the
Securities Exchange Act of 1934 (the "Act") are now required to include in
those reports certain information concerning the issuer's controls and
procedures for complying with the disclosure requirements of the federal
securities laws. These disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information
required to be disclosed by an issuer in the reports it files or submits
under the Act, is communicated to the issuer's management, including its
principal executive officer or officers and principal financial officer or
officers, or persons performing similar functions, as appropriate to allow
timely decisions regarding required disclosure.
We have established our disclosure controls and procedures to ensure that
material information related to Highlands Bankshares, Inc. is made known to
our principal executive officers and principal finance officer on a regular
basis, in particular during the periods in which our quarterly and annual
reports are being prepared. These disclosure controls and procedures
consist principally of communications between and among the Chief Executive
Officer and Chief Financial Officer, and the other executive officers of
Highlands Bankshares, Inc. and its subsidiaries to identify any new
transactions, events, trends, contingencies or other matters that may be
material to the Company's operations. As required, we will evaluate the
effectiveness of these disclosure controls and procedures on a quarterly
basis, and most recently did so as of the end of the period covered by this
report.
The Company's chief executive officer and chief financial officer, based on
their evaluation as of the end of the period covered by this Annual Report
of the Company's disclosure controls and procedures (as defined in Rule
13(a)-14(e) of the Securities Exchange Act of 1934), have concluded that
the Company's disclosure controls and procedures are adequate and effective
for purposes of Rule 13(a)-14(c) and timely, alerting them to financial
information relating to the Company required to be included in the
Company's filings with the Securities and Exchange Commission under the
Securities Exchange Act of 1934.
Changes in Internal Controls
During the period reported upon, there were no significant changes in the
internal controls of Highlands Bankshares, Inc. pertaining to its financial
reporting and control of its assets or in other factors that could
significantly affect these controls.
Due to the nature of the Company's business as stewards of assets of
customers, internal controls are of the utmost importance. The company has
established procedures undertaken during the normal course of business to
reasonably ensure that fraudulent activity of either an amount material to
these results or in any amount is not occurring. In addition to these
controls and review by executive officers, the Company retains the services
of Yount, Hyde & Barbour, P.C., a public accounting firm, to complete regular
internal audits to examine the processes and procedures of the Company and
its subsidiary banks to ensure that these processes are both reasonably
effective to prevent fraud, both internal and external, and that these
processes comply with relevant regulatory guidelines of all relevant banking
authorities. The findings of Yount, Hyde & Barbour are presented both to
Management of the subsidiary banks and to the Audit Committee.
20
Part II Other Information
Item 1. Legal Proceedings - Not Applicable
Item 2. Changes in Securities - Not Applicable
Item 3. Defaults Upon Senior
Securities - Not Applicable
Item 4. Submission of Matters to
a Vote of Security
Holders - Not Applicable
Item 5. Other Information - Not Applicable
Item 6. Exhibits and Reports on 8-K -
(a) Exhibits
3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are
incorporated by reference to Appendix C to Highlands Bankshares,
Inc.'s Form S-4 filed October 20, 1986.
3 (ii) Bylaws of Highlands Bankshares, Inc. are incorporated by reference
to Exhibit 3(ii) to Highland Bankshares, Inc.'s Form 10-Q filed
May 15, 2003.
31.1 Certification of Chief Executive Officer Pursuant to section 302 of the
Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and
(B).
31.2 Certification of Chief Financial Officer Pursuant to section 302 of the
Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and
(B).
32.1 Statement of Chief Executive Officer and Financial Officer Pursuant
to 18 U.S.C.ss. 1350.
(b) Reports on Form 8-K filed during the three months ended March 31, 2004.
On January 29, 2004 the Company filed a report on Form 8-K, Item 5 announcing
the retirement of Leslie A. Barr as President and Chief Executive Officer.
On February 13, 2004, the Company filed a report on Form 8-K, Item 5 announcing
the appointment of Clarence E. Porter as President and Chief Executive Officer.
21
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HIGHLANDS BANKSHARES, INC.
/s/ C.E. PORTER
---------------------------------------
C.E. Porter
President
/s/ R. ALAN MILLER
---------------------------------
R. Alan Miller
Finance Officer
May 8, 2004