FORM 10-Q

For the Quarterly Period Ended: June 30, 2004

OR

For the transition period from:__________________ to __________________

Commission File Number: 0-19297

First Community Bancshares, Inc.

(276) 326-9000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 of 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 filing requirements for the past 90 days.

Indicate by check mark whether Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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First Community Bancshares, Inc.

FORM 10-Q

INDEX

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     PART I. ITEM 1. Financial Statements

FIRST COMMUNITY BANCSHARES, INC.

See Notes to Consolidated Financial Statements.

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FIRST COMMUNITY BANCSHARES, INC.

See Notes to Consolidated Financial Statements.

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FIRST COMMUNITY BANCSHARES, INC.

See Notes to Consolidated Financial Statements.

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FIRST COMMUNITY BANCSHARES, INC.

See Notes to Consolidated Financial Statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Unaudited Financial Statements

The unaudited consolidated balance sheet as of June 30, 2004, the unaudited consolidated statements of income for the six and three months ended June 30, 2004 and 2003 and the consolidated statements of cash flows and changes in stockholders’ equity for the six months ended June 30, 2004 and 2003 have been prepared by the management of First Community Bancshares, Inc. (“FCBI” or the “Company”). In the opinion of management, all adjustments (including normal recurring accruals) necessary to present fairly the financial position of FCBI and subsidiaries at June 30, 2004 and its results of operations, cash flows, and changes in stockholders’ equity for the three months ended June 30, 2004 and 2003 have been made. These results are not necessarily indicative of the results of consolidated operations that might be expected for the full calendar year.

The consolidated balance sheet as of December 31, 2003 has been extracted from the audited financial statements included in the Company’s 2003 Annual Report to Stockholders on Form 10-K. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted in accordance with standards for the preparation of interim financial statements. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2003 Annual Report of FCBI on Form 10-K.

A more complete and detailed description of FCBI’s significant accounting policies is included within Footnote 1 to the Company’s Annual Report on Form 10-K for December 31, 2003. In addition, the Company’s required disclosure of the application of critical accounting policies is included within the “Application of Critical Accounting Policies” section of Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included herein.

The following is an update of certain required disclosures pursuant to the requirements of Financial Accounting Standards Board (“FASB”) Statement 148.

Summary of Significant Accounting Policy Update for Certain Required Disclosures: Stock Options

The Company has in existence a stock option plan for certain executives and directors accounted for under the intrinsic value method. Because the exercise price of the Company’s employee/director stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The effect of option shares on earnings per share relates to the dilutive effect of the underlying options outstanding. To the extent the granted exercise share price is less than the current market price (“in the money”) there is an economic incentive for the shares to be exercised and an increase in the dilutive effect on earnings per share results.

A new Omnibus Stock Option Plan was approved at the annual 2004 shareholder meeting to be used in conjunction with retention, recruitment and hiring of employees. 42,000 option shares and an additional 5,000 stock awards were granted and reserved for future issuance in May 2004 subject to acceptance of agreements by the optionees. The maximum number of grants and awards under this Plan is limited to 200,000 shares.

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Assuming use of the fair value method of accounting for stock options, pro forma net income and earnings per share for the six and three month periods ended June 30, 2004 and 2003 would have been estimated as follows:

Note 2. Discontinued Operations

On July 8, 2004 First Community announced the termination of a previously announced sale of its mortgage subsidiary. While the mortgage banking subsidiary continues to be held for sale, termination of the previously announced sale led to the elimination of the wholesale portion of the mortgage company’s business and a substantial downsizing of the remaining retail division. In connection with the exit of its wholesale mortgage banking business and as previously reported, the Company recorded impairment charges of $933,000 in the second quarter of 2004 (bringing total impairment charges to $1,385,000 for the first six months of 2004) to reduce the carrying value of the subsidiary to its estimated fair value less costs to sell. To facilitate its decision to exit the wholesale mortgage banking business, First Community has provided management and professional resources to settle the mortgage company’s wholesale interest rate lock commitments; has overseen a transition in management at the mortgage company; and has taken steps to reduce overhead for the company’s remaining mortgage business, which will be offered through its retail network. The strategic decision to exit the wholesale mortgage business will reduce the Company’s exposure to risk associated with the large fluctuations previously experienced in the volume-driven, wholesale business and its hedged interest rate lock commitments and closed loans. The change in strategic direction and decision to exit the wholesale mortgage business will permit the Company to focus its resources on its core community banking business, which has continued to grow and perform. The results of operations of the mortgage company are reported as discontinued operations. The loss from discontinued operations was $1.9 million or $0.17 per diluted share for the second quarter of 2004 and $3.3 million or $0.29 per diluted share for the six months ended June 30, 2004.

The business related to UFM is accounted for as discontinued operations and, therefore, the results of operations and cash flows have been removed from the Company’s results of continuing operations in accordance with FAS 144 for all periods presented in this document. The results of UFM are presented as discontinued operations in a separate category on the income

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statement following results from continuing operations. The income from discontinued operations for the six months and three months ended June 30, 2004 and 2003, respectively, is as follows:

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All assets and liabilities of UFM were classified as discontinued as of the June 30, 2004 and December 31, 2003 periods presented in this report. The major asset and liability categories of discontinued operations are as follows:

Note 3. Mergers, Acquisitions and Branch Development

After the close of business on March 31, 2004, the Company acquired PCB Bancorp, Inc., a Tennessee-chartered bank holding company (“PCB Bancorp”) headquartered in Johnson City, Tennessee. PCB Bancorp had six full service branch offices located in Johnson City, Kingsport and surrounding areas in Washington and Sullivan Counties in East Tennessee. At acquisition, PCB Bancorp had total assets of $171.0 million, total loans of $128.0 million and total deposits of $150.0 million. These resources were included in the Company’s financial statements beginning with the second quarter of 2004.

Under the terms of the merger agreement, shares of PCB Bancorp common stock were purchased for $40.00 per share in cash. The total deal value, including the cash-out of outstanding stock options, was approximately $36.0 million. Concurrent with the PCB Bancorp acquisition, Peoples Community Bank, the wholly-owned subsidiary of PCB Bancorp, was merged into First Community Bank, N.A., (the “Bank”) a wholly-owned subsidiary of First Community Bancshares, Inc. As a result of the acquisition and preliminary purchase price allocation, approximately $21.3 million in goodwill has been recorded which represents the excess of the purchase price over the fair market value of the net assets acquired and identified intangibles.

On June 6, 2003, the Company acquired The CommonWealth Bank, a Virginia-chartered commercial bank (“CommonWealth”). CommonWealth’s four branch facilities located in the Richmond, Virginia metro area were simultaneously merged with and into the Bank. The completion of this transaction resulted in the addition of $136.5 million in assets, including $120.0 million in loans and added an additional $105.0 million in deposits to the Bank. As a result of the purchase price allocation, approximately $14.1 million of goodwill was recorded.

In the second and third quarters of 2003, the Company opened three de novo branches in Winston-Salem, North Carolina. The Company also opened two additional loan production offices during the first quarter of 2004 in Mount Airy and Charlotte, North Carolina and opened, or were in the process of opening, two new loan production offices in Blacksburg and Norfolk, Virginia. The Company does not anticipate that these new offices will be profitable until market development has proven

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successful and adequate loan balances and corresponding loan revenue are established to support the added facilities, infrastructure and other operating costs of these branches and offices.

In January 2003, the Bank completed the acquisition of Stone Capital Management, Inc. (“Stone Capital”), based in Beckley, West Virginia. This acquisition expanded the Bank’s operations to include a broader range of financial services, including wealth management, asset allocation, financial planning and investment advice. Stone Capital at December 31, 2003 had total assets of $59 million under management and continues to operate under its name. Stone Capital was acquired through the issuance of 8,409 shares of Company common stock, which represented 50% of the total consideration. In 2003, Stone Capital exceeded the annual revenue requirement outlined in the acquisition agreement and another 2,541 shares were paid to the original shareholders subsequent to December 31, 2003. The balance of the remaining consideration ($175,000) is payable over the next two years in the form of Company common stock, subject to the achievement of minimum requirements set forth in the acquisition agreement. As a result of the purchase price allocation, approximately $360,000 of goodwill was recorded.

Note 4. Borrowings

Federal Home Loan Bank (“FHLB”) borrowings and other indebtedness are comprised of $107.3 million in convertible and callable advances and $34.4 million of noncallable term advances from the FHLB of Atlanta. The callable advances may be redeemed at quarterly intervals after various lockout periods. These call options may substantially shorten the lives of these instruments. If these advances are called, the debt may be paid in full, converted to another FHLB credit product, or converted to an adjustable rate advance. Prepayment of the advances may result in substantial penalties based upon the differential between contractual note rates and current advance rates for similar remaining time periods.

The following schedule details the contractual terms of outstanding FHLB advances, rates and corresponding final maturities at June 30, 2004. Also included in the table are the fair value adjustments related to debt obligations acquired in the CommonWealth Bank and People’s Community Bank acquisitions. The unamortized premium of approximately $420,000 is being amortized as interest expense over the anticipated life of the borrowings and is reflected as an adjustment to the effective rate paid.

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In addition to the FHLB borrowings listed in the foregoing table, the Company issued through FCBI Capital Trust, a business trust subsidiary, $15.0 million of trust preferred securities in September 2003 at a variable rate indexed to the 3 Month LIBOR rate + 2.95%. The securities mature on October 8, 2033 and are callable beginning October 8, 2008.

The Company’s wholly owned mortgage subsidiary, United First Mortgage, Inc. (“UFM”), also maintained a warehouse line of credit with a third party which was entered into in the third quarter of 2003 and used to fund mortgage loan inventory. The maximum line available under this credit facility was $15 million with a maturity of August 10, 2004, and carries an interest rate of New York Prime, adjusting as the prime rate changes. UFM had an outstanding balance at June 30, 2004 of $4.7 million which was reported in liabilities related to discontinued operations. The outstanding amount on this line was paid off subsequent to June 30, 2004.

Other various debt obligations of the Company were approximately $26,000 at June 30, 2004.

Note 5. Commitments and Contingencies

In the normal course of business, the Company is a defendant in various legal actions and asserted claims, most of which involve lending, collection and employment matters. While the Company and legal counsel are unable to assess the ultimate outcome of each of these matters with certainty, they are of the belief that the resolution of these actions, singly or in the aggregate, should not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

In May, 2004, the Company was named a party to an action filed in the Circuit Court of Nicholas County, West Virginia by Fidelity & Guaranty Life Insurance Company seeking to determine the rights of the Company’s banking subsidiary and members of the LeRose family to $1,000,000 in life insurance proceeds paid on a life insurance policy previously assigned to the Bank as partial collateral for a multimillion indebtedness due and owing to the bank as a consequence of a kiting scheme. The life insurance proceeds have been paid by the insurance company into a court-administered account for ultimate distribution to the rightful owner.

The Company conducts mortgage banking operations through UFM, which is discussed more fully under Note 2 “Discontinued Operations”. The majority of loans originated by UFM are sold to larger national investors on a service released basis. Loans are sold under loan sales agreements which contain various repurchase provisions. These repurchase provisions give rise to a contingent liability for loans which could subsequently be submitted to UFM for repurchase. The principal events which could result in a repurchase obligation are (i.) the discovery of fraud or material inaccuracies in a sold loan file and (ii.) a default on the first payment due after a loan is sold to the investor, coupled with a ninety day delinquency in the first year of the life of the loan. Other events and variations of these events could result in a loan repurchase obligation under terms of other loan sales agreements. The volume of contingent loan repurchases, if any, is largely dependent on the quality of loan underwriting and systems employed by UFM for quality control in the production of mortgage loans. To date, loans submitted for repurchase have not been material and have not had a material adverse effect on the results of operations, financial condition or liquidity of UFM or the Company.

UFM also originates government guaranteed FHA and VA loans that are also sold to third party investors. The Department of Housing and Urban Development (“HUD”) periodically audits loan files of government guaranteed loans and may require UFM to execute indemnification agreements on loans which do not meet certain predefined underwriting guidelines or may require the repurchase of the underlying loan. To date, the number of required indemnification agreements, or loan repurchases have not been material and no subsequent losses have been incurred. Loan indemnifications and repurchases under the FHA, VA and VHDA loan programs have not had a material adverse effect on the financial condition, results of operations or cash flows of UFM or the Company.

UFM is subject to net worth requirements issued by HUD. Failure to meet these minimum capital requirements can result in certain mandatory and possibly additional discretionary actions that, if undertaken, could have a direct material effect on UFM’s operations. UFM was in compliance with HUD’s minimum net worth requirement at June 30, 2004. UFM’s adjusted tangible net worth for HUD purposes was $712,000 at June 30, 2004, which exceeded the HUD requirement.

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. These instruments involve, to varying degrees, elements of credit and interest rate risk beyond the amount recognized on the balance sheet. The contractual amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

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Commitments to extend credit are agreements to lend to a customer as long as there is not a violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the counterparties. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Standby letters of credit and written financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. To the extent deemed necessary, collateral of varying types and amounts is held to secure customer performance under certain of those letters of credit outstanding.

Financial instruments whose contract amounts represent credit risk at June 30, 2004 are commitments to extend credit (including availability of lines of credit) of $128.4 million and standby letters of credit and financial guarantees written of $8.1 million. In addition, at June 30, 2004, UFM had commitments to originate loans of $44.6 million. Of these commitments, the fallout/pullthrough model employed by UFM identified $29.1 million that are anticipated to close.

In September 2003, the Company issued, through FCBI Capital Trust, $15.0 million of trust preferred securities in a private placement. In connection with the issuance of the preferred securities, the Company has committed to irrevocably and unconditionally guarantee the following payments or distributions with respect to the preferred securities to the holders thereof to the extent that FCBI Capital Trust has not made such payments or distributions and has the funds therefore: (i) accrued and unpaid distributions, (ii) the redemption price, and (iii) upon a dissolution or termination of the trust, the lesser of the liquidation amount including all accrued and unpaid distributions or the amount of assets of the trust remaining available for distribution.

Note 6. Other Comprehensive Income

The Company currently has one component of other comprehensive income, which is comprised of unrealized gains and losses on securities available for sale, detailed as follows:

Note 7. Recent Accounting Developments

On March 9, 2004, the SEC issued SAB 105, “Application of Accounting Principles to Loan Commitments” to inform registrants of the Staff’s view that the fair value of the recorded loan commitments, that are required to follow derivative accounting under Statement 133, Accounting for Derivative Instruments and Hedging Activities, should not consider the expected future cash flows related to the associated servicing of the future loan. The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. Though the Company sold its loans through the discontinued segment on a servicing released basis, the Company adopted the provisions of SAB 105 on January 1, 2004 and this had the impact of reducing the fair value of such instruments by $252,000.

In December 2003, the AICPA issued Statement of Position (“SOP”) 03-3 “Accounting for Certain Loans or Debt Securities Acquired in a Transfer". This statement, which is effective for loans acquired in fiscal years beginning after December 15, 2004, addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. This standard will require a fair value measure of loans acquired and as such no corresponding loss

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reserve will be permitted on loans acquired in a transfer that are within the scope of SOP 03-3. The impact of the Standard is prospective and will require new recognition and measurement techniques upon adoption.

In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include trust preferred securities in their Tier 1 capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. On May 6, 2004, the Federal Reserve issued a proposed rule that would continue to allow trust preferred securities, such as the Trust, to constitute Tier 1 capital for bank holding companies. The proposed rules would impose stricter quantitative and qualitative limits on the Tier 1 treatment of trust preferred securities. Currently, trust preferred securities and qualifying perpetual preferred stock are limited in the aggregate to no more than 25% of a holding company’s core capital elements. The proposed rule would amend the existing limit by providing that restricted core capital elements (including trust preferred securities and qualifying perpetual preferred stock) can be no more than 25% of core capital, net of goodwill. It is possible that the Federal Reserve rules will not be adopted as proposed and that the Federal Reserve will conclude that trust preferred securities should no longer be treated as Tier 1 regulatory capital. At June 30, 2004, $15 million in trust preferred securities issued by FCBI Capital Trust were outstanding and treated as Tier 1 capital for bank regulatory purposes. If FCBI’s outstanding trust preferred securities at June 30, 2004 were not treated as Tier 1 capital at that date, FCBI’s Tier 1 leverage capital ratio would have declined from 6.97% to 6.14%, its Tier 1 risk-based capital ratio would have declined from 10.20% to 8.99%, and its total risk-based capital ratio would have declined from 11.48% to 10.26% as of June 30, 2004. These reduced capital ratios would continue to meet the applicable “well capitalized” Federal Reserve capital requirements.

Note 8. Earnings per Share

The following schedule details earnings and shares used in computing basic and diluted earnings per share for the six and three months ended June 30, 2004 and 2003.

Note 9. Provision and Allowance for Loan Losses

The Company’s lending strategy stresses quality growth diversified by product, geography, and industry. All loans made by the Company are subject to common credit standards and a uniform underwriting system. Loans are also subject to an annual review process which varies based on the loan size and type. The Company utilizes this ongoing review process to evaluate loans for changes in credit risk. This process serves as the primary means by which the Company evaluates the adequacy of the loan loss allowance. The total loan loss allowance is divided into the following categories: i) specifically identified losses on loan relationships which are on non-accrual status, ninety days past due or more and loans with elements of credit weakness, and ii) formula allowances and special allocations addressing other qualitative factors including industry concentrations, economic conditions, staffing and other conditions.

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Specific allowances are established to cover loan relationships, which are identified as having significant cash flow weakness and for which a collateral deficiency may be present. The allowances established under the specific identification method are judged based upon the borrower’s estimated cash flow and projected liquidation value of related collateral.

Formula allowances, based on historical loss experience, are available to cover homogeneous groups of loans not individually evaluated. The formula allowance is developed and evaluated against loans in general by specific category (commercial, mortgage, and consumer). The allowance is developed for each loan category based upon a review of historical loss percentages for the Company and other qualitative factors. The calculated percentage is considered in determining the estimated allowance excluding any relationships specifically identified and individually evaluated. While consideration is given to credit weaknesses for specific loans and classifications within the various categories of loans, the allowance is available for all loan losses.

In developing the allowance for loan losses, the Company also considers various inherent risk factors, such as current economic conditions, the level of delinquencies and non-accrual loans, trends in the volume and term of loans, anticipated impact from changes in lending policies and procedures, and any concentration of credits in certain industries or geographic areas. In addition, management continually evaluates the adequacy of the allowance for loan losses and makes specific adjustments to the allowance based on the results of risk analysis in the credit review process, the recommendation of regulatory agencies, and other factors, such as loan loss experience and prevailing economic conditions.

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Report of Independent Registered Public Accounting Firm

The Audit Committee of the Board of Directors
First Community Bancshares, Inc.

We have reviewed the accompanying condensed consolidated balance sheet of First Community Bancshares, Inc. and subsidiary (the Company) as of June 30, 2004, and the related consolidated statements of income for the three month and six month periods ended June 30, 2004 and 2003 and the consolidated statements of cash flows and changes in stockholders’ equity for the six month periods ended June 30, 2004 and 2003. These financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements referred to above for them to be in conformity with U. S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) the consolidated balance sheet of the Company as of December 31, 2003, and the related consolidated statements of income, cash flows and changes in stockholders’ equity for the year then ended (not presented herein) and in our report dated March 9, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Ernst & Young LLP

August 6, 2004

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First Community Bancshares, Inc.

The following discussion and analysis is provided to address information about the Company’s financial condition and results of operations. This discussion and analysis should be read in conjunction with the 2003 Annual Report to Shareholders on Form 10-K and the other financial information included in this report.

The Company is a multi-state bank holding company headquartered in Bluefield, Virginia with total assets of $1.85 billion at June 30, 2004. FCBI provides financial, trust and investment advisory services to individuals and commercial customers through 52 full-service banking locations in the four states of Virginia, West Virginia, North Carolina and Tennessee and two trust and investment management offices. First Community Bank is also the parent of Stone Capital Management, Inc., a SEC registered investment advisory firm, which offers wealth management and investment advice and United First Mortgage, Inc., which operates 4 retail mortgage offices in Virginia. First Community Bancshares, Inc.’s common stock is traded on the NASDAQ National market under the symbol “FCBC”.

FORWARD LOOKING STATEMENTS

The Company may from time to time make written or oral “forward-looking statements”, including statements contained in its filings with the Securities and Exchange Commission (“SEC”) (including this Quarterly Report on Form 10-Q and the Exhibits hereto and thereto), in its reports to stockholders and in other communications which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include, among others, statements with respect to the Company’s beliefs, plans, objectives, goals, guidelines, expectations, anticipations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors (many of which are beyond the Company’s control). The words “may”, “could”, “should”, “would”, “believe”, “anticipate”, “estimate”, “expect”, “intend”, “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company’s financial performance to differ materially from that expressed in such forward-looking statements: the strength of the United States economy in general and the strength of the local economies in which the Company conducts operations; the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; inflation, interest rate, market and monetary fluctuations; the timely development of competitive new products and services of the Company and the acceptance of these products and services by new and existing customers; the willingness of customers to substitute competitors’ products and services for the Company’s products and services and vice versa; the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking, securities and insurance); technological changes; the effect of acquisitions, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions; the growth and profitability of the Company’s non-interest or fee income being less than expected; unanticipated regulatory or judicial proceedings; changes in consumer spending and saving habits; and the success of the Company at managing the risks involved in the foregoing.

The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

First Community’s consolidated financial statements are prepared in accordance with U. S. generally accepted accounting principles and conform to general practices within the banking industry. First Community’s financial position and results of operations are affected by management’s application of accounting policies, including judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in First Community’s consolidated financial position and/or consolidated results of operations.

Estimates, assumptions, and judgments are necessary principally when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded based upon the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal modeling techniques and/or appraisal estimates.

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First Community’s accounting policies are fundamental to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following is a summary of First Community’s more subjective and complex “critical accounting policies.” In addition, the disclosures presented in the Notes to the Consolidated Financial Statements and in management’s discussion and analysis, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, the valuation of loans held for sale and the valuation of derivative instruments utilized in mortgage banking and hedging activity to be the accounting areas that require the most subjective or complex judgments.

Allowance for Loan Losses: The allowance for loan losses is established and maintained at levels management deems adequate to cover losses inherent in the portfolio as of the balance sheet date and is based on management’s evaluation of the risks in the loan portfolio and changes in the nature and volume of loan activity. Estimates for loan losses are determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of FCBI’s regulators, changes in the size and composition of the loan portfolio and industry information. Also included in management’s estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. These events may include, but are not limited to, a general slowdown in the economy, fluctuations in overall lending rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographic areas in which First Community conducts business.

As more fully described in the Notes to the Consolidated Financial Statements and in the discussion included in the Allowance for Loan Losses section of Management’s Discussion and Analysis, the Company determines the allowance for loan losses by making specific allocations to impaired loans and loan pools that exhibit inherent weaknesses and various credit risk factors. Allocations to loan pools are developed giving weight to risk ratings, historical loss trends and management’s judgment concerning those trends and other relevant factors. These factors may include, among others, actual versus estimated losses, regional and national economic conditions, business segment and portfolio concentrations, industry competition and consolidation, and the impact of government regulations. The foregoing analysis is performed by the Company’s credit administration department to evaluate the portfolio and calculate an estimated valuation allowance through a quantitative and qualitative analysis that applies risk factors to those identified risk areas.

This risk management evaluation is applied at both the portfolio level and the individual loan level for commercial loans and credit relationships while the level of consumer and residential mortgage loan allowance is determined primarily on a total portfolio level based on a review of historical loss percentages and other qualitative factors including concentrations, industry specific factors and economic conditions. The commercial and commercial real estate portfolios require more specific analysis of individually significant loans and the borrower’s underlying cash flow, business conditions, capacity for debt repayment and the valuation of secondary sources of payment (collateral). This analysis may result in specifically identified weaknesses and corresponding specific impairment allowances.

The use of various estimates and judgments in the Company’s ongoing evaluation of the required level of allowance can significantly impact the Company’s results of operations and financial condition and may result in either greater provisions against earnings to increase the allowance or reduced provisions based upon management’s current view of portfolio and economic conditions and the application of revised estimates and assumptions.

Loans Held for Sale, Derivative Instruments and Hedging Activities: UFM’s operations, currently included as discontinued operations, provided a distribution outlet for the sale of loans produced by UFM’s wholesale division (terminated in July 2004) and retail operations. It originates residential mortgage loans through its production offices located in Eastern Virginia and sells the majority of its loans through pooled commitments to national investors on a servicing released basis. Through June 30, 2004, UFM also acquired loans from a network of wholesale brokers for subsequent resale to these national investors. UFM originates all loans with the intent to sell. Loans held for sale are stated at the lower of cost or market (“LOCOM”). The LOCOM analysis on pools of homogeneous loans is applied on a net aggregate basis. Interest income with respect to loans held for sale is accrued on the principal amount outstanding. LOCOM valuation techniques applicable to loans held for sale are based on estimated market price indications for similar loans. Pricing estimates are established by participating mortgage purchasers and prevailing economic conditions. The majority of the loans held for sale have established market pricing indications. The loans held for sale portfolio originated by UFM at June 30, 2004 was $18.4 million compared to $17.7 million at December 31, 2003.

Risks associated with this lending function include interest rate risk, which is mitigated through the utilization of financial instruments (commonly referred to as derivatives) to assist in offsetting the effect of changing interest rates. The Company accounts for these instruments in accordance with FASB Statement No. 133, as amended “Accounting for Derivative Instruments and Hedging Activity.” This Statement established accounting and reporting standards for derivative instruments and for hedging activities. UFM uses forward mortgage contracts and options (short position sales and options) to manage interest rate risk in the pipeline of loans and interest rate lock commitments (“RLCs”) from the point of the loan commitment

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to the subsequent allocation and delivery to outside investors. As a result of the timing from origination to sale, and the likelihood of changing interest rates, forward commitments and options are placed with counter-parties to attempt to counter the effect of changing interest rates. The options and forward commitments to sell securities are considered to be derivatives and, as such, are recorded on the consolidated balance sheets at fair value. The changes in the fair value of derivatives are reflected in the consolidated statements of income as gain or loss.

The fair value of the RLCs is based on prevailing interest rates, and the assumed probability of closing (pull-through). The assumption of a given pull-through percentage enters into the determination of the volume of derivative contracts. Pull-through assumptions are continually monitored for changes in the interest rate environment and characteristics of the pool of RLCs. Differences between pull-through assumptions and actual pull-through could result in a mismatch in the volume of security contracts corresponding to RLCs and lead to volatility in profit margins on the loan products ultimately delivered. As more fully described in Note 7, to the Notes to Consolidated Financial Statements under Recent Accounting Developments, effective January 1, 2004, the Company adopted the valuation techniques used to measure loan commitments in recent guidance issued by the SEC in Staff Accounting Bulletin (“SAB”) 105. SAB 105 indicates that the value of internally generated loans has little or no value at inception separate from the servicing intangible that is created upon subsequent sale of the loan. Management applied SAB 105 in the first quarter of 2004 through the elimination of the servicing component of the sales price for the RLC valuation, which had a negative impact of $252,000 on the market value of the commitments outstanding.

The valuation of RLCs is considered critical because of the impact of borrower behavior and the impact that this behavior pattern will have on the pull-through ratio during times of significant rate volatility. Customer behavior is modeled by a mathematical tool based upon historical pull-through experience; however, substantial volatility can be experienced, as has been the case over the last year, as a result of the general movement in mortgage rates. As a result, pull-through has varied significantly over this time period. While customer behavior is difficult to model, the mathematical tool utilized by UFM incorporates volatility derived from market data in an attempt to anticipate borrower reaction to market rate movements and the corresponding desired security coverage.

At June 30, 2004, UFM held an investment in forward mortgage contracts with a notional value of $27.0 million and mortgage-backed security put options totaling $3.0 million. These instruments are collectively referred to as hedging instruments or securities. These contracts hedge interest rate risk associated with RLCs and closed loans not allocated to a forward commitment of $35.5 million. At June 30, 2004, the fair value of the securities was a liability of $267,000, which represents a $51,000 decrease in the fair value of the liability since December 31, 2003. The fair value of the RLCs at June 30, 2004 declined $288,000 from the fair value at December 31, 2003 including $252,000 related to the adoption of SAB 105.

For the six months ended June 30, 2004, the Company recognized $833,000 in gains on forward mortgage derivative contracts to originate and sell $282.4 million in loans, compared to the first six months of the prior year in which $472.3 million in loans were originated for sale with underlying forward mortgage contracts that cost $3.3 million. The lower cost of forward mortgage contracts between the two periods is reflective of the volatility of the pricing of these types of contracts during times of significant interest rate volatility. Although the pricing of the contracts was favorable to the Company in the current period, UFM’s pricing and margin on loans sold were substantially less favorable as a result of the market pricing dynamics and significant competitive forces. The significant decrease in hedging cost as well as the market price of loans sold, demonstrate the potential volatility to earnings and the sensitivity to pull-through assumptions. The cost of these derivative contracts is included as a component of the (loss) income from discontinued operations in the consolidated statements of income.

RECENT ACQUISITIONS AND BRANCHING ACTIVITY

The Company acquired PCB Bancorp, Inc., a Tennessee-chartered bank holding company (“PCB Bancorp”) after the close of business on March 31, 2004. PCB Bancorp has six full service branch offices located in Johnson City, Kingsport and surrounding areas in Washington and Sullivan Counties in East Tennessee. PCB Bancorp had total assets of $171 million, loans of $128 million and total deposits of $150 million as of the date of the merger. The assets, liabilities and results of operations have been included in the Company’s financial statements beginning with the second quarter 2004.

Under the terms of the acquisition agreement, shares of PCB Bancorp common stock were purchased for $40.00 per share in cash. The total deal value, including the cash-out of outstanding stock options, was approximately $36.0 million. Concurrent with the PCB Bancorp acquisition, Peoples Community Bank, the wholly-owned subsidiary of PCB Bancorp, was merged into First Community Bank, N.A., a wholly-owned subsidiary of the Company.

In June 2003, the Company acquired CommonWealth, a Virginia-chartered commercial bank for total consideration of approximately $23.2 million. The merger was accomplished through the exchange of .9015 shares of the Company’s common stock valued at $30.50, cash, or a combination of the Company’s stock and cash equivalent to $30.50 for each share of

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CommonWealth common stock. At acquisition, CommonWealth had total assets of $136.5 million, net loans of $120.0 million and total deposits of $105.0 million.

In February 2004, as part of the Company’s planned expansion into the Central Piedmont area of North Carolina, the Company opened two loan production offices in Charlotte and Mount Airy, North Carolina. The Charlotte office has since been converted to a full-service branch. Also, in the second quarter of 2004, two new loan production offices were opened, or were in the process of being opened in Norfolk and Blacksburg, Virginia.

In the second and third quarters of 2003, the Company opened three de novo branches in Winston-Salem, North Carolina. The Company does not anticipate that these branches will be profitable until market development has proven successful and adequate loan balances and corresponding loan revenue are established to support the added facilities, infrastructure and other operating costs of these branches.

In January 2003, the Bank completed the acquisition of Stone Capital, based in Beckley, West Virginia. This acquisition expanded the Bank’s operations to include a broader range of financial services, including wealth management, asset allocation, financial planning and investment advice. Stone Capital at June 30, 2004 had total assets of $67.4 million under management and continues to operate under its name. Stone Capital was acquired through the issuance of 8,409 shares of Company common stock, which represents 50% of the total consideration. In 2003, Stone Capital exceeded the annual revenue requirement outlined in the acquisition agreement and another 2,541 shares were paid to the original shareholders subsequent to December 31, 2003. The balance of the remaining consideration ($175,000) is payable over the next two years in the form of Company common stock, subject to the achievement of minimum revenue requirements set forth in the acquisition agreement.

RESULTS OF OPERATIONS

General

Net income for the six months ended June 30, 2004 was $9.9 million or $0.87 per diluted share compared with $13.7 million or $1.25 per diluted share for the six months ended June 30, 2003. Income from continuing operations for the six months ended June 30, 2004 was $13.2 million, versus $12.8 million for the six months ended June 30, 2003. Contributing to this increase in income from continuing operations was a $3.0 million or 9.9% increase in net interest income and a $2.3 million or 34.6% increase in non-interest income. Return on average equity from continuing operations for the first six months of 2004 was 14.98% compared to 16.25% for the first six months of last year. Return on average assets from continuing operations was 1.52% compared to 1.73% for the first six months of 2003.

On July 8, 2004 First Community announced the termination of a previously announced sale of its mortgage subsidiary. While the mortgage banking subsidiary continues to be held for sale, termination of the previously announced sale led to the elimination of the wholesale portion of the mortgage company’s business and substantial downsizing of the remaining retail division. In connection with the exit of its wholesale mortgage banking business and as previously reported, the company recorded impairment charges of $933,000 in the second quarter of 2004 (and $1,385,000 for the first six months of 2004) to reduce the carrying value of the subsidiary to its estimated fair value less costs to sell. To facilitate its decision to exit the wholesale mortgage banking business, First Community has provided management and professional resources to settle the mortgage company’s wholesale interest rate lock commitments; has overseen a transition in management at the mortgage company; and has taken steps to reduce overhead for the Company’s remaining mortgage business, which will be offered through its retail network. The strategic decision to exit the wholesale mortgage business will reduce the Company’s exposure to risk associated with the large fluctuations previously experienced in the volume-driven, wholesale business and its hedged interest rate lock commitments and closed loans. The change in strategic direction and decision to exit the wholesale mortgage business will permit the Company to focus its resources on its core community banking business, which has continued to grow and perform. The results of operations of the mortgage company are reported as discontinued operations. The loss from discontinued operations was $1.9 million or $0.17 per diluted share for the second quarter of 2004 and $3.3 million or $0.29 per diluted share for the six months ended June 30, 2004.

Net Interest Income–Year-to-date Comparison (See Table I)

Net interest income, the largest contributor to earnings, was $33.6 million for the six months ended June 30, 2004 compared to $30.6 million for the corresponding period in 2003. For purposes of the following discussion, comparison of net interest income is done on a tax equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable. As indicated in Table I, tax equivalent net interest income totaled $35.8 million for the six months ended June 30, 2004, an increase of $3.4 million from the $32.4 million reported in the first six months of 2003. This $3.4 million increase was based on an $8.4 million increase in volume as earning assets were added to the portfolio which was partially offset by a $5.0 million reduction due to rate changes on the underlying assets as asset yields fell in the declining rate environment. Management was able to help counter the effect of the declining asset yield through aggressive management of deposit rates. Average earning assets increased $220.3 million while interest-bearing liabilities

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increased $201.2 million. As indicated in Table I, the yield on average earning assets decreased 61 basis points from 6.69% for the six months ended June 30, 2003 to 6.08% for the six months ended June 30, 2004. However, this decrease was largely offset by a 47 basis point decline in the cost of funds during the same period leaving the net interest rate spread (the difference between interest income on earning assets and expense on interest bearing liabilities) lower at 4.20% compared to 4.34% for the same period last year. The Company’s tax equivalent net interest margin of 4.48% for the six months ended June 30, 2004 decreased 25 basis points from 4.73% in 2003.

The largest contributor to the decrease in the yield on average earning assets in 2004, on a volume-weighted basis, was the decrease in the overall tax equivalent yield on loans held for investment of 77 basis points from the prior year to 6.68%, as loans repriced downward in response to the declining rate environment while the average balance increased $172.3 million. The decline in asset yield is attributable to the current interest rate environment which creates refinancing or repricing incentives for fixed rate borrowers to lower their current borrowing costs. In addition, due to the volume of loans directly tied to prime and other indices that are either adjustable incrementally or are variable rate advances, asset yields have declined in response to rate cuts and drops in the prime loan rate which began in 2001.

During the six months ended June 30, 2004, the taxable equivalent yield on securities available for sale decreased 50 basis points to 4.65% while the average balance increased by $57.8 million. Consistent with the current rate environment, the Company and the securities industry as a whole have experienced rapid turnover in securities as higher yielding securities are either called or prepaid as the refinancing opportunity presents itself. Although the total portfolio grew by $57.8 million from June 30, 2003, the relative rate on securities acquired since that time has declined substantially. The increasing average security balance is the result of continued reinvestment of available funds largely through bank acquisitions. The June 30, 2004 average balance of investment securities held to maturity decreased by $2.9 million to $37.3 million while the yield decreased only 10 basis points to 7.99% compared to the June 30, 2003 year-to-date average yield of 8.09%.

Compared to the June 30, 2003 average interest-bearing balances with banks of $41.2 million, these funds decreased $4.2 million while the yield decreased 9 basis points to 1.47%.

The Company actively manages its product pricing by staying abreast of the current economic climate and competitive forces in order to enhance repricing opportunities available with respect to the liability side of its balance sheet. In doing so, the cost of interest-bearing liabilities decreased by 47 basis points from 2.35% for the six months ended June 30, 2003 to 1.88% for the same period of 2004 while the average volume increased $201.2 million. Active deposit liability pricing management is performed weekly.

When comparing the six months ended June 30, 2004 to the corresponding period of the prior year, the 2004 average balance of FHLB and other short-term convertible and callable borrowings increased by $71.2 million in 2004 to $126.2 million while the rate decreased 228 basis points to 4.47%, the result of the addition of balances acquired with the CommonWealth and PCB acquisitions and the addition of new advances at lower rates which partially funded the PCB acquisition. The average balance of all other borrowings increased $7 million for the first six months of 2004 versus 2003 as a result of the issuance of $15 million in trust preferred securities late in the third quarter of 2003 while the rate paid decreased 105 basis points.

Average fed funds and repurchase agreements increased $9.1 million at June 30, 2004, while the average rate decreased 65 basis points compared to the same period in 2003. In addition, the average balances of interest-bearing demand and savings deposits increased $71.2 million and $26.4 million, respectively, for the six months ended June 30, 2004 while the corresponding average rate paid on these deposit categories declined 21 and 13 basis points, respectively. Average time deposits increased $16.4 million while the average rate paid decreased 59 basis points from 3.05% in 2003 to 2.46% in 2004. The level of average non-interest-bearing demand deposits increased $40.0 million to $204.3 million at June 30, 2004 compared to the corresponding period of the prior year. Average interest bearing deposits and non-interest bearing demand deposits for the acquired CommonWealth Bank branches totaled $64.9 million and $25.6 million at June 30, 2004 and $8.8 million and $4.9 million at June 30, 2003. Included in the June 30, 2004 average balances related to the PCB acquisition for interest-bearing and non-interest bearing deposits were $67.7 million and $9.0 million at June 30, 2004, respectively.

Net Interest Income –Quarterly Comparison (See Table II)

Net interest income for the quarter ended June 30, 2004 was $17.6 million compared to $15.5 million for the same period in 2003, an increase of $2.1 million. Likewise, tax equivalent net interest income increased $2.5 million from $16.4 million for the quarter ended June 30, 2003, to $18.9 million for the quarter ended June 30, 2004 (refer to Table II). A 46 basis point decrease in the rate paid on interest-bearing liabilities partially offset a 53 basis point decline in the average rate earned on interest-earning assets, resulting in a decrease in the net interest margin of 18 basis points to 4.51% for the quarter ended June 30, 2004. While the net interest margin decreased, average earning assets increased $277.6 million in the second quarter of 2004 compared to the second quarter of 2003 resulting in the improvements in net interest income. The largest increases in average earning assets included increases in average loans held for investment of $240.9 million and securities available for sale of $55.5 million. In the second quarter of 2004, average interest-bearing deposits with banks decreased $13.2 million and Fed Funds Sold decreased $427,000. The $2.4 million increase in net

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interest income was achieved through the combined effect of changes in volume and corresponding rates on the underlying assets and liabilities. Earnings attributable to the net volume increase in earning assets over paying liabilities was approximately $9.4 million while the effect of declining rates represented an offsetting net reduction of approximately $6.9 million for a combined effect on net interest income of $2.4 million. The volume driven increase in net interest income is largely attributable to the PCB acquisition which contributed $1.3 million in net interest income in the second quarter of 2004 following the March 31, 2004 consummation.

As previously mentioned, the impact of the declining interest rate environment continued to reduce asset yields as assets repriced into lower interest rate products and as securities were replaced with lower yielding instruments reflecting the lower rate environment. This refinancing/repricing scenario is reflected in all categories of interest earning assets. Management continues to focus on margin enhancement by funding the balance sheet growth with lower priced deposits and borrowings without significantly extending balance sheet duration (the weighted average maturity) in anticipation of future rate increases.

Similar to the decline in asset yields created by the current interest rate cycle, deposit and borrowing costs also have been adjusted when possible to obtain this benefit on the liability side of the balance sheet. As previously mentioned, management continues to strive for lower cost funding in light of falling asset yields. Management monitors the overall performance of assets and interest-bearing liabilities through the Company’s product management group. Total interest-bearing liabilities increased $256.4 million with average interest-bearing deposits increasing $174.2 million. The average rate on paying liabilities and deposits dropped 46 and 51 basis points, respectively. For the same periods, average Fed Funds purchased and repurchase agreements increased $11.7 million while the average rate decreased 56 basis points. Average short-term borrowings increased $63.6 million while the rate decreased 163 basis points and long-term borrowings increased $7.0 million while the rate decreased 107 basis points.

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