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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2003
Commission File Number 000-27622
HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
Virginia 54-1796693
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
340 West Main Street
Abingdon, Virginia 24210-1128
(Address of Principal Executive Offices) (Zip Code)
(276) 628-9181
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class on Which Registered
------------------- -------------------
None n/a
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.25 par value
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter periods that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes _X_ No ___
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ X ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Exchange Act Rule 12b-2). Yes ___ No _X_
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which the
common equity was last sold, or the average bid and asked price of such common
equity as of the last business day of the registrant's most recently completed
second fiscal quarter. $52,141,329
Indicate the number of shares outstanding of each of the registrant's
classes of common stock as of the latest practicable date. As of March 10, 2004,
there were 2,659,187 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Annual Report to Shareholders for the fiscal year
ended December 31, 2003--Part II
Proxy Statement for the 2004 Annual Meeting of Shareholders--Part III
Table of Contents
Page Number
-----------
Part I
Item 1. Business 3
Item 2. Properties 28
Item 3. Legal Proceedings 30
Item 4. Submission of Matters to a Vote of
Security Holders 30
Part II
Item 5. Market for Registrant's Common Equity
and Related Stockholder Matters 30
Item 6. Selected Financial Data 31
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operation 32
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk 32
Item 8. Financial Statements and Supplementary Data 32
Item 9. Changes in and Disagreements With Accountants With
Accountants on Accounting and Financial Disclosure 33
Item 9A. Controls and Procedures 33
Part III
Item 10. Directors and Executive Officers of the Registrant 33
Item 11. Executive Compensation 34
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 34
Item 13. Certain Relationships and Related Transactions 34
Item 14. Principal Accounting Fees and Services 34
Part IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 34
2
Forward-Looking Information
This report contains forward-looking statements with respect to the
financial condition, results of operations and business of Highlands Bankshares,
Inc. (the "Corporation"). These forward-looking statements involve risks and
uncertainties and are based on the beliefs and assumptions of the management of
the Corporation, and on the information available to management at the time that
these disclosures were prepared. Factors that may cause actual results to differ
materially from those contemplated by such forward-looking statements include,
among others, the following possibilities:
* competitive pressures among depository and other financial
institutions may increase significantly;
* changes in the interest rate environment may reduce margins;
* general economic conditions, either nationally or regionally, may
be less favorable than expected, resulting in, among other
things, a deterioration in credit quality and / or a reduced
demand for credit;
* legislative or regulatory changes, including changes in
accounting standards, may adversely affect the businesses in
which the Corporation and its subsidiaries are engaged;
* competitors may have greater financial resources and develop
products that enable such competitors to compete more
successfully than the Corporation and its subsidiaries; and
* adverse changes may occur in the securities markets.
Part I.
Item I. Business
General
Highlands Bankshares, Inc. (the "Corporation") was incorporated in
Virginia in 1995 to serve as the holding company for Highlands Union Bank, (the
"Bank"). The shareholders of the Bank approved the Plan of Reorganization at the
Annual Meeting on December 13, 1995, and the reorganization was consummated on
December 29, 1995 with the Bank becoming a wholly-owned subsidiary of the
Corporation. The Bank is a state charted bank with principal offices in
Abingdon, Virginia. The Bank was incorporated in 1985.
At December 31, 2003, the Corporation had total assets of $543,416,000,
deposits of $450,009,000 and net worth of $35,434,000.
The Corporation's principal business activities, which are conducted
through the Bank, are attracting checking and savings deposits from the general
public through its retail banking offices and originating and servicing loans
secured by first mortgage liens on single-family dwellings, including
condominium units. All of the retail banking offices are located in Virginia,
North Carolina and Tennessee. The Bank also lends funds to retail banking
customers by means of home equity and installment loans, and originates
construction loans and loans secured by commercial property, multi-family
dwellings and manufactured housing units. The Bank opened an indirect lending
department in 1997. The majority of indirect lending originates through new and
used car dealerships. The indirect lending portfolio comprises a significant
portion of the total consumer loan portfolio. The Bank invests in certain U.S.
Government and agency obligations and other investments permitted by applicable
laws and regulations. The operating
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results of the Corporation are highly dependent on net interest income, the
difference between interest income earned on loans and investments and the cost
of checking and savings deposits and borrowed funds.
The Bank is a member of the Federal Deposit Insurance Corporation
("FDIC"), and its deposit accounts are insured up to $100,000 as required by
FDIC guidelines. The Bank is also a member of the Federal Reserve System, as
such, the Bank and the Corporation are subject to the supervision, regulation
and examination of the Federal Reserve. As a Virginia state chartered bank, the
Bank is also subject to supervision, regulation and examination by the Virginia
State Corporation Commission, Bureau of Financial Institutions.
The Corporation has two direct subsidiaries as of December 31, 2003:
the Bank, which was formed in 1985, and Highlands Capital Trust I, a statutory
business trust (the "Trust") which was formed in 1998. The Corporation's
material assets as of December 31, 2003 include: cash in bank of approximately
$1.23 million; trust preferred securities repurchased of $1.20 million;
building, land, and equipment with a net book value of approximately $1.43
million; approximately $3.40 million in real estate secured loan participations
from the Bank; approximately $406 thousand in other assets; and its investment
in subsidiaries, approximately $35.44 million. The Corporation's only material
liability is the note payable on the trust preferred debentures issued in
January of 1998, $7.5 million.
The Bank has two wholly-owned subsidiaries, Highlands Union Insurance
Services, Inc., which was formed in 1999 and Highlands Union Financial Services,
Inc. which was formed in 2001. The Bank, through Highlands Union Insurance
Services, Inc., joined a consortium of approximately forty-seven other financial
institutions to form Bankers' Insurance, LLC. Bankers' Insurance, LLC, as of
December 31, 2003, had purchased seven full service insurance agencies across
the state of Virginia. Highlands Union Insurance Services, Inc. will be used to
sell insurance services through the Bankers' Insurance, LLC. Highlands Union
Financial Services, Inc. was formed in order for the Bank to continue to offer
third-party mutual funds, annuities and other financial services to its
customers in all market areas served.
Also during 2002, the Bank became an equity owner in the Virginia Title
Center, LLC. This entity is owned by approximately 16 member banks located in
Southwest Virginia. The organization is involved in the underwriting and
issuance of title insurance on real estate closings, primarily as a result of
referrals from the member banks.
As of December 31, 2003, the Bank operates ten full-service banking
facilities throughout Washington County, Virginia, the City of Bristol,
Virginia, Marion, Virginia, Glade Spring, Virginia, Rogersville, Tennessee,
Blountville, Tennessee and Boone, North Carolina. The Bank closed its loan
production office in Kingsport, Tennessee in 2003 due to the opening of its
Blountville branch office. The Company felt that it would be able to adequately
service those Kingsport, Tennessee customers from its Rogersville and
Blountville, Tennessee branch offices. The Corporation also operates thirty
off-site ATM's throughout the service areas listed above as well as Russell
County, Virginia, Wythe County, Virginia, Bristol, Tennessee and Banner Elk,
North Carolina.
The results of operations for the fiscal years ended December 31, 2003,
2002, and 2001 ("fiscal year 2003", "fiscal year 2002" and "fiscal year 2001",
respectively) reflect the Corporation's strategies of expanding its community
banking operations. See "Management's Discussion and Analysis" of operations and
financial condition, included as part of the Annual Report to Shareholders, for
a detailed discussion of certain aspects of the Corporation's business.
4
During the second quarter of 2002, the Bank purchased approximately
$7.38 million in bank owned life insurance. The policies were issued to insure
the lives of a selected number of officers and directors of the Bank. The Bank
is the named beneficiary, and the premiums were allocated among four separate
highly rated carriers. The earnings related to the policies will be used to
offset future employee benefit costs. The life insurance purchased by the Bank
will remain a corporate asset even after the employer / employee relationship is
terminated. The Bank has also entered into a separate agreement with each of the
insureds to provide their named beneficiary(s) a separate death benefit. This
amount is approximately 20% of the proceeds received by the Bank from the
various carriers and requires that the named insureds are actively employed or
still serving as a director upon death. This death benefit amount will be fully
taxable to the recipient(s) and tax deductible to the Bank.
Lending Activities
Residential Mortgage Lending
The Bank's lending policy is generally to lend up to 80% of the
appraised value of residential property. The Bank lends up to 95% of the
appraised value with the normal requirement of insurance from private mortgage
insurance companies. This insurance normally covers amounts in excess of 80%
loan to value up to 95%.
The in-house residential mortgages are comprised of primarily one,
three and five year adjustable rate mortgages and 15 year fixed rate mortgages
as well as three and five year balloon mortgages. Adjustable rate mortgages are
indexed to 275 basis points over the average yield on United States Treasury
securities adjusted to a constant maturity of one, three or five years. An
adjustment limitation (increase or decrease) of 2% per annum applies to the one
year adjustable product. A 4% lifetime cap over the initial rate of the loan is
included in the one, three and five year adjustable rate mortgages.
The Bank's existing loan contracts generally provide for repayment of
residential mortgage loans over periods ranging from 15 to 30 years. However,
such loans normally have remained outstanding for much shorter periods of time
as borrowers refinance or prepay their loans through the sale of their homes.
Most of the Bank's residential mortgage loans have "due on sale"
clauses which allows the creditor the right to declare a loan immediately due
and payable in the event the borrower sells or otherwise disposes of the real
property. Most of the Bank's residential mortgage loans are not assumable.
Aggregate debt to any one borrower exceeding $850,000 but less than
$2,000,000 must be approved by the loan committee of the Board of Directors.
Loan requests in excess of the customer's aggregate debt of $2,000,000 must be
approved by the Board of Directors.
All of the Bank's mortgage lending is subject to loan origination
procedures established by the Board of Directors. Most originations require a
property valuation by state licensed appraisers, for a fee, approved by the
Board of Directors. Loan applications are obtained to determine the borrowers'
ability to repay. Significant items are verified through the use of credit
reports, financial statements, etc.
5
It is generally the Bank's policy to require title insurance on first
mortgage loans in excess of $50,000 (lower where deemed necessary). It is also
the Bank's general policy to require an attorney's opinion statement on all
first mortgage deeds of trust. Fire and casualty insurance (extended coverage)
is required on all property serving as security for these loans. Hazard
insurance and flood insurance (where required) is provided by the customer prior
to closing of the loan. The borrower is responsible for paying insurance
premiums and real estate taxes.
Federal regulations allow the Bank to originate loans on real estate
within its designated market area, and within limits, to originate and purchase
loans or loan participations secured by real estate located in any part of the
United States. During fiscal year 2003 the Bank's primary lending area was
Washington County, Virginia, the City of Bristol, Virginia, Smyth County,
Virginia, Hawkins County, Tennessee, Sullivan County, Tennessee and Watauga
County, North Carolina.
Residential loan originations come from many sources. Some of these
sources include existing customers, walk-in applications, referrals from real
estate brokers and others.
Federal regulation limits loans to one borrower to a maximum of 15% of
unimpaired capital and unimpaired surplus of the Bank.
The Bank receives fees in addition to interest in connection with real
estate loan originations, loan modifications, late payments, etc. Income from
these activities varies from period to period depending on the volume and type
of loan made. Although not a significant portion of the Bank's income, late
charges are received when monthly payments are delinquent but are later paid.
The Bank also offers secondary market fixed rate mortgages with terms
up to 30 years and up to 95% loan to value. The Bank also offers a special
secondary market lending program to first time home buyers that will fund 100%
loan to value. These loans and servicing rights are generally sold immediately
into the secondary market and fees received are booked into income. These loans
must meet certain criteria generally set by the secondary market.
Residential mortgages, including equity lines of credit, made up
approximately 41.32% of the loan portfolio as of December 31, 2003.
Construction and Commercial Real Estate Lending
The Bank generally makes construction loans for periods up to one year
on residential and commercial real estate property including vacant land. These
loans are for interim financing and are either paid off or converted to
permanent financing when completed. At December 31, 2003, outstanding
construction, commercial real estate and vacant land loans (net of undisbursed
funds) totaled $12,482,000. These loans are generally made at 80% or less of
appraised value at completion. Funds are advanced as the project is completed
after an inspection by a staff inspector or the appraiser as deemed appropriate.
These loans are made based on established corporate underwriting standards. Most
of these construction loans are one to four family dwellings. The Bank generally
charges a 1% origination fee on these construction loans in addition to
applicable interest.
Loans on commercial properties, multi-family dwellings, and apartment
buildings are typically made at 75% to 80% of the appraised value. These loans
totaled $99,911,000 or 26.45% of total loans held for investment at December 31,
2003.
6
Commercial and construction loans, by nature, entail additional risk as
compared to residential mortgage lending. They are generally more complex and
involve larger balances than typical residential mortgages. Payments are
typically dependent upon successful operation of a related real estate project
or business as compared to individual earnings on most residential mortgages.
Therefore, the market risk is somewhat greater. Construction delays, cost
overruns or the inability of the contractor to sell the finished product add an
element of risk to such lending.
Consumer lending
The Bank offers other types of loans in addition to real estate
mortgage and construction loans. Consumer loans of many types are offered by the
Bank. Some of these loans are loans to purchase automobiles, boats, recreational
vehicles and manufactured housing, as well as other secured and unsecured
consumer loans, including credit cards. The Bank further makes loans secured by
savings accounts at 5% above the rate of the savings instrument. The Bank also
makes loans secured by certificates of deposit issued internally. The terms
generally do not exceed ten years for manufactured housing loans and five years
on other consumer loans. Outstanding consumer loans at December 31, 2003 were
$56,971,000.
The Bank maintains a significant portfolio of dealer paper originated
through its indirect lending department. As of December 31, 2003 this portfolio
had a balance of $23,734,000 included in the $57 million above.
Commercial and agriculture non-real estate loans
The Bank also makes commercial (including agriculture) non-real estate
loans. These loans in general have higher risks associated with them than real
estate loans. They are generally secured by inventory, equipment, accounts
receivable, etc., or unsecured in some cases backed by appropriate financial
condition as per the underwriting standards of the Bank. Agriculture loans are
generally secured by machinery, equipment, other miscellaneous assets or
unsecured in keeping with the underwriting standards of the Bank. The timely pay
back is dependent upon the successful operation of the business or farm. The
outstanding balance of non-real estate commercial loans was $39,180,000 at
December 31, 2003, and the outstanding balance of non-real estate agriculture
loans was $4,918,000 at December 31, 2003.
Investments
Investment Securities
The Bank invests in mortgage-backed securities, agency notes and bonds,
collateralized mortgage obligations (CMO's), municipal bonds, agency equity
securities, asset-backed securities, equity securities and trust preferred
securities.
A substantial portion of the mortgage-backed security portfolio
consists of securities that are either insured or guaranteed by FHLMC, FNMA or
GNMA. Guaranteed securities are more liquid than individual mortgage loans. At
December 31, 2003, the Bank's mortgage-backed securities portfolio had a
carrying value of $53,474,000 or 9.84% of total assets compared to $57,730,000
or 11.89% of total assets at December 31, 2002. Amortized costs of
mortgage-backed securities were $53,583,000 at December 31, 2003 and $57,052,000
for the comparable 2002 period. Due to repayments and prepayments of the
underlying loans, the actual maturities of mortgage-backed securities are
expected to be substantially less than the scheduled maturities.
7
The Bank held investments in CMO's for the years ended December 31,
2003 and 2002. At December 31, 2003 and 2002, the Bank had carrying value of
CMO's of $45,000 and $2,305,000, respectively. These carrying values represent
0..08% and 0.47% of total assets for the respective year-ends. Amortized cost of
CMO's were $44,000 and $2,292,000 as of December 31, 2003 and 2002.
The Bank invests in municipal securities that are bank-qualified. As of
December 31, 2003 and 2002, the Corporation had carrying values of $48,631,000
and $30,719,000, respectively. These investments represent 8.95% and 6.33% of
total assets as of December 31, 2003 and 2002.
The Bank also invests in agency equity securities. As of December 31,
2003 and 2002 the Bank had carrying values of $10,343,000 and $8,278,000,
respectively.
The Bank holds the following equity investments: Federal Reserve Bank
Stock of $295,000 for each of the periods ending December 31, 2003 and 2002,
respectively; Federal Home Loan Bank Stock of $2,550,000 and $1,832,000 for the
same dates as above; and Community Bankers' Bank Stock of $54,750 and $54,750
for the same dates as above.
The Bank also holds investments in corporate bonds of $4,965,000 and
$2,201,000 as of December 31, 2003 and 2002, respectively. These investments
represented approximately 0.91% and 0.47% of total assets at those dates.
The Bank holds investments in SLMA and SBA issued securities. At
December 31, 2003 and 2002, the Bank had $1,344,000 and $1,413,000 in carrying
value in these investments, respectively.
At December 31, 2003, the Bank had investments in U.S. Agency
securities with a carrying value of $3,262,000 and amortized cost of $3,247,000.
Investment Activities
Under Federal Reserve regulations, the Bank is required to maintain
certain liquidity ratios and does so by investing in certain obligations and
other securities that qualify as liquid assets. See "Regulation". As a state
chartered bank, the Bank's investment authority is limited by federal and state
law which permits investment in, among other things, certain certificates of
deposit issued by commercial banks, banker's acceptances, loans to commercial
banks for Federal Funds, United States government and agency obligations of
state governments, and corporate bonds.
The Bank's internal investment committee, made up of the CEO, Cashier,
CFO and V.P. of Accounting, meets routinely to determine portfolio strategies
following Federal Reserve guidelines with respect to portfolio investment and
accounting. The Committee performs pre-purchase and pre-sale analysis on all
individual securities and presents this information to the full board of
directors monthly. Such Federal Reserve guidelines state that insured
institutions must account for securities held for investment, sale and/or
trading in accordance with generally accepted accounting principles. The Bank
maintains a written investment policy to set forth investment portfolio
composition and investment strategy. The investment portfolio composition policy
considers, among other factors, the financial condition of the institution, the
types of securities, amounts of investments in those securities and safety and
soundness considerations
8
pertaining to the institution. The investment strategy considers, among other
factors, interest rate risk, anticipated maturity of each type of investment and
the intent of the institution with respect to each investment.
Sources of Funds
General
Deposit accounts have traditionally been the principal source of the
Bank's funds for use in lending and for other general business purposes. In
addition to deposits, the Bank derives funds from loan repayments, repayments
from securities, correspondent bank credit lines, Federal Home Loan Bank System
("FHLB") advances, the national certificate of deposit market and loan
participation sales. Borrowings and the national certificate of deposit market
may be used on a short-term basis to compensate for seasonal or other reductions
in deposits or inflows at less than projected levels, as well as on a long-term
basis to support expanded lending activities.
Deposit Activities
The Bank, in its continuing effort to remain a competitive force in its
markets, offers a wide variety of deposit services, with varied maturities,
minimum-balance requirements and market-sensitive interest rates that are
attractive to all types of depositors. The Bank's deposit products include
checking accounts, statement savings accounts, money market deposit accounts,
negotiable orders of withdrawal accounts, individual retirement accounts and
certificates of deposit accounts. The Bank is able to offer a broad array of
products that are consistent with current Federal Reserve regulations, and as a
major result, the Bank's deposit portfolio is, for the most part, sensitive to
general market fluctuations.
The following table sets forth the deposit liabilities of the Bank for
the year ended December 31, 2003.
2003 Weighted Minimum Amount
Average Balance in % of
Type of Account Rate Term Deposit Thousands Total
--------------- ---- ---- ------- --------- -----
Checking Account 0.00% none $ 100.00 $59,057 13.12%
Interest Checking 1.11 none 100.00 27,098 6.02
Statement Savings 1.55 none 25.00 80,764 17.95
Money Market
Deposit Accounts 1.64 none 500.00 36,950 8.21
Christmas Club Accts. 2.25 none 5.00 116 0.03
Individual Retirement
Accounts 4.62 various 500.00 49,271 10.95
Certificates of Deposit
Accounts 3.11 various 500.00 196,753 43.72
------- -----
Totals $450,009 100.00%
-------- -------
The variety of deposit accounts offered by the Bank and the competitive
rates paid on these deposit accounts have increased the Bank's ability to retain
deposits and has allowed it to be more competitive in obtaining new funds,
reducing the threat of disintermediation (the flow of funds away from deposit
institutions into direct investment vehicles such as government and corporate
securities). The Bank recognized several years ago that it would be necessary to
diversify into new market areas in order to continue the growth in its deposit
base. The new markets in Western North Carolina and Northeast Tennessee have
aided the Bank in fulfilling this growth. As customers have become more rate
conscious and willing to move funds to higher yielding accounts, the ability of
the Bank to attract and maintain deposits and the Bank's cost of funds have
9
been, and will continue to be, significantly affected by money market
conditions.
The following table sets forth information relating to the Bank's
deposit flows during the years indicated.
Years Ended December 31,
(In Thousands) 2003 2002 2001
-------------- ---- ---- ----
Increase (decrease) in deposits before
interest credited back to accounts $ 29,588 $ 5,452 $ 28,516
Interest credited back to accounts 10,120 12,756 17,262
-------- -------- --------
Net increase in deposits 39,708 18,208 45,778
-------- -------- --------
Total deposits at year end $450,009 $410,301 $392,093
-------- -------- --------
Borrowings
The Bank may obtain advances from the FHLB upon the security of the
capital stock it owns in the bank and certain of its home mortgage loans,
provided certain standards related to creditworthiness have been met. Such
advances may be made pursuant to several different credit programs. Each credit
program has its own interest rate and range of maturities, and the FHLB
prescribes the acceptable uses to which the advances pursuant to each program
may be used, as well as limitations on the size of such advances. Depending on
the program, such limitations are based either on a fixed percentage of the
Bank's net worth or on the FHLB's assessment of the Bank's creditworthiness. The
FHLB is required to review its credit limitations and standards at least once
every six months. FHLB advances have from time to time been available to meet
seasonal and other withdrawals of savings accounts and to expand lending.
The Bank also has established credit arrangements with several of its
correspondent banks. At December 31, 2003, the Bank had approximately
$91,567,000 of unused lines of credit, including FHLB unused lines of credit, to
fund any necessary cash requirements.
The following table sets forth certain information as to the Bank's
advances and other borrowings at the dates indicated. See Notes 9, 10, and 11 to
the Consolidated Financial Statements, included as part of the Annual Report to
Shareholders, for information as to rates, maturities, average balances and
maximum amounts outstanding.
Years Ended December 31,
(In Thousands) 2003 2002 2001
-------------- ---- ---- ----
Advances from FHLB $ 49,000 $ 33,072 $ 23,214
Guaranteed preferred beneficial
interests in corporation's junior
subordinated debt securities 6,300 7,500 7,500
Other borrowings 429 222 269
--------- --------- ---------
Total Borrowings $ 55,729 $ 40,794 $ 30,983
In January 1998, the Corporation issued $7,500,000 of trust-preferred
securities through its subsidiary Highlands Capital Trust I. The proceeds from
this issue are included in the
10
Corporations' Tier 1 and Tier 2 capital up to specified levels according to
federal regulations. The subordinated notes were issued with a final maturity of
30 years and a ten-year call option at the discretion of the Corporation. The
issuance of these trust-preferred securities has enabled the Corporation to
continue expansion while maintaining a well-capitalized position according to
regulatory standards.
Highlands Bankshares, Inc. repurchased 48,000 shares of Highlands
Capital Trust I on April 18, 2003, on the open market, at $26.15 per share. The
price paid per share corresponds to the January 2008 call price. The premium
paid of $55 will be expensed when the securities are called or at the maturity
date of the capital securities.
Competition
The Bank encounters competition for both deposits and loans. For
deposits, competition comes from other commercial banks, savings and loan
associations and/or savings banks, mutual money market funds, credit unions and
various other corporate and financial institutions. Competition also comes from
interest paying obligations issued by various levels of government and from a
variety of securities paying dividends or interest. Competition for loans comes
primarily from other commercial banks, savings and loan associations and/or
savings banks, insurance companies, mortgage companies and other lending
institutions.
The Bank's primary market areas include: Washington County, Virginia;
Smyth County, Virginia; City of Bristol, Virginia; Hawkins County, Tennessee and
Watauga County, North Carolina. As of June 30, 2003 the Bank had the following
deposit market share in its primary market areas based on the FDIC Summary of
Deposits: Washington County, Virginia market share of 34.64%; Smyth County,
Virginia market share of 8.19%; City of Bristol, Virginia market share of
23.23%; Hawkins County, Tennessee market share of 2.77%, and Watauga County,
North Carolina market share of 1.46%.
Employees
The Corporation and its subsudiaries, at December 31, 2003, had 230
full time employees. None of these employees are represented by a collective
agent, and the Corporation believes its employee relations are excellent.
Bank Owned Life Insurance
During 2002, the Bank purchased insurance on the lives of certain key
directors and officers. As beneficiary, the Bank receives the cash surrender
value if the policy is terminated, and upon death of the insured, receives all
benefits payable. The current value of the policies at December 31, 2003 is
$7,929,000.
Subsidiaries
The Corporation was incorporated in Virginia in 1995 to serve as the
holding company for the Bank. The Bank is a state chartered bank with its
principal offices in Abingdon, Virginia. The Bank was incorporated in 1985 under
the laws of the Commonwealth of Virginia. The Corporation formed a statutory
business trust, Highlands Capital Trust I, in January 1998 to issue trust
preferred securities in order to raise additional capital.
The Bank formed a wholly-owned subsidiary, Highlands Union Insurance
Services, Inc., in 1999 for the purpose of selling insurance services through
Bankers' Insurance, LLC. The Bank, through Highlands Union Insurance Services,
Inc. joined a consortium of approximately forty-seven other financial
institutions to form Bankers' Insurance, LLC. Bankers' Insurance LLC, as of
December 31, 2003, had purchased seven full service insurance agencies across
the state of Virginia.
11
The Bank also formed a wholly-owned subsidiary, Highlands Union
Financial Services, Inc., in 2001 for the purpose of selling non-banking
financial products through Independent Community Bankers' Association Financial
Services.
Federal Home Loan Bank System
The Bank is a member of the FHLB, which consists of 12 regional FHLB
banks. The FHLB is regulated by the Federal Housing Finance Board ("FHFB"). The
FHFB is composed of five members, including the Secretary of Housing and Urban
Development and four private citizens appointed by the President with the advice
and consent of the Senate for terms of seven years. At least one director must
be chosen from organizations with more than a two-year history of representing
consumer or community interests on banking services, credit needs, housing or
financial consumer protections.
The Bank, as a member of the FHLB of Atlanta, is required to purchase
and maintain stock in its bank in an amount as if 30 percent of the member's
assets were home mortgage loans.
The FHFB is required to adopt regulations establishing standards of
community investment or service for members of the FHLB as a condition for
continued access to advances. The regulations are to take into account the
record of performance of the institution under the Community Reinvestment Act of
1977 and its record of lending to first time homebuyers.
In addition, new collateral requirements for advances are to be
established which will be designed to insure credit quality and marketability of
the collateral.
Regulation
General
The Corporation and its subsidiaries are subject to the supervision,
regulation and examination of the Federal Reserve Board, the Federal Deposit
Insurance Corporation and the state regulators of the Commonwealth of Virginia
which has jurisdiction over financial institutions. The Corporation and its
subsidiaries have obtained regulatory approval for its various activities to the
extent required.
Federal and State Laws and Regulations
Bank holding companies and banks are extensively regulated under
federal and state law. To the extent that the following information describes
statutory and regulatory provisions, it is qualified in its entirety by
reference to such statutes and regulations. Any change in applicable law or
regulation may have a material effect on the business of the Corporation and its
subsidiaries.
Bank Holding Company Regulation
The Corporation is registered as a "bank holding company" with the
Board of Governors of the Federal Reserve System ("Federal Reserve"), and is
subject to supervision by the Federal Reserve under the Bank Holding Corporation
Act of 1956 ("BHC Act"). The Corporation is required to file with the Federal
Reserve periodic reports and such additional information as the
12
Federal Reserve may require pursuant to the BHC Act. The Federal Reserve
examines the Corporation and the Bank.
The BHC Act requires prior Federal Reserve approval for, among other
things, the acquisition by a bank holding company of direct or indirect
ownership or control of more than 5% of the voting shares or substantially all
of the assets of any bank, or for a merger or consolidation of a bank holding
company with another bank holding company. With certain exceptions, the BHC Act
prohibits a bank holding company from acquiring direct or indirect ownership or
control of the voting shares of any company which is not a bank or bank holding
company and from engaging directly or indirectly in any activity other than
banking or managing or controlling banks or performing services for it's
authorized subsidiaries. A bank holding company may, however, engage in or
acquire an interest in a company that engages in activities which the Federal
Reserve has determined by regulation or order to be so closely related to
banking or managing or controlling banks as to be a proper incident thereto.
Bank Regulation
The Bank, as a state chartered member of the Federal Reserve, is
subject to regulation and examination by the Virginia State Corporation
Commission and the Federal Reserve Board. In addition, the Bank is subject to
the rules and regulations of the Federal Deposit Insurance Corporation, which
currently insures the deposits of each member bank to a maximum of $100,000 per
depositor.
The commercial banking business is affected by the monetary policies
adopted by the Federal Reserve Board. Changes in the discount rate on member
bank borrowings, availability of borrowing at the "discount window", open market
operations, the imposition of any changes in reserve requirements against member
banks' deposits and certain borrowings by banks and their affiliates, and the
limitation of interest rates which member banks may pay on deposits, are some of
the instruments of monetary policy available to the Federal Reserve Board. Taken
together, these controls give the Federal Reserve Board a significant influence
over the growth and profitability of all banks. Management of the Bank is unable
to predict how the Federal Reserve Board's monetary policies (or the fiscal
policies or economic controls imposed by Federal or state governments) will
affect the business and earnings of the Bank or the Corporation, or what those
policies or controls will be.
The references in this section to various aspects of supervision and
regulation are brief summaries which do not purport to be complete and which are
qualified in their entirety by reference to applicable laws, rules and
regulations.
Federal Deposit Insurance Corporation Improvement Act of 1991
The difficulties encountered nationwide by financial institutions
during 1990 and 1991 prompted federal legislation designed to reform the banking
industry and to promote the viability of the industry and of the deposit
insurance system. The Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDICIA"), which became effective on December 19, 1991, bolsters the
deposit insurance fund, tightens bank and thrift regulation and trims the scope
of federal deposit insurance as summarized below.
FDICIA requires each federal banking regulatory agency to prescribe, by
regulation, standards for all insured depository institutions and depository
institution holding companies relating to (i) internal controls, information
systems and audit systems; (ii) loan documentation;
13
(iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi)
compensation, fees and benefits; and (vii) such other operational and managerial
standards as the agency determines to be appropriate. The compensation standards
would prohibit employment contracts, compensation or benefit arrangements, stock
option plans, fee arrangements or other compensatory arrangements that provide
excessive compensation, fees or benefits or could lead to material financial
loss. In addition, each federal banking regulatory agency must prescribe by
regulation standards specifying (i) a maximum ratio of classified assets to
capital; (ii) minimum earnings sufficient to absorb losses without impairing
capital; (iii) to the extent feasible, a minimum ratio of market value to book
value for publicly traded shares of depository institutions and depository
institution holding companies; and (iv) such other standards relating to asset
quality, earnings and valuation as the agency determines to be appropriate. If
an insured institution fails to meet any of the standards promulgated by
regulation, then such institution will be required to submit a plan to its
federal regulatory agency specifying the steps it will take to correct the
deficiency.
Prompt corrective action measures adopted in FDICIA and which became
effective on December 19,1992, impose significant new restrictions and
requirements on depository institutions that fail to meet their minimum capital
requirements. Under Section 38 of the Federal Deposit Insurance Act ("FDI Act"),
the federal banking regulatory agencies have developed a classification system
pursuant to which all depository institutions are placed into one of five
categories based on their capital levels and other supervisory criteria: well
capitalized, adequately capitalized; undercapitalized; significantly
undercapitalized; and critically undercapitalized.
The Bank met the requirements at December 31, 2003 to be classified as
"well capitalized." This classification is determined solely for the purposes of
applying the prompt corrective action regulations and may not constitute an
accurate representation of the Corporation's overall financial condition.
An undercapitalized depository institution is required to submit a
capital restoration plan to its principal federal regulator. The federal banking
agencies may not accept a capital plan without determining, among other things,
that the plan is based on realistic assumptions and is likely to succeed in
restoring the depository institution's capital and is guaranteed by the parent
holding company. If a depository institution fails to submit an acceptable plan,
it will be treated as if it were significantly undercapitalized.
Unless its principal federal regulator has accepted its capital plan,
an undercapitalized bank may not increase its average total assets in any
calendar quarter. If an undercapitalized institution's capital plan has been
accepted, asset growth will be permissible only if the growth is consistent with
the plan and the institution's ratio of tangible equity to assets increases
during the quarter at a rate sufficient to enable the institutions to become
adequately capitalized within a reasonable time.
An institution that is undercapitalized depository institution may not
solicit deposits by offering rates of interest that are significantly higher
than the prevailing rates on insured deposits in the institution's normal market
areas or in the market area in which the deposits would otherwise be accepted.
An undercapitalized depository institution may not branch, acquire an
interest in another business or institution or enter a new line of business
unless its capital plan has been accepted and its principal federal regulator
approves the proposed action.
14
An insured depository institution may not pay management fees to any
person having control of the institution nor may an institution, except under
certain circumstances and with prior regulatory approval, make any capital
distribution if, after making such payment or distribution, the institution
would be undercapitalized.
Significantly undercapitalized depository institutions may be subject
to a number of requirements and restrictions, including orders to sell
sufficient voting stock to become adequately capitalized, requirements to reduce
total assets and cessation of receipt of deposits from correspondent banks.
Critically undercapitalized institutions are subject to appointment of a
receiver or conservator.
If its principal federal regulator determines that an adequately
capitalized institution is in an unsafe or unsound condition or is engaging in
an unsafe or unsound practice, it may require the institution to submit a
corrective action plan, restrict its asset growth and prohibit branching, new
acquisitions and new lines of business. An institution's principal federal
regulator may deem it to be engaging in unsafe or unsound practices if it
receives a less than satisfactory rating for asset quality, management, earnings
or liquidity in its most recent examination.
In addition, regulators were required to draft a new set of non-capital
measures of bank safety, such as loan underwriting standards and minimum
earnings levels, effective December 1, 1993. The legislation also requires
regulators to perform annual on-site bank examinations, place limits on real
estate lending by banks and tightens auditing requirements.
Section 36 of FDICIA significantly affects financial institutions with
more then $500 million in total assets. Highlands Union Bank will come under the
following provisions beginning in January of 2004.
Key FDICIA requirements include the following:
* Audit committees must be comprised of independent outside
directors--regardless of bank size.
* Institutions must have an adequate system of internal control
according to some generally accepted framework.
* Section I agreed-upon-procedures testing of compliance with
laws and regulations must be performed by either internal
audit or the entity's independent public accountants.
* Section II agreed-upon-procedure testing of compliance with
laws and regulations must be performed by the entity's
independent public accountant if management elected to have
internal auditors perform Section I agreed-upon procedures.
* Management must perform its own investigation and review of
the effectiveness of internal controls and compliance with
laws.
* A management report must be submitted and signed by the chief
executive officer and chief accountant (or chief financial
officer), which states management's responsibility for the
internal control system, an assessment of the
15
effectiveness of the system at fiscal year-end, and an
assessment of compliance with laws and regulations during the
fiscal year.
* An independent public accountant's report that attests to
management's assertions concerning the bank's internal control
and procedure for financial reporting is required.
Federal and State Taxation
General
The following discussion of federal taxation is a summary of certain
pertinent federal income tax matters as they pertain to the Corporation. With
some exceptions, including particularly the reserve for bad debts discussed
below, the Corporation is subject to federal income tax under the Internal
Revenue Code of 1986 (the "Code") in the same general manner as other
corporations.
Bad Debt Reserves
Commercial banks such as the Bank, which meet certain definitional
tests primarily relating to their assets and the nature of their businesses, are
permitted to establish a reserve for bad debts and to make annual additions to
the reserve. These additions, may within specified formula limits, be deducted
in arriving at the Bank's taxable income. For purposes of computing the
deductible addition to its bad debt reserve, the Bank utilizes the experience
method.
Under the experience method, the deductible annual addition is the
amount necessary to increase the balance of the reserve at the close of the
taxable year to the greater of (1) the amount which bears the same ratio to
loans outstanding at the close of the taxable year as the total net bad debts
sustained during the current and five preceding taxable years bears to the sum
of the loans outstanding at the close of those six years or (2) the lower of (a)
the balance in the reserve account at the close of the last taxable year prior
to the most recent adoption of the experience method (the base year is the last
taxable year beginning before 1988), or (b) if the amount of loans outstanding
at the close of the taxable year is less than the amount of loans outstanding at
the close of the base year, the amount which bears the same ratio to loans
outstanding at the close of the taxable year as the balance of the reserve at
the close of the base year bears to the amount of loans outstanding at the close
of the base year.
The Bank has become subject to the direct charge-off method of writing
off bad debts since it has reached $500 million in total assets. The Bank has
elected to remove equal amounts of its tax reserve over a four year period
beginning with year end 2003.
Other
For federal income tax purposes, the Corporation reports its income and
expenses on the accrual basis method of accounting and uses a year ending
December 31 for filing its income tax returns. The Corporation may carry back
net operating losses to the preceding two taxable years and forward to the
succeeding twenty taxable years.
The Commonwealth of Virginia imposes an income tax on corporations
domiciled in the state. The Virginia taxable income is based on the federal
taxable income with certain adjustments for interest and dividend income on
obligations of securities of the United States and
16
states other than Virginia. The tax rate is 6% of taxable income of the
Corporation, exclusive of the Bank and its subsidiaries. The State of Virginia
assesses a Bank Franchise Tax for Banks located in the Commonwealth. The rate is
1% of capital subject to certain deductions and additions. The majority of the
tax is paid back to the Virginia localities in which the Bank operates. The
State of North Carolina imposes a state income tax while Tennessee assesses a
combined Franchise / Excise Tax.
See Note 7 to the Consolidated Financial Statements, included as part
of the Annual Report to Shareholders, for additional information regarding the
income taxes of the Company.
17
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and
Interest Differential
Year Ended December 31,
2003 2002 2001
(Dollars in Thousands)
Interest Interest Interest
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate Balance Expense Rate
------- ------- ---- ------- ------- ---- ------- ------- ----
ASSETS
Interest earning assets
(taxable-equivalent basis)
Loans (net of unearned
discount (2) $359,187 $ 24,893 6.93% $335,823 $ 26,095 7.77% $309,753 $ 27,574 8.90%
Securities (1)(3) 115,313 4,495 4.87 99,768 4,758 5.52 87,254 5,107 6.40
Federal funds sold 7,757 75 0.97 5,544 91 1.64 9,133 317 3.47
-------- ------- ---- -------- ------- ---- -------- -------- ----
Total interest-earning
assets $482,257 $29,463 6.34% $441,134 $30,944 7.18% $406,140 $ 32,998 8.24%
-------- ------- ---- -------- ------- ---- -------- -------- ----
LIABILITIES
Interest bearing
liabilities
Interest bearing dep. $380,229 $ 10,335 2.72% $343,900 $ 11,768 3.42% $322,847 $ 16,740 5.19%
Other interest bearing
liabilities 41,119 2,542 6.18 38,783 2,498 6.44 31,117 2,146 6.90
-------- ------- ---- -------- ------- ---- -------- -------- ----
Total interest-bearing
liabilities $421,348 $12,877 3.06% $382,683 $14,266 3.73% $353,964 $ 18,886 5.34%
-------- ------- ---- -------- ------- ---- -------- -------- ----
Net interest income. $16,586 $16,678 $ 14,112
Net margin on interest
earning assets on a
tax equivalent basis 3.67% 3.95% 3.59%
Average interest spread 3.29% 3.45% 2.90%
(1) Tax equivalent adjustments (using 34% federal tax rates) have been made in
calculating yields on tax-free investments. Virginia banks are exempt from
state income tax.
(2) For the purposes of these computations, non-accruing loans are included in
the daily average loan amounts outstanding.
(3) The yield on securities classified as available for sale is computed based
on the average balance of the historical amortized cost balance without the
effects of the fair value adjustment required by FAS 115.
18
As the largest component of income, net interest income represents the
amount that interest and fees earned on loans and investments exceed the
interest costs of funds used to support these earning assets. Net interest
income is determined by the relative levels, rates and mix of earning assets and
interest-bearing liabilities. The following table attributes changes in net
interest income either to changes in average volume or to changes in interest
rates. Dollar changes have been allocated to volume and rate changes in
proportion to the relationship of the absolute dollar amounts of the change in
each.
Increase/(Decrease) Due to Volume and Rate
2003 Compared to 2002 2002 Compared to 2001
Increase Increase Increase Increase
(decrease) due (decrease) due (decrease) due (decrease) due
to change in to change in Net increase to change in to change in Net increase
Increase (Decrease) in volume rate (decrease) volume rate (decrease)
- ---------------------- ------ ---- ---------- ------ ---- ----------
(Dollars in Thousands)
INTEREST INCOME
Securities $ 483 $ (756) $ (263) $ 800 $(1,149) $ (349)
Federal funds sold 21 (37) (16) (125) (101) (226)
Loans 1,619 (2,821) (1,202) 2,000 (3,479) 1,479)
------- ------- ------- ------- ------- -------
Total Income Change $ 2,123 $(3,604) $(1,481) $ 2,675 $(4,729) $(2,054)
------- ------- ------- ------- ------- -------
INTEREST EXPENSE
Savings and time deposits $ 988 $(2,420) $(1,433) $ 1,091 $(6,063) $(4,972)
Other interest-bearing
liabilities 144 (101) 43 528 (177) 351
------- ------- ------- ------- ------- -------
Total Expense Change $ 1,132 $(2,521) $(1,390) $ 1,619 $(6,240) $(4,621)
------- ------- ------- ------- ------- -------
Increase (Decrease) in
Net Interest Income $ 991 $(1,083) $ (92) $ 1,056 $ 1,511 $ 2,567
------- ------- ------- ------- ------- -------
Investment Portfolio
The Corporation categorizes investments into three groups and further provides
for the accounting and reporting treatment of each group. Investments may be
classified as held-to-maturity, available-for-sale or trading. The Corporation
does not purchase or hold any investment securities for the purpose of trading
such investments. At December 31, 2003 the entire investment portfolio of the
Corporation was classified as available-for-sale. The following table sets forth
the book values and carrying values of the investment portfolio as of December
31:
2003 2002 2001
Book Carrying Book Carrying Book Carrying
Value Value Value Value Value Value
--------------------- ------------------- -------------------
Available-for-sale securities:
U.S Government agencies and corporations $ 3,247 $ 3,262 $ - $ - $ 501 $ 502
State and political subdivisions 48,275 48,631 29,824 30,719 24,378 24,305
Mortgage-backed securities 53,583 53,474 57,052 57,730 62,309 62,767
Other Securities 17,231 16,697 14,335 14,294 10,775 10,725
----------- ---------- ---------- ---------- ---------- ----------
$122,336 $122,064 $101,211 $102,743 $ 97,963 $ 98,299
=========== ========== ========== ========== ========== ==========
19
The following table presents the maturity distribution, market value,
amortized cost and approximate tax equivalent yield (assuming a 34% federal
income tax rate) of the investment portfolio at December 31, 2003.
(Dollars in Thousands)
One Year Five Years
Within One Through Through After Ten Market Amortized
Year Five Years Ten Years Years Yield Value Cost
---------- ---------- --------- --------- ----- ------ ---------
Mtg.-backed Sec - fixed rate $ 55 $ 78 $ 5,546 $ 2,709 4.51% $ 8,388 $ 8,307
Mtg.-backed Sec - variable rate - - - 45,086 3.13 45,086 45,277
State & Muni's - tax exempt - - 1,002 46,618 6.76 47,620 47,289
State & Muni's - taxable 1,010 - - - 7.37 1,010 986
U.S. Agencies - fixed rate - 756 1,002 1,002 4.03 2,760 2,750
U.S. Agencies - variable rate - - - 503 7.64 503 497
Agency Preferred - fixed rate - - - 1,385 4.98 1,385 1,505
Agency Preferred - variable rate 870 - - 8,088 3.27 8,958 9,403
Corporate bonds - fixed rate - - - 1,067 8.92 1,067 1,000
Corporate bonds - variable rate - - - 3,898 3.25 3,898 3,932
Asset-backed - variable rate - - 988 - 2.10 988 988
SBA bonds - variable rate - - - 356 1.48 356 358
CMO's - variable rate - - - 45 3.36 45 44
-------- -------- -------- -------- ------- -------- --------
TOTAL $ 1,935 $ 834 $ 8,538 $110,757 4.65 $122,064 $122,336
======== ======== ======== ======== ======= ======== ========
Loan Portfolio
The table below classifies gross loans by major category and percentage
distribution at December 31, 2003 for each of the past five years:
December 31,
(Dollars in thousands)
2003 2002 2001 2000 1999
Amount Percentage Amount Percentage Amount Percentage Amount Percentage Amount Percentage
------ ---------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
Real Estate Secured:
Residential 1-4 family $141,693 37.49% $ 128,462 37.82% $114,556 35.18% $102,631 35.14% $ 94,356 36.04%
Multi-family 2,651 0.70 3,383 1.00 3,011 0.92 3,909 1.34 3,072 1.17
Commercial, Construction
and Land Development 113,146 29.93 85,468 25.16 80,673 24.77 61,666 21.11 53,893 20.58
Second Mortgages 6,976 1.85 11,676 3.43 7,737 2.38 5,342 1.83 4,199 1.60
Equity Line of Credit 7,430 1.96 5,253 1.54 4,166 1.28 3,455 1.18 3,536 1.35
Farmland 4,483 1.28 5,589 1.65 5,055 1.56 4,928 1.69 4,403 1.68
--------- ------ --------- ------ -------- ------ -------- ------ -------- ------
$ 276,739 73.21% $ 239,831 70.60% $215,208 66.09% $181,931 62.29% $163,459
62.42%
Secured, Other:
Personal $ 48,637 12.87% $ 49,483 14.57% $60,532 18.59% $63,137 21.62% $60,492 23.10%
Commercial 27,247 7.21 26,043 7.67 26,002 7.98 26,463 9.05 18,226 6.97
Agricultural 4,506 1.19 4,209 1.23 3,274 1.01 2,498 0.86 2,408 0.92
--------- ------ --------- ------ -------- ------ -------- ------ -------- ------
$ 80,390 21.27% $ 79,735 23.47% $89,808 27.58% $92,098 31.53% $81,126 30.99%
Unsecured: $ 20,868 5.52% $ 20,135 5.93% $20,614 6.33% $18,059 6.18% $17,258 6.59%
--------- ------ --------- ------ -------- ------ -------- ------ -------- ------
Loans, gross $ 377,997 100.00% $ 339,701 100.00% $325,630 100.00% $292,088 100.00% $261,843 100.00%
--------- ------ --------- ------ -------- ------ -------- ------ -------- ------
20
The following table shows the maturity of loans outstanding, inclusive of
contractual amortization as of December 31, 2003.
December 31, 2003
(Dollars in Thousands)
Within One After One But After Five
Year Within Five Years Years
---- ----------------- -----
Fixed Floating Fixed Floating Fixed Floating
Rate Rate Rate Rate Rate Rate Total
---- ---- ---- ---- ---- ---- -----
Real Estate Secured:
Residential 1-4 family $ 6,533 $ 4,279 $22,692 $ 10,667 $23,161 $74,361 $ 141,693
Multi-family 160 0 1,867 0 624 0 2,651
Commercial, Construction &
Land Development 14,074 16,481 58,147 3,677 13,730 7,037 113,146
Second Mortgages 1,345 600 2,433 110 1,750 738 6,976
Equity Line of Credit 0 588 0 2,667 0 4,175 7,430
Farmland 740 649 2,837 74 514 29 4,843
Secured, Other:
Personal 14,953 139 31,609 0 2,694 0 49,395
Commercial 7,169 6,464 11,148 1,298 408 0 26,487
Agricultural 661 2,674 1,056 74 43 0 4,508
Unsecured 7,370 10,190 2,278 942 88 0 20,868
-------- -------- -------- -------- -------- -------- --------
Loans, Gross $ 53,005 $ 42,064 $134,067 $ 19,509 $ 43,012 $ 86,340 $377,997
-------- -------- -------- -------- -------- -------- --------
Non-performing loans
The loan portfolio of the Bank is reviewed regularly by senior officers
to evaluate loan performance. The frequency of the review is based on a rating
of credit worthiness of the borrower utilizing various factors such as net
worth, credit history, customer relationship, etc. The evaluations emphasize
different factors depending upon the type of loan involved. Commercial and real
estate loans are reviewed on the basis of estimated net realizable value through
an evaluation of collateral and the financial strength of the borrower.
Installment loans are evaluated largely on the basis of delinquency data because
of the large number of such loans and relatively small size of each individual
loan.
Management's review of commercial and other loans may result in a
determination that a loan should be placed on a non-accrual of interest basis.
It is the policy of the Bank to discontinue the accrual of interest on any loan
on which full collectability of principal and / or interest is doubtful.
Subsequent collection of interest is recognized as income on a cash basis upon
receipt. Placing a loan on non-accrual status for the purpose of income
recognition is not in itself a reliable indication of potential loss of
principal. Other factors, such as the value of the collateral securing the loan
and the financial condition of the borrower, serve as more reliable indications
of potential loss of principal.
The policy of the Bank is that non-performing loans consist of loans
accounted for on a non-accrual basis and loans which are contractually past due
90 days or more in regards to interest and/ or principal payments. As of the
five periods ended December 31, 2003, 2002, 2001, 2000 and 1999 non-performing
loans amounted to $4,521,000 $2,606,000, $2,063,000, $1,502,000 and $1,641,000,
respectively. As of the five periods ended December 31, 2003, 2002, 2001, 2000
and 1999 non-accrual loans amounted to $3,723,000, $1,728,000, $1,159,000,
$586,000 and $559,000, respectively. As of the five periods ended December 31,
2003, 2002, 2001, 2000 and 1999 loans past-due 90 days and more amounted to
$802,000, $891,000, $950,000, $916,000 and $1,082,000, respectively. Interest
income lost
21
on non-accruing loans was approximately $234,731, $104,000, $73,000, $121,000
and $136,000 for the years ended December 31, 2003, 2002, 2001, 2000 and 1999,
respectively. Interest income realized on loans past-due 90 days and more and
still accruing was approximately $15,000, $18,000, $15,000, $17,000 and $10,000
for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively.
Summary of Loan Loss Experience
The allowance for loan losses is increased by the provision for loan
losses and reduced by loans charged off net of recoveries. The allowance for
loan losses is established and maintained at a level judged by management to be
adequate to cover any anticipated loan losses to be incurred in the collection
of outstanding loans. In determining the adequate level of the allowance for
loan losses, management considers the following factors: (a) loan loss
experience; (b) problem loans, including loans judged to exhibit potential
charge-off characteristics, loans on which interest is no longer being accrued,
loans which are past due and loans which have been classified in the most recent
regulatory examination; and (c) anticipated economic conditions and the
potential impact these conditions may have on individual classifications of
borrowers.
The following table presents the Corporation's loan loss experience for
the past five years:
Years Ended December 31,
(Dollars in Thousands)
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Allowance for loan losses at
beginning of year $ 3,877 $ 3,418 $ 2,950 $ 2,494 $ 2,008
Loans charged off:
Commercial 299 389 107 69 357
Real Estate - mortgage 270 94 10 0 27
Consumer 1,211 1,043 1,087 925 710
Other 0 0 0 0 0
-------- -------- -------- --------- --------
Total $ 1,780 $ 1,526 $ 1,204 $ 994 $ 1,094
-------- -------- -------- --------- --------
Recoveries of loans previously charged off:
Commercial $ 8 $ 5 $ 3 $ 6 $ 97
Real Estate - mortgage 0 0 0 0 0
Consumer 116 155 221 167 65
Other 0 0 0 0 0
-------- -------- -------- --------- --------
Total $ 124 $ 160 $ 224 $ 173 $ 162
-------- -------- -------- --------- --------
Net loans charged off $ 1,656 $ 1,366 $ 980 $ 821 $ 932
-------- -------- -------- --------- --------
Provision for loan losses 2,053 1,825 1,448 1,277 1,418
-------- -------- -------- --------- --------
Allowance for loan losses end of year $ 4,274 $ 3,877 $ 3,418 $ 2,950 $ 2,494
-------- -------- -------- --------- --------
Average total loans (net of unearned income) $359,187 $335,823 $309,753 $ 277,115 $246,687
Total loans (net of unearned income) at year-end $377,808 $339,521 $325,460 $ 291,897 $261,678
Ratio of net charge-offs to average loans 0.461% 0.407% 0.316% 0.296% 0.378%
Ratio of provision for loan losses to average loan 0.572% 0.543% 0.467% 0.461% 0.575%
Ratio of provision for loan losses to net charge-off 123.973% 133.602% 147.755% 155.542% 152.146%
Allowance for loan losses to year-end loans 1.131% 1.142% 1.050% 1.011% 0.953%
22
Allocation of the allowance for loan losses
The following table provides an allocation of the allowance for loan
losses as of December 31, 2003, 2002, 2001, 2000 and 1999.
Year Ended December 31,
Percent of Loans on each Category
(Dollars in Thousands)
2003 2002
Allowance for Percentage of Percentage of Allowance for Percentage of Percentage of
Loan Loss Total Loan Loss Total Loans Loan Loss Total Loan Loss Total Loans
--------- --------------- ----------- --------- --------------- -----------
Commercial $ 830 19.42% 10.37% $ 972 25.06% 10.87%
Real Estate 224 5.24 73.25 228 5.89 70.60
Consumer 3,220 75.34 15.08 2,672 68.93 17.05
Other 0 0.00 1.30 5 0.12 1.48
------- ------ ------ ------- ------ ------
Total $ 4,274 100.00% 100.00% $ 3,877 100.00% 100.00%
------- ------ ------ ------- ------ ------
2001
Allowance for Percentage of Percentage of
Loan Loss Total Loan Loss Total Loans
--------- --------------- -----------
Commercial $ 857 25.06% 7.98%
Real Estate 201 5.89 66.09
Consumer 2,356 68.93 24.92
Other 4 0.12 1.01
------- ------ ------
Total $ 3,418 100.00% 100.00%
------- ------ ------
2000 1999
Allowance for Percentage of Percentage of Allowance for Percentage of Percentage of
Loan Loss Total Loan Loss Total Loans Loan Loss Total Loan Loss Total Loans
--------- --------------- ----------- --------- --------------- -----------
Commercial $ 739 25.06% 12.52% $ 625 25.06% 10.34%
Real Estate 174 5.89 62.29 147 5.89 62.42
Consumer 2,033 68.93 24.09 1,719 68.93 26.01
Other 4 0.12 1.10 3 0.12 1.23
------ ------ ------ ------ ----- -----
Total $ 2,950 100.00% 100.00% 0 0 0
------ ------ ------ ------ ----- -----
23
Deposits
The following table provides a breakdown of deposits at December 31 for
the years indicated:
December 31,
(Dollars in Thousands)
2003 2002 2001
---- ---- ----
Non-interest bearing demand deposits $ 59,057 $ 55,597 $ 50,248
Interest bearing demand deposits 64,048 49,519 37,464
Savings deposits 80,764 70,258 60,166
Time deposits 246,140 234,927 244,215
-------- -------- --------
Total Deposits $450,009 $410,301 $392,093
======== ======== ========
The average daily amount of deposits and rates paid on such deposits
is summarized for the periods indicated in the following table:
Year Ended December 31,
(Dollars in Thousands)
2003 2002 2001
---- ---- ----
Amount Rate Amount Rate Amount Rate
------ ---- ------ ---- ------ ----
Non-interest bearing
demand deposits $ 59,110 0.00% $54,979 0.00% $47,271 0.00%
Interest-bearing demand
deposits 58,764 1.40 43,537 1.76 29,003 2.80
Savings deposits 77,470 1.55 65,790 2.07 52,655 3.38
Time deposits 243,995 3.41 234,573 4.11 241,190 5.85
-------- --------- ---------
Total $439,339 $ 398,879 $ 370,119
-------- --------- ---------
The remaining maturities of time deposits greater than $100,000 at
December 31, 2003 are as follows (in thousands) :
Maturity
3 months or less....................................$ 12,599
3 months through 6 months........................... 13,204
Over 3 through 12 months............................ 16,092
Over 12 months...................................... 27,909
------
Total $ 69,804
------
Interest Rate Sensitivity Analysis
Interest rate risk refers to the exposure of the Corporation's earnings
and market value of equity ("MVE") to changes in interest rates. The amount of
change in net interest income and MVE resulting from shifts in interest rates is
determined by contractual maturity of fixed rate instruments, the repricing date
for variable rate instruments, competition and customer reactions.
24
The Corporation runs simulation models through a range of positive and
negative interest rate movements to determine the effect these shifts in
interest rates would have on the market value of the Corporation's equity. The
market value is determined by applying a discount rate to the Corporations
interest-earning assets and interest-bearing liabilities, that are not carried
at market value, based on current rate levels at the time the model is run and
calculating the present value of future cash flows.
There are several common sources of interest rate risk that must be
effectively managed to maintain minimal impact on the Corporation's earnings and
capital. Repricing risk comes largely from timing differences in the pricing of
interest-earning assets and interest-bearing liabilities. Reinvestment risk
refers to the reinvestment of cash flows from interest and principal payments
and maturing assets at lower or higher rates. Basis risk arises when different
yield curves or pricing indices do not change at precisely the same moment in
time or magnitude so that earning assets and interest-bearing liabilities with
the same maturity are not affected equally. Yield curve risk refers to unequal
movements in short-term and long-term interest rates.
The following table provides the maturities of investment securities,
loans, and deposits as of December 31, 2003, and measures the interest rate
sensitivity gap for each range of maturity indicated: The amounts below also
reflect various prepayment assumptions.
December 31, 2003
(Dollars in Thousands)
Maturing
Within One After One But After Five
Year Within Five Years Years Total
---- ----------------- ----- -----
ASSETS
Interest-bearing
Investment Securities $ 50,761 $ 7,044 $ 67,159 $124,964
Fed Funds Sold 389 0 0 389
Loans 195,074 160,682 22,052 377,808
Other interest-bearing assets 0 0 7,929 7,929
Noninterest-bearing
Other Assets 0 0 32,326 32,326
-------- -------- -------- --------
Total Assets $246,224 $167,726 $129,466 $543,416
-------- -------- -------- --------
LIABILITIES AND SHARE-
HOLDERS' EQUITY
Interest-bearing
(1) All Interest-bearing Deposits $290,154 $ 94,611 $ 6,187 $390,952
Other Interest-bearing Liab. 16,035 39,459 235 55,729
Noninterest-bearing
Demand Deposit Non-Interest 0 0 59,057 59,057
Other Liabilities 2,244 0 0 2,244
Shareholders' Equity 0 0 35,434 35,434
-------- -------- -------- --------
Total Liabilities and
Shareholders' $308,433 $134,070 $ 100,913 $543,416
-------- -------- -------- --------
Equity
Interest Rate Sensitivity GAP $(62,209) $ 33,656 $ 28,552 $ 0
(1) For purposes of this schedule, the Corporation includes 100% of its
statement savings, NOW and MMDA's in the one year column.
25
Asset Liability Management
The Corporation's primary objectives for asset and liability management
are to establish internal controls and procedures that will result in managing
interest rate risk, liquidity management, capital planning, asset mix and volume
control, and loan and deposit pricing. The Asset and Liability Committee (ALCO)
is headed by the CEO and includes management personnel from the different areas
of the Bank. The Committee meets on a monthly basis.
Interest rate risk refers to the exposure of the Corporation's
earnings to changes in interest rates. There are several sources of interest
rate risk that must be effectively managed if there is to be minimal impact on
the Corporation's earnings and capital.
Repricing risk arises from timing differences in the repricing of
assets and liabilities. Reinvestment risk refers to the ability, or lack
thereof, to reinvest cash flows of maturing assets at lower or higher rates.
In determining the appropriate level of interest rate risk, the ALCO
reviews the changes in projected net interest income subject to various changes
in interest rates. To help effectively measure interest rate risk, the ALCO
utilizes rate sensitivity and simulation analysis to determine the impact on net
interest income as well as the changes in the Economic Value of Equity.
Simulation analysis is used to subject or "shock" the current repricing and
maturing amounts to rising and falling interest rates. Rate change increments of
1% and 2% up and down are used in the monthly simulation analysis. Loan and
investment security prepayments are estimated using current market information.
The following table shows the estimated cumulative impact on net interest
income for the next 12 months as of December 31, 2003, subject to the specified
interest rate changes. For purposes of this schedule the Corporation used a
parallel rate shock on its interest earning assets and interest bearing
liabilities. A parallel rate shock means that a 100 basis point increase in the
rate index (prime rate) would result in an immediate 100 basis point increase on
interest earning assets and interest bearing liabilities subject to the interest
rate reset date. The Corporation uses a 50 basis point slope for its
computation. The slope is the number of basis points per month that an index can
increase or decrease until it reaches the target rate.
Rate change increment % change in net interest income $ change in net
interest income
Up 1% -3.59% $ -686,000
Up 2% -6.57% $ -1,255,000
Down 1% 3.98% $ 761,000
Down 2% 1.59% $ 304,000
Liquidity
Liquidity is the measure of the Bank's ability to generate sufficient
funds in order to meet customers' demands for withdrawal of deposit balances and
for the funding of loan requests. The Bank
26
maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and
has sufficient flow of funds from investment security payments as well as loan
payments to meet current liquidity needs.
Management of the Bank continuously monitors and plans the Bank's
liquidity position for the future. Liquidity is provided from cash and due from
banks, federal funds sold, loan and investment security payments, core deposits,
the national certificate of deposit market, lines of credit with correspondent
banks and lines of credit with the Federal Home Loan Bank, Management believes
that these sources of funds provide sufficient and timely liquidity for the
foreseeable future.
The Bank's major source of funding and liquidity is derived from its
deposit base. The mix of the deposit base (demand deposits, statement savings,
certificates of deposit, money market and interest checking) is constantly
subject to change. During 2003, as reflected in the Consolidated Balance Sheets,
the deposit mix changed with an increase in non-interest bearing demand deposits
of $3.5 million, an increase in interest-bearing NOW and Money Market deposits
of $14.5 million, an increase in statement savings deposits of $10.5 million and
a increase in total time deposits of $11.2 million. During 2003 total deposits
increased $39.7 million.
The Bank had approximately $122.1 million in investment securities at
December 31, 2003. The Bank utilizes its investment portfolio as a secondary
form of liquidity. Management has designated $122.1 million of the investment
portfolio as available for sale under the requirements of FAS 115. Under this
designation, the Bank has the ability to sell any of these available for sale
securities to meet extraordinary liquidity needs without negative impact to the
financial position or results of operations. The Bank has $113.1 million of
unencumbered securities available as a secondary source of liquidity.
The Consolidated Statements of Cash Flows appearing in the financial
statements of the Corporation reflects a net decrease in cash and cash
equivalents of $3.6 million over the comparable 2002 period. This decrease was
greatly due to the bank's increase in loans and investment securities.
Liquidity strategies are implemented and monitored on a daily basis by
the Corporation's Asset Liability Committee. The Committee uses a simulation
model to assess future liquidity needs of the Corporation and to manage the
investment of funds. The Committee meets formally on a monthly basis.
Contractual Obligations
Listed below are the contractual obligation of the Corporation and
Subsidiaries at December 31, 2003 aggregated by type and due date. Optional call
date provisions are reflected in the table below.
Less than One to Three Three to Five More Than
Total one year Years Years Five Years
Long-term debt obligations $16,429 $ 44 $ 98 $16,111 $ 176
Operating lease obligations 57 42 - -
Purchase obligations 224 224 - - -
Other long-term liabilities
reflected on the Company's
balance sheet 6,300 - - 6,300 -
The Corporation does not have any capital lease obligations, as
classified under applicable FASB statements.
27
Return on Equity and Assets
The following table highlights certain ratios for the periods
indicated:
Year Ended December 31,
(Percentage)
2003 2002 2001
---- ---- ----
Net income to:
Average total assets 0.87 0.87 0.77
Average shareholders' equity 13.27 13.82 12.78
Divided payout ratio (dividends declared per
share divided by net income per share) 5.87 5.81 6.39
Average shareholders' equity to average total
assets ratio 6.59 6.32 6.00
Item 2. Properties
The Corporation's and the Bank's main offices are located at 340 W.
Main Street, Abingdon, Virginia. The main office is a two-story brick and stucco
structure owned by the Bank. The Bank utilizes the entire structure for its
day-to-day operations. Attached to the main office is a four-lane drive thru
facility constructed in 1998. The new drive thru replaced an older unit that was
detached from the main office's structure. The main office opened for operations
in 1985. In addition, the Bank has three other branch locations within
Washington County, Virginia.
The East Abingdon branch is a one story brick facility located at 24412
Maringo Road that operates as a full service branch. The branch was completed
and opened for operation in 1993.
The West Abingdon location was expanded during 2003 from an "express
facility", containing four drive thru lanes and a walk-up window, to a full
service branch. The West Abingdon Express branch was completed and opened for
operations in 1994 and is located at Exit 14, I-81, Jonesboro Road, Abingdon,
Virginia.
During 1998, the Bank constructed and placed in service a two-story
brick building located at 506 Maple Avenue, Glade Spring, Virginia. The Glade
Spring Office is a full service location with four drive thru lanes.
The Bank also has two full service branch locations within the City
of Bristol, Virginia. The East Bristol office is located at 999 Old Airport
Road, Bristol, Virginia. This is a two story brick building with interior
customer loan and deposit areas as well as a four lane drive thru unit. The
office was completed and opened for operations in 1988.
The Commonwealth office is located at 821 Commonwealth Avenue, Bristol,
Virginia. This is a two story block building with full service customer service
areas and a four lane drive thru facility. The Bank also operates its dealer
finance division out of the Commonwealth office. This office was completed and
opened for operations in 1995.
The Bank also has a full service branch at 1425 North Main Street,
Marion, Virginia. The branch was placed in service in December of 1997. It is a
two story brick building and operates as a full service branch. The Marion
office has four drive thru lanes and a drive-up ATM. The Bank also owns a vacant
28
lot, located approximately 1/2 mile from the branch on North Main Street, that
originally had a drive-up ATM on location. The ATM was relocated to the Marion
branch during 2001. This property is free of all liens.
All of the Bank's branch locations have an on-premises ATM. All branch
properties, except for the Boone, North Carolina branch office, are owned by the
Bank and are free of liens. In September 1998, the Bank acquired the adjacent
building to its Commonwealth office to facilitate future expansion. This is a
one story brick structure, located at 801-805 Commonwealth Avenue, Bristol,
Virginia and is currently leased. A note payable to the sellers was executed and
is secured by a first deed of trust. The note was paid in full in 2003.
Also during 1998, the Bank initiated an off premises ATM program. This
program has continued to expand to include 28 offsite ATMs purchased and
installed throughout the Bank's market areas. Six machines are placed in
Bristol, Virginia; one is installed in Bristol, Tennessee; ten are installed in
Washington County, Virginia; two in Russell County, Virginia; six in Smyth
County, Virginia, one in Wythe County, Virginia, one in Banner Elk, North
Carolina and one in Boone, North Carolina. All machines are free of liens.
During 1999 the Bank purchased a building, across from the Main Office
in Abingdon, to provide for expansion of the Bank's operations. The building is
a brick and frame structure that is being used to house the Bank's Financial
Services Department, the Collections Department, the Bank's credit card, Human
Resources department, Customer Call Center, Check Card and ATM Card Operations
department, Security and Facilities department as well as the Bank's Check
Printing Department. The office space not currently being used by the Bank is
being leased to one other business. This property is free of any liens.
On September 23, 2000, the Bank closed on the purchase of a branch
office of a bank in Rogersville, Tennessee. This purchase included approximately
$3.9 million of deposit accounts, $54,000 of overdraft protection accounts,
$7,000 of specified furniture and equipment and approximately $639,000 for the
building and real estate. The branch office is a one-story masonry and concrete
structure constructed in 1985. The branch is located at 410 Highway 66 South in
Rogersville, Tennessee. This building is being used as a Highlands Union Bank
full service facility with two drive-thru lanes and a drive-up ATM.
The Bank also purchased a tract of land located off of Highway 11W in
Bristol, Tennessee, known as Bristol West Development, for future expansion. The
land is approximately 1/2 acre and is currently zoned for commercial use. This
property is free of any liens.
During 2000 the Bank began construction of a two-story brick building
in Boone, North Carolina that opened as a full service branch of the Bank in
January of 2001. The Seller of this property originally financed $250,000 of the
purchase price of the land. The balance of this note as of December 31, 2003 was
approximately $179,000.
The Corporation acquired a commercial building during 1997 that is
located at 266 West Plumb Alley, Abingdon, Virginia. The building is a two story
concrete structure that was originally constructed by another bank for use as an
operations center. During 1997, the Corporation entered into a leasing
arrangement with its subsidiary to lease the first floor to be used for its
operations center. This lease was expanded to include the second floor of the
building that was renovated during 2001. During 2001, the Corporation renovated
the second floor of this building and it currently houses the Bank's electronic
data processing operations, bookkeeping operations, proof operations and
electronic banking operations. The West Plumb Alley property is free of liens.
During 1998, the Corporation purchased the adjacent property to the operations
center. The property purchased is a one story brick structure that currently
29
houses the Corporation's technology department. It is management's intention to
utilize the property as growth continues. The property is owned free and clear
of all liens.
During 2003 the Bank completed construction and opened a full service
branch office located on Highway 394 in Blountville, Tennessee. This Branch is a
two story brick building and operates as a full service branch office. There are
three drive thru lanes and a drive-up ATM. This property is free of all liens.
During 2003, the Bank purchased a piece of property in Banner Elk,
North Carolina and began construction of a full-service one story branch bank.
The purchase price of the property was $520,000 of which $250,000 was a note
financed by the seller. The branch is expected to open in February 2004.
All of the Corporation's properties are in good operating condition
and are adequate for the Corporation's present and anticipated future needs.
Item 3. Legal Proceedings
The Corporation is not involved in any pending legal proceedings, other
than non-material legal proceedings undertaken in the ordinary course of
business.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during
the quarter ended December 31, 2003.
Part II.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
There is no established trading market for the stock of Highlands
Bankshares, Inc. At March 10, 2004, the Corporation had approximately 1,275
shareholders of record. The Corporation acts as its own registered Stock
Transfer Agent, without charging a transfer fee, ensuring that all applicable
federal guidelines relating to stock transfers are enforced.
The Corporation maintains a list of individuals who are interested in
purchasing its common stock and connects these people with shareholders who are
interested in selling their stock. These parties negotiate the per share price
independent of the Corporation. The stock transfer agent of the Corporation
attempts to keep a record of what the stock sales are trading at by asking the
parties about the trade price per share. Please refer to the table below
entitled Common Stock Performance for a breakdown of the trades for the four
quarters of 2003 and 2002. It is the opinion of management that this range
accurately reflects the market value of the Corporation's common stock for the
periods presented.
Common Stock Performance-December 31, 2003
High Low Quarterly Average
---- --- -----------------
First Quarter $26.00 $26.00 $26.00
Second Quarter $26.00 $26.00 $26.00
Third Quarter $27.00 $26.00 $26.07
Fourth Quarter $28.00 $27.00 $27.99
30
Common Stock Performance-December 31 2002
High Low Quarterly Average
---- --- -----------------
First Quarter $25.50 $25.00 $25.47
Second Quarter $26.00 $24.00 $25.26
Third Quarter $26.00 $25.50 $25.93
Fourth Quarter $26.00 $26.00 $26.00
The Corporation's Board of Directors determines whether to declare
dividends and the amount of any dividends declared. Such determinations by the
Board take into account the Corporation's financial condition, results of
operations, and other relevant factors. The declaration, amount and timing of
future dividends will be determined by the Board of Directors after a review of
the Corporation's operations and will be dependent upon, among other factors,
the Corporation's income, operating costs, overall financial condition, capital
requirements and upon general business conditions. The Corporation declared and
paid annual cash dividends of $265,000 or $0.10 per share during 2003 and
$238,000 in cash dividends or $0.09 per share during 2002. The Corporation's
principal asset is its investment in the Bank, a wholly owned consolidated
subsidiary. The primary source of income for the Corporation historically has
been dividends from the Bank. Regulatory agencies limit the amount of funds that
may be transferred from the Bank to the Corporation in the form of dividends,
loans or advances. The Bank paid $1.2 million in dividends to the Corporation in
2003.
Under applicable laws and without prior regulatory approval, the total
dividend payments of the Bank in any calendar year are restricted to the net
profits of that year, as defined, combined with the retained net profits for the
two preceding years. The total dividends that may be declared in 2003 without
regulatory approval totals $9.8 million plus year-to-date 2004 net profits as of
the declaration date.
Item 6. Selected Financial Data
The following table sets forth certain selected consolidated financial
data for the past five years.
31
Years Ended December 31,
(Dollars in thousands, except per share data)
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Income Statement Amounts:
Gross interest income $ 29,463 $ 30,944 $ 32,998 $ 30,418 $ 25,671
Gross interest expense 12,877 14,266 18,887 17,700 14,167
Net interest income 16,586 16,678 14,111 12,718 11,504
Provision for possible loan losses 2,053 1,825 1,448 1,277 1,418
Net interest income after provision 14,533 14,853 12,663 11,441 10,086
Other operating income 4,652 3,646 3,364 2,480 1,353
Other operating expense 13,470 13,046 11,619 9,713 8,187
Income before income taxes
and other items 5,715 5,453 4,408 4,208 3,252
Income taxes 1,195 1,349 1,107 1,229 1,121
Income before cumulative effect of
change in accounting principles 4,520 4,104 3,301 2,979 2,131
Cumulative effect of change in
accounting principles 0 0 0 0 0
Net income $ 4,520 $ 4,104 $ 3,301 $ 2,979 $ 2,131
Per Share Data(1):
Net income per share $ 1.70 $ 1.55 $ 1.25 $ 1.13 $ 0.85
Cash dividends per share 0.10 0.09 0.08 0.07 0.06
Book value (at year end) 13.33 12.16 10.38 9.17 7.77
Balance Sheet Amounts (at year-end):
Total assets $ 543,416 $ 485,603 $ 453,745 $ 405,212 $ 358,348
Total loans (net of unearned income) 377,808 339,521 325,460 291,895 261,678
Total deposits 450,009 410,301 392,093 346,315 306,193
Long-term debt 16,429 14,200 10,483 18,669 10,599
Capital Securities 6,300 7,500 7,500 7,500 7,500
Total equity 35,434 32,199 27,452 24,183 20,408
(1) Adjusted for 1999 two-for-one stock split.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The information required herein is incorporated by reference from the
Annual Report to Shareholders for the fiscal year ended December 31, 2003.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The information required herein is incorporated by reference to pages
24-26 above on Interest Rate Sensitivity Analysis, Asset Liability Analysis and
Liquidity.
Item 8. Financial Statements and Supplementary Data
The following financial statements are incorporated by reference from
the Annual Report to Shareholders for the fiscal year ended December 31, 2003:
Independent Auditor's Report;
32
Consolidated Statements of Financial Condition as of December
31, 2003, 2002 and 2001;
Consolidated Statements of Operations for each of the years in
the three year period ended December 31, 2003;
Consolidated Statements of Stockholder's Equity for each of
the years in the three year period ended December 31,
2003;
Consolidated Statements of Cash Flows for each of the years
in the three year period ended December 31, 2003; and
Notes to Consolidated Financial Statements for December 31,
2003, 2002 and 2001.
Item 9. Changes in Accountants and Disagreements with Accountants on Accounting
and Financial Disclosure
None.
Item 9A. Controls and Procedures
On an on-going basis, senior management monitors and reviews the
internal controls established for the various operating segments of the Bank.
Additionally, the Company has created a Disclosure Review Committee to review
not only internal controls but the information used by Company's financial
officers to prepare the Corporation's periodic SEC filings and corresponding
financial statements. The Committee is comprised of the Senior Management Team
of the Bank and meets at least quarterly. Internal audits conducted by the
Company's internal audit department are also reviewed by senior officers to
assist them in assessing the adequacy of the Company's internal control
structure. These audits are also discussed in detail with the Company's Audit
Committee.
We have carried out an evaluation, under the supervision and the
participation of our management, including our Executive Vice President and
Chief Executive Officer, our Executive Vice President and Chief Operations
Officer, our Chief Financial Officer and our Vice President of Accounting, of
the effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the "Act") as of the end of the fiscal year
covered by this report. Based upon that evaluation, our CEO, COO, CFO and VP
Accounting concluded that our disclosure controls and procedures are effective
in providing reasonable assurance that (a) the information required to be
disclosed by us in the reports that we file or submit under the Act is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms, and (b) such information
is accumulated and communicated to our management, including our CEO, COO, CFO
and VP Accounting, as appropriate to allow timely decisions regarding required
disclosure.
Management asserts that there have not been any changes in the
Corporation's internal controls over financial reporting during the fourth
fiscal quarter of the fiscal year covered by this report that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
Part III.
Item 10. Directors and Executive Officers of the Registrant
Pursuant to General Instruction G(3) of Form 10-K, the information
contained under the headings "The Nominees," "Executive Officers Who Are Not
Directors," "Section 16(a) Beneficial
33
Ownership Reporting Compliance," "The Board of Directors and its
Committees -- Audit Committee" (with respect to the designation of an audit
committee financial expert) and "Code of Ethics" in the Company's Proxy
Statement for the 2004 Annual Meeting of Shareholders is incorporated herein by
reference.
Item 11. Executive Compensation
Pursuant to General Instruction G(3) of Form 10-K, the information
contained under the headings "Director Compensation," "Executive Officer
Compensation," "Stock Options" and "Option Exercises and Holdings" in the
Company's Proxy Statement for the 2004 Annual Meeting of Shareholders is
incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Pursuant to General Instruction G(3) of Form 10-K, the information
contained under the headings "Security Ownership of Management and Certain
Beneficial Owners" and "Equity Compensation Plans" in the Company's Proxy
Statement for the 2004 Annual Meeting of Shareholders is incorporated herein by
reference.
Item 13. Certain Relationships and Related Transactions
Pursuant to General Instruction G(3) of Form 10-K, the information
contained under the heading "Certain Transactions" in the Company's Proxy
Statement for the 2004 Annual Meeting of Shareholders is incorporated herein by
reference.
Item 14. Principal Accounting Fees and Services
Pursuant to General Instruction G(3) of Form 10-K, the information
contained under the headings "Services and Fees during 2003" and "Pre-Approved
Services" in the Company's Proxy Statement for the 2004 Annual Meeting of
Shareholders is incorporated herein by reference.
Part IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) (1) The response to this portion of Item 15 is submitted as a
separate section of this report.
(2) All applicable financial statement schedules required by
Regulation S-X are included in the Notes to the 2003
Consolidated Financial Statements.
(3) Exhibits:
3.1 Articles of Incorporation of Highlands Bankshares, Inc.
(restated in electronic format), filed as Exhibit 4.1 to
the Registration Statement on Form S-3, Registration No.
333-83618, filed with the Commission on March 1, 2002,
incorporated herein by reference.
3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit
3.2 to the Registration Statement on Form 8-A, File No.
000-27622, filed with the Commission on January 24, 1996,
incorporated herein by reference.
34
10.1 Highlands Union Bank 1995 Stock Option Plan, attached as
Exhibit 10.1 to the Annual Report on Form 10-K for the
fiscal year ended December 31, 2002, File No. 000-27622,
incorporated herein by reference.
11 Statement regarding computation of per share earnings
(included as Note 1 of the Notes to Consolidated Financial
Statements in the 2003 Annual Report to Shareholders and
incorporated herein by reference).
13.1 Annual Report to Shareholders.
21 Subsidiaries of the Corporation.
23.1 Consent of Brown, Edwards & Company, L.L.P.
31.1 Section 302 Certification of Chief Executive Officer.
31.2 Section 302 Certification of Chief Operations Officer.
31.3 Section 302 Certification of Chief Financial Officer of
the Corporation.
31.4 Section 302 Certification of Chief Financial Officer of
the Bank.
32.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.
ss.1350.
32.2 Statement of Chief Operations Officer Pursuant to 18
U.S.C.ss.1350.
32.3 Statement of Chief Financial Officer of the Corporation
Pursuant to 18 U.S.C.ss.1350.
32.4 Statement of Chief Financial Officer of the Bank Pursuant
to 18 U.S.C.ss.1350.
(b) Reports on Form 8-K.
No reports on Form 8-K were filed by the Company during
the last quarter of the period covered by this report.
(c) Exhibits.
The response to this portion of Item 15 as listed in Item
15(a)(3) above is submitted as a separate section of this
report.
(d) Financial Statement Schedules.
The response to this portion of Item 15 is submitted as a
separate section of this report.
35
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 26, 2004 BY: /s/ Samuel. Neese
-------------------------------------
Samuel L. Neese
Executive Vice President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on March 26, 2004.
Signature Title Date
--------- ----- ----
/s/ James D. Morefield Chairman of the Board, and Director March 26, 2004
- -----------------------------------------
James D. Morefield
/s/ Dr. James D. Moore, Jr. President March 26, 2004
- -----------------------------------------
Dr. James D. Moore, Jr.
/s/ J. Carter Lambert Vice Chairman March 26, 2004
- -----------------------------------------
J. Carter Lambert
/s/ Samuel L. Neese Executive Vice President, and Chief March 26, 2004
- ----------------------------------------- Executive Officer
Samuel L. Neese
/s/ James T. Riffe Executive Vice President and Cashier March 26, 2004
- -----------------------------------------
James T. Riffe
/s/ William E. Chaffin Director March 26, 2004
- -----------------------------------------
William E. Chaffin
/s/ E. Craig Kendrick Director March 26, 2004
- -----------------------------------------
E. Craig Kendrick
36
/s/ Clydes B. Kiser Director March 26, 2004
- -----------------------------------------
Clydes B. Kiser
/s/ Charles P. Olinger Director March 26, 2004
- -----------------------------------------
Charles P. Olinger
/s/ William J. Singleton Director March 26, 2004
- -----------------------------------------
William J. Singleton
/s/ Dr. H. Ramsey White, Jr. Director March 26, 2004
- -----------------------------------------
Dr. H. Ramsey White, Jr.
37
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
3.1 Articles of Incorporation of Highlands Bankshares, Inc.
(restated in electronic format), filed as Exhibit 4.1 to
the Registration Statement on Form S-3, Registration No.
333-83618, filed with the Commission on March 1, 2002,
incorporated herein by reference.
3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit
3.2 to the Registration Statement on Form 8-A, File No.
000-27622, filed with the Commission on January 24, 1996,
incorporated herein by reference.
10.1 Highlands Union Bank 1995 Stock Option Plan, attached as
Exhibit 10.1 to the Annual Report on Form 10-K for the
fiscal year ended December 31, 2002, File No. 000-27622,
incorporated herein by reference.
11 Statement regarding computation of per share earnings
(included as Note 1 of the Notes to Consolidated Financial
Statements in the 2003 Annual Report to Shareholders and
incorporated herein by reference).
13.1 Annual Report to Shareholders.
21 Subsidiaries of the Corporation.
23.1 Consent of Brown, Edwards & Company, L.L.P.
31.1 Section 302 Certification of Chief Executive Officer.
31.2 Section 302 Certification of Chief Operations Officer.
31.3 Section 302 Certification of Chief Financial Officer of
the Corporation.
31.4 Section 302 Certification of Chief Financial Officer of
the Bank.
32.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.
ss.1350.
32.2 Statement of Chief Operations Officer Pursuant to 18
U.S.C.ss.1350.
32.3 Statement of Chief Financial Officer of the Corporation
Pursuant to 18 U.S.C.ss.1350.
32.4 Statement of Chief Financial Officer of the Bank Pursuant
to 18 U.S.C.ss.1350.