Back to GetFilings.com

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, 2004

Commission file number  0-18868

Premier Community Bankshares, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (540) 869-6600

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $1.00 per share

(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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   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.  [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  X   No     

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.  $76,583,574

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of March 2, 2005.  4,927,148

DOCUMENTS INCORPORATED BY REFERENCE

Proxy Statement for the 2005 Annual Meeting of Shareholders – Part III

PART I

Item 1. Business

General

Premier Community Bankshares, Inc. is a bank holding company that was incorporated in June 1989.  We own all of the outstanding stock of The Marathon Bank, which was incorporated in August 1987, and Rockingham Heritage Bank, which was incorporated in June 1989.  We acquired Rockingham Heritage Bank in November 2000.  Our headquarters are in Frederick County, Virginia.  

Premier is a holding company for Marathon and Rockingham Heritage and is not directly engaged in the operation of any other business.  All of our business is conducted through Marathon and Rockingham Heritage.  Our subsidiary banks operate autonomously, with separate local identities, management teams and decision-making processes, and without strict operating control from the holding company.  Each bank has full responsibility for day-to-day operations, with minimal support from the holding company level.  As a result, each bank can tailor its services and products to the needs of its community.  The board of directors of the holding company does monitor the financial and operational performance of both banks.

Marathon and Rockingham Heritage, which are chartered under Virginia law, conduct a general banking business.  Both banks’ deposits are insured by the Federal Deposit Insurance Corporation and both are members of the Federal Reserve System.  

We offer checking accounts, savings and time deposits, and commercial, real estate, personal, home improvement, automobile and other installment and term loans.  We also offer travelers checks, safe deposit, collection, notary public, discount brokerage service, and other customary bank services (other than trust services).  The three principal types of loans that we make are commercial and industrial loans, real estate loans and loans to individuals for household, family, and other consumer costs.  Our banking offices include drive-up facilities.  There are automated teller machines located at each of Marathon’s offices and an additional nine off-premise ATMs operated by Marathon.  Rockingham Heritage has 23 ATMs throughout its market area.

Principal Market Areas

Our business in the area served by Marathon (the counties of Frederick, Clarke, Shenandoah, Warren and the city of Winchester, Virginia) and Rockingham Heritage (Rockingham and Augusta counties, and the cities of Harrisonburg, Waynesboro, and Staunton, Virginia) is highly competitive with respect to both loans and deposits.  In addition, the loan production office in Martinsburg, West Virginia serves the counties of Morgan, Jefferson, and Berkeley, West Virginia.  In our primary service area, there are numerous commercial banks (including large, multi-state banks with multiple offices) offering services ranging from deposits and real estate loans to full service banking.  Certain of the commercial banks in this service area have higher lending limits than us and may provide various services for their customers that we do not offer.

According to a market share report prepared by the FDIC, Marathon’s deposits as a percentage of total deposits in financial institutions in its market areas was 10.9% as of June 30, 2004, the most recent date for which market share information is available.  Rockingham Heritage’s deposits as a percentage of total deposits in financial institutions in its market areas was 6.6% as of June 30, 2004.  Total deposits in the market areas of Marathon and Rockingham as of June 30, 2004, were $2.7 billion and $2.5 billion, respectively.

Expansion into West Virginia

The Corporation intends to organize a third bank in West Virginia, which will be named Premier Bank.  The Corporation plans to locate Premier Bank's headquarters in Martinsburg and its initial branch office in Shepherdstown, West Virginia.  It is expected that Premier Bank will open in the second quarter of 2005. The banking charter has been received from the state of West Virginia, as well as approval for deposit insurance from the FDIC.  Premier Bank was originally expected to open during the third quarter of 2004, but was unable to do so due to unexpected delays in the local government planning process.  Premier Bank will offer a wide variety of deposits and loans, including residential loans, commercial loans and commercial construction and development loans. The Corporation currently operates a loan production office in the Martinsburg area, which was approved by West Virginia’s Division of Banking on October 6, 2003.

2

Martinsburg and Shepherdstown are located in Berkeley County and Jefferson County, respectively, in West Virginia’s eastern panhandle.  Martinsburg and Shepherdstown are approximately 80 and 60 miles, respectively, from both Washington, D.C. and Baltimore, Maryland.  Many commuters to Washington and Baltimore and their populous suburbs in northern Virginia and Maryland live in Berkeley County and Jefferson County.  There is commuter train service from Martinsburg to Washington and Baltimore.

Since 1990, the projected market area for our new bank has experienced rapid growth.  Berkeley County’s population grew from 59,300 to 75,900 between 1990 and 2000.  In 2000, its average unemployment rate was 3.0% and its per capita income was $23,000.  Major employers in Berkeley County include Berkeley County Schools, General Motors and Quad Graphics, and a number of other companies maintain distribution centers there.  The federal government also has a strong presence in the county, including an Internal Revenue Service center, the VA Medical Center and the West Virginia Air National Guard.  As of June 30, 2004, the most recent date for which market share information is available, Berkeley County had $802 million of total bank deposits.

From 1990 to 2000, Jefferson County’s population grew from 36,000 to 42,000.  In 2002, its per capita income was $26,900 and its unemployment rate was 3.1%.  Major employers in Jefferson County include Penn National Gaming in Charles Town, Jefferson Memorial Hospital and the Jefferson County Board of Education.  As of June 30, 2004, Jefferson County had $577 million of total bank deposits.

Credit Policies

The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of our borrowers.  Within each category, such risk is increased or decreased, depending on prevailing economic conditions.  In an effort to manage the risk, our policy gives loan amount approval limits to individual loan officers based on their position and experience.  The risk associated with real estate mortgage loans and consumer loans varies, based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness.  The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

We have written policies and procedures to help manage credit risk.   Our loan review process includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with our policies.

Marathon uses an in-house management loan committee and a directors’ loan committee to approve loans.

The in-house loan committee, which consists of the president or senior vice president and two vice presidents, meets weekly to review loans which exceed individual loan authorities for loans that are intended to be held in the portfolio.  This committee approves unsecured loans up to $400,000, secured loans with non-negotiable collateral up to $500,000 and secured loans with negotiable collateral up to $1,000,000.  The directors’ loan committee, which is made up of six directors, approves loans up to the legal lending limit.   The directors’ loan committee also reviews lending policies proposed by management.

Rockingham’s loan approval structure is similar to Marathon’s.  Rockingham’s officer loan committee, which consists of the president or chief lending officer and two additional senior lending officers, approves loans in excess of individual loan officers lending authorities.  These individual authorities vary up to $500,000.  Loans in excess of $1,000,000 and up to the bank’s legal lending limit are approved by a directors’ loan committee, which consists of the president and three outside directors.  The directors’ loan committee also reviews loan policies and procedures, delinquent loans and other potential problem loans.

In the experience of both subsidiary banks, residential loan originations come primarily from walk-in customers, real estate brokers and builders.  Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers.  All completed loan applications are reviewed by our salaried loan officers.  As part of the application process, information is obtained concerning the income, financial condition, employment and credit history of the applicant.  If commercial real estate is involved, information is also obtained concerning cash flow after debt service.  Loan quality is analyzed based on each subsidiary bank’s experience and guidelines with respect to credit underwriting, as well as the guidelines issued by the Federal Home Loan Mortgage Corporation, Federal National Mortgage Association and other purchasers of loans, depending on the type of loan involved.  The non-conforming one-to-four-family adjustable-rate mortgage

3

loans that we originate, however, are not readily salable in the secondary market because they do not meet all of the secondary marketing guidelines. Real estate is appraised by independent fee appraisers who have been pre-approved by the bank and/or board of directors.  

In the normal course of business, we make various commitments and incur certain contingent liabilities that are disclosed but not reflected in our annual financial statements, including commitments to extend credit.  At December 31, 2004, commitments to extend credit totaled $76.4 million.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in our market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches.  At December 31, 2004, commercial real estate loans aggregated $142.9 million or 29.1% of our gross loans.  

In our underwriting of commercial real estate, we may lend up to 100% of the secured property’s appraised value, although our loan to original appraised value ratio on such properties is 80% or less in most cases.  Commercial real estate lending entails significant additional risk, compared with residential mortgage lending.  Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy generally.  Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness and prior credit history and reputati on, and we generally require personal guarantees or endorsements of borrowers.  We also carefully consider the location of the security property.  

One-to-Four-Family Residential Real Estate Lending

We make loans secured by one-to-four-family residences, all of which are located in our market area.  We evaluate both the borrower’s ability to make principal and interest payments and the value of the property that will secure the loan. We make loans in amounts of up to 100% of the appraised value of the underlying real estate.  Loans are made with a loan to value up to 95% for conventional mortgage loans and up to 100% for loans guaranteed by either the Federal Housing Authority or the Veterans Administration.  For conventional loans in excess of 80% loan to value, private mortgage insurance is secured insuring the mortgage loans to 75% loan to value.  Generally if the loans are not made to credit standards of FHLMC, additional fees and rate are charged.

Although, due to competitive market pressures, we do originate long-term, fixed-rate mortgage loans, we currently underwrite and document all such loans to permit their sale in the secondary mortgage market. Certain loans that may not qualify for sale into the secondary market are structured as balloon notes payable in full within a five-year period and are held in our portfolio.  At December 31, 2004, loans secured by one-to-four family residences aggregated $131.2 million or 26.7% of our gross loans.  

All one-to-four-family real estate mortgage loans being originated by us contain a “due-on-sale” clause providing that we may declare the unpaid principal balance due and payable upon the sale of the mortgage property.  It is our policy to enforce these due-on-sale clauses concerning fixed-rate loans.

We require, in connection with the origination of residential real estate loans, title opinions or title insurance and fire and casualty insurance coverage, as well as flood insurance where appropriate, to protect our interest.  The cost of this insurance coverage is paid by the borrower.

We expect that Premier Bank, once it is organized, will make adjustable rate mortgages, in addition to fixed rate mortgage loans.  One-to-four-family residential adjustable-rate mortgage loans will have interest rates that adjust every one or three years, generally in accordance with the rates on one-year  and three-year U.S. Treasury bills.  We expect that these loans will generally limit interest rate increases for each rate adjustment period and have an established ceiling rate at the time the loans are made.  To compete with other lenders in our market area, we may make one-year loans at interest rates that, for the first year, are below the index rate that would otherwise apply to these loans.  There are unquantifiable risks resulting from potential increased costs to the borrower as a result of repricing.  It is possible, therefore, that during periods of rising interest rates, the risk of defaults on these loans may increase due to the upward adjustment of interest costs to borrowers.

4

Construction Lending

We make local construction loans, both residential and commercial, and land development loans.  At December 31, 2004, construction and land development loans outstanding were $101.4 million, or 20.6%, of gross loans.  All of these loans are concentrated in our local market area.  The average life of a construction loan is approximately nine months. While some loan rates are fixed, many reprice monthly to meet the market, based on the prime rate.  Because the interest charged on these loans floats with the market, they help us in managing our interest rate risk.  Construction lending entails significant additional risks, compared with residential mortgage lending.  Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the home or land under construction, which is of uncertain value prior to the completion of construction.  Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios.  To minimize the risks associated with construction lending, we limit most of our loan amounts to 80.0% of appraised value, in addition to our usual credit analysis of our borrowers.  We also obtain a first lien on the property as security for our construction loans and personal guarantees from the borrower’s principal owners.

Consumer Lending

We offer various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans, letters of credit, and home equity loans.  At December 31, 2004, we had consumer loans of $25.5 million or 5.2% of gross loans.  Such loans are generally made to customers with whom we had a pre-existing relationship.  We originate all of our consumer loans in our market area and intend to continue our consumer lending in this geographic area.

Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles.  In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.  The remaining deficiency often does not warrant further substantial collection efforts against the borrower.  In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.  Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.  Such loans may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loan such as us, and a borrower may be able to assert against such assignee claims and defenses which it has against the seller of the underlying collateral.  We add general provisions to our loan loss allowance at the time that the loans are originated.  Consumer loan delinquencies often increase over time as the loans age.  We have very few unsecured consumer loans.

The underwriting standards that we employ for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income for primary employment, and additionally from any verifiable secondary income.  Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Commercial Loans

Commercial business loans generally have a higher degree of risk than residential mortgage loans, but have commensurately higher yields.  To manage these risks, we generally secure appropriate collateral and monitor the financial condition of our business borrowers.  Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from his employment and other income and are secured by real estate whose value tends to be easily ascertainable.  In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory.  As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself.  Further, the collateral for commercial business loans may depreciate over time and cannot be appraised with as much precision as residential real estate.  Our standard operating procedure includes a credit review and monitoring

5

process to review the cash flow of commercial borrowers.  At December 31, 2004, commercial loans totaled $63.1 million, or 12.8% of gross loans.

Employees

As of December 31, 2004, we had 243 total employees, 204 of which were full-time employees. None of our employees is covered by any collective bargaining agreement, and relations with employees are considered excellent.

Supervision and Regulation

General.  As a bank holding company, the Corporation is subject to regulation under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and the examination and reporting requirements of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).  Under the BHCA, a bank holding company may not directly or indirectly acquire ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank or merge or consolidate with another bank holding company without the prior approval of the Federal Reserve Board.  The BHCA also generally limits the activities of a bank holding company to that of banking, managing or controlling banks, or any other activity that is determined to be so closely related to banking or to managing or controlling banks that an exception is allowed for those activities.

As state-chartered banks, Marathon and Rockingham Heritage are subject to regulation, supervision and examination by the Virginia State Corporation Commission’s Bureau of Financial Institutions.  They also are subject to regulation, supervision and examination by the Federal Reserve Board.  State and federal law also governs the activities in which Marathon and Rockingham Heritage engage, the investments that they make and the aggregate amount of loans that may be granted to one borrower.  Various consumer and compliance laws and regulations also affect the operations of each of Marathon and Rockingham Heritage.

Premier Bank, which we are currently organizing in West Virginia, will also be a state-chartered bank, but it will not be a member of the Federal Reserve.  As a result, Premier Bank will be subject to regulation, supervision and examination by West Virginia’s Division of Banking and the Federal Deposit Insurance Corporation.

The earnings of the Corporation’s subsidiaries, and therefore the earnings of the Corporation, are affected by general economic conditions, management policies, changes in state and federal legislation and actions of various regulatory authorities, including those referred to above.  The following description summarizes the significant federal and state laws to which the Corporation and Marathon and Rockingham Heritage are subject.  To the extent that statutory or regulatory provisions or proposals are described, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

Payment of Dividends.  

The Corporation is a legal entity separate and distinct from its banking and other subsidiaries.  Virtually all of the Corporation’s revenues will result from dividends paid to the Corporation by Marathon and Rockingham Heritage.  Marathon and Rockingham Heritage are subject to laws and regulations that limit the amount of dividends that they can pay.  In addition, the Corporation and Marathon and Rockingham Heritage are subject to various regulatory restrictions relating to the payment of dividends, including requirements to maintain capital at or above regulatory minimums.  Banking regulators have indicated that banking organizations should generally pay dividends only if the organization’s net income available to common shareholders over the past three years has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition.  The Corporation does not expect that any of these laws, regulations or policies will materially affect the ability of Marathon and Rockingham Heritage to pay dividends.

Insurance of Accounts, Assessments and Regulation by the FDIC.  The deposits of Marathon and Rockingham Heritage are insured by the Federal Deposit Insurance Corporation (the “FDIC”) up to the limits set forth under applicable law.  The deposits of Marathon and Rockingham Heritage are subject to the deposit insurance assessments of the Bank Insurance Fund (“BIF”) of the FDIC.  

The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors (including

6

supervisory evaluations).  Depository institutions insured by the BIF that are “well capitalized” are required to pay only the statutory minimum assessment of $2,000 annually for deposit insurance, while all other banks are required to pay premiums ranging from .03% to .27% of domestic deposits.  These rate schedules are subject to future adjustments by the FDIC.  In addition, the FDIC has authority to impose special assessments from time to time.  However, because the legislation enacted in 1996 requires that both Savings Association Insurance Fund insured and BIF-insured deposits pay a pro rata portion of the interest due on the obligations issued by the Financing Corporation, the FDIC is assessing BIF-insured deposits an additional 1.30 basis points per $100 of deposits to cover those obligations.

The FDIC is authorized to prohibit any BIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund.  Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital.  If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC.  Management is not aware of any existing circumstances that could result in termination of any deposit insurance of TMB or RHB.

Capital.  The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises.  Under the risk-based capital requirements, the Corporation and Marathon and Rockingham Heritage are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%.  At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles (“Tier 1 capital”).  The remainder may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital,” which, together with Tier 1 capital, composes “total capital”).

In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations.  Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.

The risk-based capital standards of the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy.  The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

Premier Bank will be subject to similar guidelines that the FDIC has issued.

Other Safety and Soundness Regulations.  There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent.  For example, under the requirements of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise.  In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the insolvency of commonly controlled insured depository institutions or for any assistance provided by the FDIC to commonly controlled insured depository institutions in danger of failure.  The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in the best interests of the deposit insurance funds.  The FDIC’s claim for reimbursement under the cross guarantee provisions is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and nonaffiliated holders of subordinated debt of the commonly controlled insured depository institutions.

7

The federal banking agencies also have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institution in question is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized, as defined by the law.  As of December 31, 2004, the Corporation and Marathon and Rockingham Heritage were classified as well capitalized.

State banking regulators also have broad enforcement powers over Marathon and Rockingham Heritage, including the power to impose fines and other civil and criminal penalties, and to appoint a conservator.

Community Reinvestment.   The requirements of the Community Reinvestment Act are also applicable to each bank.  The act imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions.  A financial institution’s efforts in meeting community needs currently are evaluated as part of the examination process pursuant to twelve assessment factors.  These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility.  Marathon received an outstanding rating in its most recent CRA examination, and Rockingham Heritage received an outstanding rating in its most recent CRA examination.

Interstate Banking and Branching.  Current federal law authorizes interstate acquisitions of banks and bank holding companies without geographic limitation.  Effective June 1, 1997, a bank headquartered in one state was authorized to merge with a bank headquartered in another state, as long as neither of the states had opted out of such interstate merger authority prior to such date.  After a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law.

Gramm-Leach-Bliley Act of 1999.  The Gramm-Leach-Bliley Act of 1999 (the “Act”) was signed into law on November 12, 1999.  The Act covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies.  Most of the Act’s provisions require the federal bank regulatory agencies and other regulatory bodies to adopt regulations to implement the Act, and for that reason an assessment of the full impact on the Corporation of the Act must await completion of that regulatory process.

The Act repeals sections 20 and 32 of the Glass-Stegall Act, thus permitting unrestricted affiliations between banks and securities firms.  The Act also permits bank holding companies to elect to become financial holding companies.  A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, brokerage, investment and merchant banking and insurance underwriting, sales and brokerage activities.  In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed, and have at least a satisfactory Community Reinvestment Act rating.

The Act provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage insurance sales, solicitations or cross-marketing activities.  Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in certain areas identified in the Act.  The Act directs the federal bank regulatory agencies to adopt insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.

The Act adopts a system of functional regulation under which the Federal Reserve Board is confirmed as the umbrella regulator for financial holding companies, but financial holding company affiliates are to be principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the Securities and Exchange Commission for securities affiliates and state insurance regulators for insurance affiliates.  The Act repeals the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Securities Exchange Act of 1934, as amended, but identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker”, and a set of activities in which a bank may engage without being deemed a “dealer”.  The Act also makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.

8

The Act contains extensive customer privacy protection provisions.  Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information.  The Act provides that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure.  An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes.  The Act also provides that the states may adopt customer privacy protections that are more strict than those contained in the Act.  The Act also makes a criminal offense, except in limited circumstances, obtaining or attempting to obtain customer information of a financial nature by fraudulent or deceptive means.

Filings with the SEC

The Corporation files annual, quarterly, and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission.  These reports are posted and are available at no cost on the Corporation’s website, www.premiercommunitybankshares.com, as soon as reasonably practible after the Corporation files such documents with the SEC.  Premier’s filings are also available through the SEC’s website at www.sec.gov.

Item 2. Properties

The following table provides certain information with respect to our properties:

9

10

We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.

Item 3.  Legal Proceedings

In the course of normal operations, the Corporation, Marathon and Rockingham Heritage are parties to various legal proceedings.  Based upon information currently available, and after consultations with legal counsel, management believes that such legal proceedings will not have a material adverse effect on the Corporation’s business, financial position, or results of operations.

Item 4.  Submission of Matters to a Vote of Security Holders

No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders of the Corporation through a solicitation of proxies or otherwise.

PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Prices

The Corporation’s common stock is listed on the NASDAQ Small Cap Market under the symbol “PREM”.  Prior to the common stock’s listing on NASDAQ on October 3, 1996, there were occasional transactions in the stock and management assisted in matching persons interested in buying or selling the stock.   The Corporation does not currently have a stock repurchase plan.

The following table represents the Corporation’s stock prices for 2003 and 2004.   This sales price information reflects inter-dealer prices, without retail mark-up, mark-down, or commission.

At December 31, 2004, the Corporation had approximately 2,315 stockholders of record.

The Corporation declared a $.21 per share cash dividend to stockholders of record as of December 31, 2004.  Cash dividends of $.18 per share cash declared in 2003 were paid in January, 2004 and cash dividends of $.15 per share, declared in 2002, were paid in January, 2003.

Dividend Policy

Our future dividend policy is subject to the discretion of the board of directors and will depend upon a number of factors, including future consolidated earnings, financial condition, liquidity and capital requirements of both us and Marathon and Rockingham Heritage, applicable governmental regulations and policies and other factors deemed relevant by our board of directors.

Our ability to distribute cash dividends will depend primarily on the abilities of our subsidiary banks to pay dividends to us.  As state member banks, both Marathon and Rockingham Heritage are subject to certain restrictions imposed by the reserve and capital requirements of federal and Virginia banking statutes and regulations.  Furthermore, neither we nor the banks may declare or pay a cash dividend on any of our capital stock if we are insolvent or if the payment of the dividend would render us insolvent or unable to pay our obligations as they become due in the ordinary course of business.  For additional information on these limitations, see “Government Supervision and Regulation – Payment of Dividends” in Item 1 above.

Stock Repurchases

The Corporation did not repurchase any shares of its common stock during the fourth quarter of 2004.

11

Item 6. Selected Financial Data

The following selected consolidated financial data is based upon the Corporation’s audited financial statements and related notes and should be read in conjunction with such financial statements and notes.

12

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operation

General

The following commentary discusses major components of our business and presents an overview of our consolidated financial position at December 31, 2004, and 2003, as well as results of operations for the periods ended December 31, 2004, 2003, and 2002. This discussion should be reviewed in conjunction with the consolidated financial statements and accompanying notes and other statistical information presented elsewhere in this prospectus.

Our subsidiary banks operate autonomously, with separate local identities, management teams and decision-making processes, and without strict operating control from the holding company.  The following commentary is being presented on a consolidated basis.

We are not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on our liquidity, capital resources or results of operations.  

Overview

Premier Community Bankshares, Incorporated (“Premier” or the “Corporation”) is a Virginia multi-bank holding company headquartered in Winchester, Virginia.  The Corporation owns The Marathon Bank and Rockingham Heritage Bank and its subsidiary, RHB Services, Inc.

The Corporation and its subsidiaries, The Marathon Bank and Rockingham Heritage Bank are engaged in the business of offering banking services to the general public. Premier offers checking accounts, savings and time deposits, and commercial, real estate, personal, home improvement, automobile and other installment and term loans.  The Corporation also offers financial services, travelers checks, safe deposit boxes, collection, notary public and other customary bank services (with the exception of trust services) to its customers.  The three principal types of loans made by Premier are: (1) commercial and industrial loans; (2) real estate loans; and (3) loans to individuals for household, family and other consumer expenditures.

The Corporation intends to organize a third bank in West Virginia, which will be named Premier Bank.  The Corporation plans to locate Premier Bank's headquarters in Martinsburg and its initial branch office in Shepherdstown, West Virginia.  It is expected that Premier Bank will open in the second quarter of 2005. The banking charter has been received from the state of West Virginia, as well as approval for deposit insurance from the FDIC.  Premier Bank was originally expected to open during the third quarter of 2004, but was unable to do so due to unexpected delays in the local government planning process.  Premier Bank will offer a wide variety of deposits and loans, including residential loans, commercial loans and commercial construction and development loans. The Corporation currently operates a loan production office in the Martinsburg area, which was approved by West Virginia’s Division of Banking on October 6, 2003.

Net interest income is our primary source of revenue.  We define revenue as net interest income plus non-interest income.  As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk to both maximize and stabilize net interest income.  We do this by monitoring the spread between the interest rates we earn on interest earning assets such as loans, and the interest rates we pay on interest bearing liabilities such as deposit accounts.  We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it.  In addition to management of interest rate risk, we analyze our loan portfolio for credit risk.  Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by carefully underwriting and monitoring our extension of credit.  In addition to net interest income, non-interest income is an i ncreasingly important source of income for our Corporation.  Non-interest income is derived chiefly from service charges on deposit accounts, (such as charges for non-sufficient funds and ATM fees,) as well as commissions and fees from bank services, such as mortgage originations and debit and credit card processing.

13

Caution About Forward Looking Statements

We make forward looking statements in this annual report that are subject to risks and uncertainties.  These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals.  The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements.

These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including, but not limited to:

·

the ability to successfully manage our growth or implement our growth strategies if we are unable to identify attractive markets, locations or opportunities to expand in the future;

·

maintaining capital levels adequate to support our growth;

·

maintaining cost controls and asset qualities as we open or acquire new branches;

·

reliance on our management team, including our ability to attract and retain key personnel;

·

the successful management of interest rate risk;

·

changes in general economic and business conditions in our market area;

·

changes in interest rates and interest rate policies;

·

risks inherent in making loans such as repayment risks and fluctuating collateral values;

·

competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

·

demand, development and acceptance of new products and services;

·

problems with technology utilized by us;

·

changing trends in customer profiles and behavior; and

·

changes in banking and other laws and regulations applicable to us.

Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward looking statements.  In addition, our past results of operations do not necessarily indicate our future results.

Financial Overview

At December 31, 2004 we had total assets of  $576.2 million, net loans of $486.9 million, deposits of $483.9 million and shareholders’ equity of $44.3 million.  The increase in assets was 24.4% over the amount at December 31, 2003, while net loans and deposits increased 27.3% and 21.8%, respectively, for the same period.

Our earnings per share, on a fully diluted basis, for the year ended December 31, 2004 was $1.26, which represented an increase of $0.15, or 13.5%, over earnings per share, on a fully diluted basis, of $1.11 for the same period 2003.  The increase is partially attributable to a 23.4% increase in net interest income over the same periods, due to strong growth in our earning assets.  The increase is also attributable to a 21.5% increase in non-interest income, as service charge income and other fees provided recurring sources of income.

Our return on average equity was 15.20% for the period ended December 31, 2004.  We have been able to achieve this level without relying on a disproportionate share of income from mortgage banking operations.  Our improvement has occurred as we have continued to grow through the opening of new branches.  Our efficiency ratio has also increased during this growth in the past year, rising from 59.90% at December 31, 2003 to 61.04% for year-end 2004.

Critical Accounting Policies

14

General

The financial condition and results of operations presented in the consolidated financial statements, the accompanying notes to the consolidated financial statements and this section are, to a large degree, dependent upon our accounting policies.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  We discuss below those accounting policies that we believe are the most important to the portrayal and understanding of our financial condition and results of operations.  These critical accounting policies require our most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio.  The allowance is based on two basic principles of accounting:

·

SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and

·

SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses is determined by evaluating our loan portfolio on at least a quarterly basis.   Particular attention is paid to individual loan performance, collateral values, borrower financial condition and overall economic conditions.  The evaluation includes a close review of the internal watch list and other non-performing loans.  Management uses three steps in calculating the balance of the allowance.  The first step is the specific classification which examines problem loans and applies a weight factor to each category.  The weight factor is based upon historical data and the loans within each category are reviewed on a monthly basis to determine changes in their status.  The second step applies a predetermined rate against total loans with unspecified reserves.  Again, this rate is based upon experience and can change over time.  The third step is an unallocated allowance which is determined by economic events and conditions that may have a real, but as yet undetermined, impact upon the portfolio.  Each of these steps is based on data that can be subjective and the actual losses may be greater or less than the amount of the allowance.  However, management feels that the allowance represents a reasonable assessment of the risk imbedded in the portfolio.

Other Real Estate Owned

Foreclosed properties are recorded at the lower of the outstanding loan balance at the time of foreclosure or the estimated fair value less estimated costs to sell.  At foreclosure any excess of the loan balance over the fair value of the property is charged to the allowance for loan losses. Such carrying value is periodically reevaluated and written down if there is an indicated decline in fair value, such as an independent appraisal. Historically, foreclosed properties are not carried on the books for more than two or three fiscal quarters, so the incidence of this happening is generally rare. Costs to bring a property to salable condition are capitalized up to the fair value of the property while costs to maintain a property in salable condition are expensed as incurred.

Income Taxes

Deferred income tax assets and liabilities are determined using the balance sheet method.  Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. When calculating deferred tax assets, we are making the assumption that the Corporation will continue to have taxable income, as opposed to losses.  We are also assuming that the Corporation will continue to be assessed at the current rate of 34%.

Financial Condition

Total Assets

The Corporation’s assets grew at a 24.4% pace, ending the year at $576.2 million.  Total loans at year-end 2004, were $491.9 million of which $397.9 million were loans secured by real estate.  The remaining loans consisted of $63.1 million in commercial loans, $25.5 million in consumer installment loans and $5.4 million in all other loans.  Net loans for 2004, were $486.9 million, an increase of $104.4 million or 27.3% from the December 31, 2003

15

balance of $382.5 million.  The loan to deposit ratio was 100.6% for 2004 and 96.3% as of December 31, 2003.  Steady loan demand in an expanding market, combined with continued low interest rates for the first three quarters of the year, generated the loan growth experienced for 2004.  These conditions, along with the strong Valley economy, combined with the growth realized from the new loan production office in Martinsburg, West Virginia, gives management the belief that the Corporation will continue to see strong and increased loan demand for the immediate future.

The investment portfolio increased 13.6% to $27.3 million at year-end 2004 compared to $24.1 million at December 31, 2003.  Federal funds sold increased $2.2 million to $19.1 million at December 31, 2004 compared to $16.9 million at December 31, 2003.  Total interest earning assets increased $110.7 million or 25.9% from December 31, 2003 to December 31, 2004.  This increase was primarily the result of the increase in outstanding loan balances.

Liabilities

Total deposits increased to $483.9 million at December 31, 2004, from a balance of $397.3 million at December 31, 2003, which is an increase of $86.6 million or 21.8%.  Non-interest bearing deposits have increased to $88.2 million as of December 31, 2004, an increase of $27.1 million or 44.3% from year-end 2003.  During this period interest bearing checking and savings accounts increased $18.4 million or 14.1% to $148.7 million.  The balance in time deposits was $247.0 million at the end of 2004 reflecting an increase of $41.1 million or 19.9% over 2003.  As of December 31, 2004 non-interest bearing deposits represented 18.2% of total deposits as compared to 15.4% at year-end 2003.  Low cost interest bearing deposits including savings and interest bearing checking were 30.8% of total deposits, a slight decrease from 32.8% at December 31, 2003. Time deposits represented 51.0% of total deposits at December 31, 2004, nearly unchanged from 51.8% at year-end 2003.  

Advances from the Federal Home Loan Bank were $30.0 million at December 31, 2004, an increase from $10.0 million at December 31, 2003.  In addition, we had $13.4 million in outstanding trust preferred capital notes at December 31, 2004, unchanged from year-end 2003.

Shareholders' Equity

Total equity increased $5.4 million or 13.9% during 2004.  This increase was due to net income of $6.3 million for the year plus exercised stock options of $271 thousand, offset by an unrealized loss on available for sale securities of $138 thousand and further offset by dividends declared of $1.0 million.  The primary capital to assets ratio is 7.7%.

Net Income

Net income for the year ended 2004 was $6.3 million compared to $5.3 million for the same period in 2003. This is an increase of $1.1 million or 20.7% over the same period 2003. The provision for income tax expense increased $499 thousand from $2.5 million in 2003 to $3.0 million in 2004. The return on assets was 1.20% for 2004 as compared to 1.22% for the same period 2003.  For 2004, the return on equity was 15.20% down from 15.86% for 2003.

Net income for the year ended 2003 was $5.3 million compared to $4.4 million for the same period in 2002. This is an increase of $892 thousand or 20.4% over the same period 2002. The return on assets was 1.22% for 2003 as compared to 1.27% for the same period 2002. For 2003, the return on equity was 15.86% up from 15.63% for 2002.

Net Interest Income         

Net interest income is the difference between interest income and interest expense and represents our gross profit margin. The net interest margin represents net interest income divided by average earning assets. It reflects the average effective rate that we earned on our earning assets.  Net interest margin is affected by changes in both average interest rates and average volumes of interest earning assets and interest bearing liabilities.

Net interest income for the year ending December 31, 2004 was $22.5 million, $4.3 million or 23.4% higher than the year ending 2003. This increase is the result of the growth in average earning assets of $90.5 million in 2004.  The combination of growth and rate changes had the effect of increasing the net interest margin from 4.63% at year-end 2003 to 4.65% for the same period of 2004.  As is the case with most financial institutions, Premier is liability sensitive for interest bearing balances re-pricing or maturing within one year.

Net interest income for the year ended December 31, 2003 was $18.2 million, $3.6 million or 24.4% higher than the year ended December 31, 2002. This increase is the result of the growth in average earning assets of $82.1 million in

16

2003. The combination of growth and rate changes had the effect of decreasing the net interest margin from 4.67% at year-end 2002 to 4.63% for the same period of 2003.  

Interest income totaled $31.5 million for the year ended December 31, 2004, $4.9 million or 18.6% higher than the year ending December 31, 2003.  Interest and fees on loans of $30.0 million, which was an increase of 19.5% over the $25.1 million in interest and fees on loans recognized in 2003, comprised the vast majority of interest income. Interest income from investment securities was $1.2 million for 2004, virtually unchanged from the 2003 year-end amount of $1.2 million.  Interest income on federal funds, the third major component of the bank’s investments, increased $18 thousand or 7.6%.   

Interest income totaled $26.5 million for the year ended December 31, 2003, $3.4 million or 14.7% higher than the year ended December 31, 2002. Interest and fees on loans of $25.1 million comprised the vast majority of interest income. Interest income from investment securities was $1.2 million for 2003, down slightly from the 2002 year-end amount of $1.3 million. This slight decrease was due to the decreased balance in the investment portfolio at December 31, 2003.  Interest income on federal funds sold decreased $46 thousand or 16.0%. The decline in interest earned on federal funds balances was the result of a decrease in the interest rate paid on fed funds during 2003.

Total interest expense for the year ended December 31, 2004 was $9.0 million, $678 thousand or 8.2% higher than the year ending 2003.  Interest paid on deposits for 2004 increased by $265 thousand or 3.5% over the same period 2003.  Although interest rates remained at or near record lows during the first three quarters of 2004, the additional expense was generated by an increase of $86.6 million in total deposits during the year.  Interest on borrowings increased by $414 thousand or 54.5% over the same period last year. This increase was primarily the result of interest expense related to the additional borrowings from the Federal Home Loan Bank.  

Total interest expense for the year ended December 31, 2003 was $8.3 million, $175 thousand or 2.1% lower than for the same period 2002. Interest paid on deposits for 2003 decreased by $270 thousand or 3.5% over the same period 2002. The impact of declining interest rates from December 2002 through December 2003 more than offset the additional expense generated by an increase of $52.3 million in total deposits during the same period. Interest on borrowings increased by $95 thousand or 14.0% over the same period 2002. This increase was primarily the result of additional interest expense related to the issuance of a Trust Preferred Issue of $6.0 million during 2003. Borrowings were also obtained from the Federal Home Loan Bank.

17

The following table illustrates average balances of total earning assets and total interest-bearing liabilities for the periods indicated and shows the average distribution of assets, liabilities, shareholders’ equity, and the related income, expense, and corresponding weighted average yields and costs.  The average balances used for the purpose of this table and other statistical disclosures were calculated by using the daily average balances.

18

The following table represents the variances of earning assets and interest-bearing liabilities for the periods indicated.  The total variance for each category is broken down between volume variance and rate variance which provides an analysis of the impact that growth and changes in interest rates have upon the balance sheet structure.

For discussion on our interest sensitivity, see Item 7A below.

The following table presents the amounts of our interest sensitive assets and liabilities that mature or reprice at December 31, 2004.

19

Contractual principal repayments of loans do not necessarily reflect the actual term of our loan portfolio.  The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and enforcement of due-on-sale clauses, which gives us the right to declare a loan immediately due and payable in the event, among other things, the borrower sells the real property subject to the mortgage and the loan is not repaid.  In addition, certain borrowers increase their equity in the security property by making payments in excess of those required under the terms of the mortgage.

Non-Interest Income

Our non-interest income is derived chiefly from service charges on deposit accounts, including charges for non-sufficient funds and ATM fees, and commissions and fees from bank services, such as mortgage originations and debit and credit card processing.

Total other income for 2004 was $4.4 million, an increase of $785 thousand or 21.5% over the 2003 balance of $3.7 million. This was the result of service charges and overdraft fees generated by an increasingly active deposit base and an increasing number of customer accounts, as more customers utilized the bounce protection program introduced in 2003.

Total other income for 2003 was $3.7 million, an increase of $1.2 million or 49.8% over the 2002 balance of $2.4 million. This was the result of service charges and overdraft fees generated by an increasingly active deposit base and an increasing number of customer accounts and the addition of an overdraft protection program.  

Non-Interest Expenses

Non-interest expense consists of salaries and employee benefits, occupancy expenses, furniture and equipment and other operating expenses.  Total non-interest expenses for 2004 were $16.6 million, $3.4 million or 25.4% higher than the 2003 balance.  Salary expenses increased $2.0 million or 29.6%, as the Corporation opened one new branch, expanded its operations, and increased personnel to more efficiently handle the growth of the banks.  Expenses related to a bank-owned life insurance policy, which was newly purchased in 2004, totaled $304 thousand for the year ended 2004.  Expenses related to the bounce protection program, which was instituted in mid 2003, accounted for $266 thousand of non-interest expense for 2004.  The Corporation's efficiency ratio was 61.04% for 2004 compared to 59.9% for the same period in 2003.

Total non-interest expenses for 2003 were $13.2 million, $3.7 million or 38.7% higher than the 2002 balance.  Salary expenses increased $1.6 million or 31.3% during the year.  Advertising and marketing expenses increased $178 thousand or 47.5% during the same period.  The increased salary expenses were attributable to the additional staff needed for the two new branches opened during 2003, and the additional staffing required to more efficiently handle the growth of the banks.  The marketing expenses are related to the branch openings and to the banks’ campaigns to increase market share.  The Corporation’s efficiency ratio was 59.9% for 2003 compared to 55.3% for the same period in 2002.

Income Taxes

The provision for income tax expense increased $499 thousand or 20.1% for the year ended December 31, 2004 to $3.0 million versus $2.5 million at December 31, 2003.  The provision for income tax expense increased $390 thousand or 18.6% for the year ended December 31, 2003 to $2.5 million versus $2.1 million at December 31, 2002.

20

Investments

The following tables reflect the value of the securities portfolio of the Corporation at the dates indicated.

Carrying Value of Securities Available for Sale

Carrying Value of Securities Held to Maturity

At December 31, 2004, the approximate fair value of the securities portfolio was $27.2 million, compared to December 31, 2003 value of $23.9.  As of December 31, 2004, there were no obligations by any one issuer in the investment portfolio, exclusive of obligations of the U.S. Government or U.S. Agencies and Corporations, which in the aggregate exceeded 10% of stockholders’ equity.

21

The following tables set forth the maturity of distribution and weighted average yields of the securities portfolio at December 31, 2004.  The weighted average yields are calculated on the book value of the portfolio and on securities interest income adjusted for amortization of premium and accretion of discount.

(1) Excludes Restricted Securities of $3,198

22

Loans

Net loans consist of total loans, unearned income, deferred loan fees and the allowance for loan losses and excludes loans held for sale.  Net loans were $486.9 million at December 31, 2004, an increase of 27.3% over December 31, 2003.

We have significant concentrations of credit in the land acquisition and land development and construction due to the current growth and other economic development that we have been experiencing in our market area for the last several years.  At December 31, 2004, we had $142.9 million of commercial loans secured by real estate, which represented 29.1% of gross loans at that date.  In addition, at December 31, 2004, we had $101.4 million of construction and land development loans secured by real estate, which represented 20.6% of gross loans at that date.  We believe that these loans are all well-secured and are performing as required.

The following table summarizes the composition of the loan portfolio at the dates indicated:

The Corporation had no loans outstanding to foreign countries or for highly leveraged transactions as of December 31, 2004, or any of the previous years disclosed above. In addition, there were no categories of loans that exceeded 10% of outstanding loans as of December 31, 2004, which were not disclosed.

23

Asset Quality

Asset quality is an important factor in the successful operation of a financial institution.  Banking regulations require institutions to classify their own assets and to establish prudent general allowances for losses for assets classified as substandard or doubtful.  For the portion of assets classified as loss, an institution is required to either establish specific allowances of 100% of the amount classified or charge such amounts off its books.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well–secured and in process of collection.  We place loans on “non-accrual” status at an earlier date, or we charge them off, if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until they qualify for a return to “accrual” status.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses

We maintain the allowance for loan losses at a sufficient level to provide for potential losses in the loan portfolio.  Loan losses are charged directly to the allowance when they occur, while recoveries are credited to the allowance.  Specific reserves by loan type are established based on overall historical losses, anticipated losses, and inherit risk.  Additionally, specific reserves for individual loans are established depending on the severity of the potential loss.  Loans are individually reserved once classified as a “watch item” by management.  A higher percentage of the loan is reserved for individual loans with a more severe classification.  The adequacy of the provision for loan losses is reviewed regularly by management through consideration of several factors including changes in character and size of the loan portfolio and related loan loss experience, a review and examination of overall loan quality whic h includes the identification and assessment of problem loans and an analysis of anticipated economic conditions in the market area.

24

The allowance for loan losses, at December 31, 2004, was $5.0 million. This is an increase of $903 thousand or 22.0% from December 31, 2003. The increases in our allowance for loan losses are the result of adjustments that management has made in response to the growth of our loan portfolio.

An analysis of the allowance for loan losses, including charge-off activity, is presented in the following table for the periods indicated.

25

Allocation of the Allowance for Loan Losses

The following table reflects management’s allocation of the allowance for loan losses at December 31 for each of the years indicated:

Non-Performing Assets

Non-accrual loans at December 31, 2004 were $1.1 million compared to $497 thousand for 2003.  Approximately $22 thousand of interest income would have been recorded if interest had been accrued in 2004.  As of December 31, 2004, the Corporation had a total of $1.8 million in non-accrual, and 90 days past due and still accruing interest, compared to $1.4 million in 2003.  This was an increase of $345 thousand or 23.9%.  The Corporation had no restructured loans during 2004 and 2003.

As of December 31, 2004 the Corporation had $2.6 million in impaired loans, which included the $1.1 million balance in non-accrual loans disclosed above.  The Corporation’s management and Board of Directors have reviewed the asset quality of Marathon’s and Rockingham Heritage’s loan portfolios and both loan loss allowances and have found them to be adequate.

The following table details information concerning non-accrual loans, foreclosed properties and past due loans at December 31 for each of the years indicated:

26

Sources of Funds

Deposits

We primarily use deposits to fund our loans and investment securities.  We offer individuals and small-to-medium-size businesses a variety of deposit accounts.  Deposit accounts, including checking, savings, money markets and certificates of deposit, are obtained primarily from the communities we serve.  We attract both short-term and long-term deposits from the general public by offering a wide assortment of accounts and rates.  We offer statement savings accounts, various checking accounts, various money market accounts, fixed-rate certificates with varying maturities and individual retirement accounts.

At December 31, 2004, deposits were $483.9 million, an increase of 21.8% from $397.3 million at December 31, 2003. The deposit growth is a reflection of branch office growth, aggressive pricing, increased marketing and bank consolidation in our principal market.  In order to reduce the overall cost of funds and reduce our reliance on high cost time deposits and short- term borrowings as a funding source, we continue to direct marketing efforts towards attracting lower cost transaction accounts.  However, there is no assurance that these efforts will be successful, or if successful, will reduce our reliance on time deposits and short-term borrowings.

The following table details the average amount of, and the average rate paid on the following primary deposit categories for the years ended December 31, 2004, 2003 and 2002.

The following is a summary of the maturity distribution of certificates of deposit and other time deposits in amounts of $100,000 or more at December 31, 2004.

27

Certificates of deposit in the amounts of $100,000 or more were $69.7 million at December 31, 2004.  This represents 28.2% of the total certificates of deposit balance of $247.0 million at December 31, 2004.  The Corporation does not solicit such deposits.  Further, the Corporation does bid for selected public funds deposits in large denominations, and such deposits may require a pledging of investment securities.

The Corporation competes with the major regional financial institutions for money market accounts and certificates of deposits less than $100,000.  While the Corporation is competitive with its interest rates, using a tiered rate system to increase individual account balances, the Corporation has found that it can continue to maintain a higher interest margin than its peers by matching loan maturities with certificate maturities and setting loan rates based on the Corporation’s cost of funds.

Liquidity and Capital Reserves

Liquidity is a measure of our ability to generate sufficient cash to meet present and future obligations in a timely manner.  Our liquidity requirements are measured by the need to meet deposit withdrawals, fund loans, meet reserve requirements and maintain cash levels necessary for daily operations. To meet liquidity requirements, we maintain cash reserves and have an adequate flow of funds from maturing loans, securities, and short-term investments. In addition, our banks have the ability to borrow additional funds from various sources.  Short-term borrowings are available from federal funds facilities at correspondent banks and from the discount window of the Federal Reserve Bank.  Borrowings are available from the Federal Home Loan Bank.  We consider our sources of liquidity to be ample to meet our estimated needs.

Our ability to fund these daily commitments at December 31, 2004, 2003 and 2002 is illustrated in the table below:

The net loan to deposit ratio (100.61%) as of December 31, 2004 has provided the opportunity for the Corporation to achieve a high return on its deposits.  For the year ended December 31, 2004, the Corporation experienced a return on assets of 1.20% and a net interest margin of 4.65%.  

Typically, management prefers to maintain a loan to deposit ratio of less than 100%.  The high rate of growth in new loans being produced by the loan production office in Martinsburg, West Virginia, (an office that cannot offer deposit products until it is established as a separate bank) is the primary reason for the Corporation’s higher than usual loan to deposit ratio.  Due to the anticipated deposit growth once Premier Bank has been established, and in light of the short-term borrowings available to the Corporation, management does not feel that this represents a liquidity problem, and we anticipate that the loan to deposit ratio will be back within normal ranges during 2005.

The source of new funds is strong for both long-term and short-term duration.  The growth in deposits was $86.6 million or 21.8% during 2004.  The Corporation also has access to overnight federal funds from correspondent banks totaling up to $22.1 million.  In addition, The Corporation has established borrowing limits through the Federal Reserve Bank’s discount window for $2.0 million. Also, the Corporation has $105.3 million of funds

28

available through the Federal Home Loan Bank of Atlanta of which $30.0 million has been utilized.  Management believes that the opportunity for the sale of loans on the market is good.

The following table summarizes ratios considered to be significant indicators of our profitability and financial condition for the periods indicated.

29

The following tables present the net income of the Corporation, broken down by quarter for the years ended December 31, 2004 and 2003.

Capital Resources

The Corporation’s risk-based capital position at December 31, 2004 was $57.1 million, or 11.9% of risk-weighted assets, for Tier I capital, and $62.1 million, or 12.9% for total risk based capital. Tier I capital consists primarily of common shareholders' equity and Trust Preferred Capital Notes. Total risk-based capital includes the allowance for loan losses in addition to Tier 1 Capital. Risk-weighted assets are determined by assigning various levels of risk to different categories of assets and off-balance sheet items. Under current risk-based capital standards, all banks are required to have Tier I capital of at least 4% and a total capital ratio of 8%.  The Corporation’s issuance of $7.2 million in Trust Preferred Capital Notes in the fourth quarter of 2001 and the additional issue of $6.2 million in 2003 are included in the Tier 1 capital base, and will serve as a long-term source of funding.  

Off-Balance Sheet Obligations

The Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit and commercial lines of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

The Corporation's exposure to credit loss is represented by the contractual amount of these commitments. The Corporation follows the same credit policies in making commitments as it does for on-balance-sheet instruments.

At December 31, 2004, commitments for standby letters of credit totaled $6.2 million, unfunded commitments under lines of credit totaled $76.4 million, and commitments to extend credit totaled $58.4 million.  At December 31, 2003, commitments for standby letters of credit totaled $4.8 million, unfunded commitments under lines of credit totaled $90.3 million, and commitments to extend credit totaled $35.0 million.

30

Contractual Obligations

During the normal course of business, the Corporation obligates itself to certain contractual obligations.  These obligations include long-term debt, capital leases, and operating leases.  The following table summarizes those obligations as of December 31, 2004.

31

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”).  This Interpretation provides guidance with respect to the identification of variable interest entities when the assets, liabilities, non-controlling interests, and results of operations of a variable interest entity need to be included in a Corporation’s consolidated financial statements.  An entity is deemed a variable interest entity, subject to the interpretation, if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or in cases in which the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity’s activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur.  Due to significant implementation issues, the FASB modified the wording of FIN 46 and issued FIN 46R in December of 2003.  FIN46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities (“SPEs”) until financial statements issued for periods ending after March 15, 2004.  SPEs were subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003.  Management has evaluated the Corporation’s investments in variable interest entities and potential variable interest entities or transactions, particularly in limited liability partnerships involved in low-income housing development and trust preferred securities structures because these entities or transactions constitute the Corporation’s primary FIN 46 and FIN 46R exposure.  The adoption of FIN 46 and FIN 46R did not have a material effect on the Corporation’s consolidated financial position or consolidated results of operations.

In December 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”  The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The scope of the SOP applies to unhealthy “problem”  loans that have been acquired, either individually in a portfolio, or in a business  acquisition.  The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality.  The SOP does not apply to loans originated by the Corporation.  The Corporation intends to adopt the provisions of SOP 03-3 effective January 1, 2005, and does not expect the initial implementation to have a significant effect on the Corporation’s consolidated financial position or consolidated results of operations.

Emerging Issues Task Force Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”) was issued and is effective March 31, 2004.  The EITF 03-1 provides guidance for determining the meaning of “other –than-temporarily impaired” and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”) and investments accounted for under the cost method.  The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Corporation can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity.  This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired.  On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1.  This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature.  The disclosure guidance in Issue 03-1 was not delayed.

32

EITF No. 03-16, “Accounting for Investments in Limited Liability Companies was ratified by the Board and is effective for reporting periods beginning after June 15, 2004.”  APB Opinion No. 18, “The Equity Method of Accounting Investments in Common Stock,” prescribes the accounting for investments in common stock of corporations that are not consolidated.  AICPA Accounting Interpretation 2, “Investments in Partnerships Ventures,” of Opinion 18, indicates that “many of the provisions of the Opinion would be appropriate in accounting” for partnerships. In EITF Abstracts, Topic  No. D-46, “Accounting for Limited Partnership Investments,” the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method.  Limited liability companies (LLCs) have characteristics of both characteristics of both corporations and partnerships, but are dissimilar from both in certain respects.  Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs.  The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting. We do not expect that implementation will have a significant impact on the financial statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment.” This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions).  That cost will be recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period (usually the vesting period). The entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date.    Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available).  If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification.   This Statement is effective for public entities that do not file as small business issuers—as of the beginning of the first interim or annual reporting period that begins after June 15, 2005.  Under the transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures.   For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123.