Attached files

file filename
EX-32 - EXHIBIT 32 (I) - NATIONAL BANKSHARES INCex32i.htm
EX-31 - EXHIBIT 31 (I) - NATIONAL BANKSHARES INCex31i.htm
EX-31 - EXHIBIT 31 (II) - NATIONAL BANKSHARES INCex31ii.htm
EX-32 - EXHIBIT 32 (II) - NATIONAL BANKSHARES INCex32ii.htm

 
 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-Q

[x]QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT   OF 1934
For the quarterly period ended September 30, 2010
[  ]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________ to ________
Commission File Number 0-15204

NATIONAL BANKSHARES, INC.
 (Exact name of registrant as specified in its charter)

Virginia
(State or other jurisdiction of incorporation or organization)
54-1375874
(I.R.S. Employer Identification No.)

101 Hubbard Street
P. O. Box 90002
Blacksburg, VA
 
 
24062-9002
(Address of principal executive offices)
(Zip Code)

(540) 951-6300
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 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.  [x] Yes   [  ] No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). [x] Yes   [ ] No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b–2 of the Exchange Act.

Large accelerated filer  [  ]      Accelerated filer  [x]      Non-accelerated filer  [  ]       Smaller reporting company  [  ]
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b–2 of the Exchange Act).
[ ] Yes   [x] No

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

Class
Common Stock, $1.25 Par Value
Outstanding at November 1, 2010
6,933,474

(This report contains 36 pages)


 
 

 

NATIONAL BANKSHARES, INC. AND SUBSIDIARIES

Form 10-Q
Index


 
Page
     
Item 1
3
     
 
3 - 4
     
 
5 - 6
     
 
7 - 8
     
 
9
 
 
 
 
10 - 11
 
 
 
 
12 - 20
     
Item 2
20 - 29
     
Item 3
30
     
Item 4
30
     
   
     
Item 1
30
     
Item 1A
30
     
Item 2
30
     
Item 3
30
 
 
 
Item 4
30
 
 
 
Item 5
30
     
Item 6
31
     
 
31
     
 
32 - 33




 
2

 

Part I
Financial Information
Item 1. Financial Statements
National Bankshares, Inc. and Subsidiaries
Consolidated Balance Sheets

 
 
(Unaudited)
       
   
September 30,
   
December 31,
 
$ in thousands, except per share data
 
2010
   
2009
 
Assets
               
Cash and due from banks
 
$
12,540
   
$
12,894
 
Interest-bearing deposits
   
55,367
     
32,730
 
Securities available for sale, at fair value
   
154,980
     
168,041
 
Securities held to maturity (fair value approximates $132,220 at September 30, 2010 and $129,892 at December 31, 2009)
   
127,480
     
129,376
 
Mortgage loans held for sale
   
1,732
     
126
 
Loans:
               
Real estate construction loans
   
48,908
     
45,625
 
Real estate mortgage loans
   
173,753
     
165,542
 
Commercial and industrial loans
   
269,620
     
283,998
 
Loans to individuals
   
91,328
     
95,844
 
Total loans
   
583,609
     
591,009
 
Less unearned income and deferred fees
   
(975
)
   
 (1,062
)
Loans, net of unearned income and deferred fees
   
582,634
     
589,947
 
Less allowance for loan losses
   
(7,794
)
   
(6,926
)
Loans, net
   
574,840
     
583,021
 
Premises and equipment, net
   
10,608
     
10,628
 
Accrued interest receivable
   
6,000
     
6,250
 
Other real estate owned, net
   
3,026
     
2,126
 
Intangible assets and goodwill
   
11,814
     
12,626
 
Other assets
   
24,060
     
24,549
 
Total assets
 
$
982,447
   
$
982,367
 
                 
Liabilities and Stockholders' Equity
               
Noninterest-bearing demand deposits
 
$
125,877
   
$
122,549
 
Interest-bearing demand deposits
   
316,820
     
310,629
 
Savings deposits
   
55,695
     
51,622
 
Time deposits
   
343,464
     
367,312
 
Total deposits
   
841,856
     
852,112
 
Accrued interest payable
   
304
     
336
 
Other liabilities
   
7,673
     
7,843
 
Total liabilities
   
849,833
     
860,291
 
Commitments and contingencies
   
---
     
---
 

 
3

 


                 
Stockholders' Equity
               
 
               
        Preferred stock, no par value, 5,000,000 shares authorized; none issued and outstanding
 
$
---
   
$
---
 
Common stock of $1.25 par value.
               
Authorized 10,000,000 shares; issued and outstanding 6,933,474 shares in 2010 and in 2009
   
8,667
     
8,667
 
Retained earnings
   
122,612
     
113,901
 
Accumulated other comprehensive income (loss), net
   
1,335
     
(492
)
Total stockholders' equity
   
132,614
     
122,076
 
Total liabilities and stockholders' equity
 
$
982,447
   
$
982,367
 

See accompanying notes to consolidated financial statements.

 
4

 

National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
Three Months Ended September 30, 2010 and 2009
(Unaudited)


   
September 30,
   
September 30,
 
$ in thousands, except per share data
 
2010
   
2009
 
Interest Income
               
Interest and fees on loans
 
$
9,284
   
$
9,316
 
Interest on interest-bearing deposits
   
36
     
23
 
Interest on securities – taxable
   
1,325
     
1,600
 
Interest on securities – nontaxable
   
1,642
     
1,677
 
Total interest income
   
12,287
     
12,616
 
                 
Interest Expense
               
Interest on time deposits of $100,000 or more
   
855
     
1,379
 
Interest on other deposits
   
1,871
     
2,496
 
Interest on other borrowed funds
   
---
     
1
 
Total interest expense
   
2,726
     
3,876
 
Net interest income
   
9,561
     
8,740
 
Provision for loan losses
   
710
     
305
 
Net interest income after provision for loan losses
   
8,851
     
8,435
 
                 
Noninterest Income
               
Service charges on deposit accounts
   
706
     
865
 
Other service charges and fees
   
63
     
107
 
Credit card fees
   
745
     
723
 
Trust income
   
316
     
255
 
BOLI income
   
197
     
201
 
Other income
   
72
     
76
 
Realized securities gains (losses), net
   
2
     
(15
)
Total noninterest income
   
2,101
     
2,212
 
                 
Noninterest Expense
               
Salaries and employee benefits
   
2,695
     
2,784
 
Occupancy and furniture and fixtures
   
451
     
450
 
Data processing and ATM
   
414
     
380
 
FDIC assessment
   
273
     
423
 
Credit card processing
   
588
     
550
 
Intangible assets amortization
   
270
     
271
 
Net costs of other real estate owned
   
120
     
29
 
Franchise taxes
   
241
     
221
 
Other operating expenses
   
774
     
783
 
Total noninterest expense
   
5,826
     
5,891
 
Income before income taxes
   
5,126
     
4,756
 
Income tax expense
   
1,129
     
976
 
Net Income
 
$
3,997
   
$
3,780
 
 
 
 
5

 
 
 
Basic net income per share
 
$
0.58
   
$
0.55
 
Fully diluted net income per share
 
$
0.58
   
$
0.54
 
Weighted average number of common
               
shares outstanding – basic
   
6,933,474
     
6,933,474
 
Weighted average number of common
               
shares outstanding – diluted
   
6,942,919
     
6,948,083
 
Dividends declared per share
 
$
---
   
$
---
 

See accompanying notes to consolidated financial statements.

 
6

 

National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
Nine Months Ended September 30, 2010 and 2009
(Unaudited)


   
September 30,
   
September 30,
 
$ in thousands, except per share data
 
2010
   
2009
 
Interest Income
               
Interest and fees on loans
 
$
27,720
   
$
28,170
 
Interest on interest-bearing deposits
   
85
     
73
 
Interest on securities – taxable
   
4,234
     
4,766
 
Interest on securities – nontaxable
   
4,835
     
4,896
 
Total interest income
   
36,874
     
37,905
 
                 
Interest Expense
               
Interest on time deposits of $100,000 or more
   
2,695
     
4,363
 
Interest on other deposits
   
5,860
     
8,197
 
Interest on borrowed funds
   
---
     
2
 
Total interest expense
   
8,555
     
12,562
 
Net interest income
   
28,319
     
25,343
 
Provision for loan losses
   
2,209
     
953
 
Net interest income after provision for loan losses
   
26,110
     
24,390
 
                 
Noninterest Income
               
Service charges on deposit accounts
   
2,192
     
2,506
 
Other service charges and fees
   
214
     
263
 
Credit card fees
   
2,171
     
2,060
 
Trust income
   
846
     
792
 
BOLI income
   
558
     
554
 
Other income
   
215
     
261
 
Realized securities gains (losses), net
   
(1
)
   
55
 
Total noninterest income
   
6,195
     
6,491
 
                 
Noninterest Expense
               
Salaries and employee benefits
   
8,205
     
8,409
 
Occupancy and furniture and fixtures
   
1,419
     
1,344
 
Data processing and ATM
   
1,120
     
1,016
 
FDIC assessment
   
805
     
1,429
 
Credit card processing
   
1,680
     
1,551
 
Intangible assets amortization
   
812
     
822
 
Net costs of other real estate owned
   
180
     
100
 
Franchise taxes
   
722
     
666
 
Other operating expenses
   
2,364
     
2,364
 
Total noninterest expense
   
17,307
     
17,701
 
Income before income taxes
   
14,998
     
13,180
 
Income tax expense
   
3,236
     
2,656
 
Net Income
 
$
11,762
   
$
10,524
 
 
 
 
7

 
 
 
Basic net income per share
 
$
1.70
   
$
1.52
 
Fully diluted net income per share
 
$
1.69
   
$
1.52
 
Weighted average number of common
               
shares outstanding – basic
   
6,933,474
     
6,931,672
 
Weighted average number of common
               
shares outstanding – diluted
   
6,947,460
     
6,942,712
 
Dividends declared per share
 
$
0.44
   
$
0.41
 

See accompanying notes to consolidated financial statements.

 
8

 

National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
Nine Months Ended September 30, 2010 and 2009
(Unaudited)

$ in thousands, except per share data
 
Common Stock
   
Retained Earnings
   
Accumulated Other Comprehensive Income (Loss)
   
Comprehensive Income
   
Total
 
Balances at December 31, 2008
  $ 8,662     $ 105,356     $ (3,910 )  
 
    $ 110,108  
Net income
    ---       10,524       ---     $ 10,524       10,524  
Dividends $0.41 per share
    ---       (2,843 )     ---       ---       (2,843 )
Exercise of stock options
    5       50       ---       ---       55  
Other comprehensive income, net of tax:
                                       
Unrealized gain on securities available for sale, net of income tax $1,938
    ---       ---       ---       3,600       ---  
Reclass adjustment, net of tax $15
    ---       ---       ---       27       ---  
Other comprehensive income, net of tax $1,953
    ---       ---       3,627       3,627       3,627  
Comprehensive income
    ---       ---       ---     $ 14,151       ---  
Balances at September 30, 2009
  $ 8,667     $ 113,087     $ (283 )           $ 121,471  
                                         
Balances at December 31, 2009
  $ 8,667     $ 113,901     $ (492 )           $ 122,076  
Net income
    ---       11,762       ---     $ 11,762       11,762  
Dividends $0.44 per share
    ---       (3,051 )     ---       ---       (3,051 )
Other comprehensive income, net of tax:
                                       
Unrealized gain on securities available for sale, net of income tax $979
    ---       ---       ---       1,818       ---  
Reclass adjustment, net of tax $5
    ---       ---       ---       9       ---  
Other comprehensive income, net of tax $984
    ---       ---       1,827       1,827       1,827  
Comprehensive income
    ---       ---       ---     $ 13,589       ---  
Balances at September 30, 2010
  $ 8,667     $ 122,612     $ 1,335             $ 132,614  

See accompanying notes to consolidated financial statements.

 
9

 

National Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2010 and 2009
(Unaudited)

   
September 30,
   
September 30,
 
$ in thousands
 
2010
   
2009
 
Cash Flows from Operating Activities
           
Net income
  $ 11,762     $ 10,524  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    2,209       953  
Depreciation of bank premises and equipment
    671       687  
Amortization of intangibles
    812       822  
Amortization of premiums and accretion of discounts, net
    227       268  
(Gains) on disposal of fixed assets
    (3 )     ---  
(Gains) Losses on sales and calls of securities available for sale, net
    14       (42 )
(Gains) on calls of securities held to maturity, net
    (13 )     (13 )
Losses and write-downs on other real estate owned
    67       54  
Net change in:
               
Mortgage loans held for sale
    (1,606 )     (280 )
Accrued interest receivable
    250       (562 )
Other assets
    (433 )     (1,309 )
Accrued interest payable
    (32 )     (182 )
Other liabilities
    (170 )     1,316  
Net cash provided by operating activities
    13,755       12,236  
                 
Cash Flows from Investing Activities
               
Net change interest-bearing deposits
    (22,637 )     6,721  
Proceeds from calls, principal payments, sales and maturities of securities available for sale
    58,257       19,699  
Proceeds from calls, principal payments and maturities of securities held to maturity
    29,000       31,929  
Purchases of securities available for sale
    (42,619 )     (36,542 )
Purchases of securities held to maturity
    (27,160 )     (47,024 )
Purchases of loan participations
    ---       (13 )
Collections of loan participations
    3,093       704  
Loan originations and principal collections, net
    1,231       (7,480 )
Proceeds from disposal of other real estate owned
    563       269  
Recoveries on loans charged off
    118       64  
Additions to bank premises and equipment
    (648 )     (217 )
Net cash used in investing activities
    (802 )     (31,890 )
                 
Cash Flows from Financing Activities
               
Net change in time deposits
    (23,848 )     (21,244 )
Net change in other deposits
    13,592       39,269  
Net change in other borrowed funds
    ---       (8 )
Cash dividends
    (3,051 )     (2,843 )
Stock options exercised
    ---       55  
Net cash provided by (used in) financing activities
    (13,307 )     15,229  
Net change in cash and due from banks
    (354 )     (4,425 )
Cash and due from banks at beginning of period
    12,894       16,316  
Cash and due from banks at end of period
  $ 12,540     $ 11,891  
 
 
 
10

 
 
 
Supplemental Disclosures of Cash Flow Information
               
Interest paid on deposits and borrowed funds
  $ 8,587     $ 12,744  
Income taxes paid
  $ 4,308     $ 3,200  
                 
Supplemental Disclosure of Noncash Activities
               
Loans charged against the allowance for loan losses
  $ 1,459     $ 422  
Loans transferred to other real estate owned
  $ 1,530     $ 283  
Unrealized gains on securities available for sale
  $ 2,811     $ 5,580  


See accompanying notes to consolidated financial statements.

 
11

 

National Bankshares, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2010
(Unaudited)

$ in thousands, except per share data and % data

Note 1: General

The consolidated financial statements of National Bankshares, Inc. (NBI) and its wholly-owned subsidiaries, The National Bank of Blacksburg (NBB) and National Bankshares Financial Services, Inc. (NBFS) (collectively, the Company), conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments, which are necessary for a fair presentation of the consolidated financial statements, have been included.  The results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of results of operations for the full year or any other interim period.  The interim period consolidated financial statements and financial information included in this Form 10-Q should be read in conjunction with the notes to consolidated financial statements included in the Company’s 2009 Form 10-K.  The Company posts all reports required to be filed under the Securities and Exchange Act of 1934 on its web site at www.nationalbankshares.com.
Subsequent events have been considered through the date when the Form 10-Q was issued.
Note 2: Stock-Based Compensation

The Company had a stock option plan, the 1999 Stock Option Plan, that was adopted in 1999 and that was terminated on March 9, 2009. From 1999 to 2005, incentive stock options were granted annually to key employees of NBI and its subsidiaries. None have been granted since 2005.  All of the outstanding stock options are vested. Because there have been no options granted in 2010 and all options were fully vested at December 31, 2008, there is no expense included in net income for the periods presented.

Options
 
Shares
   
Weighted
Average
Exercise
Price
   
Weighted
Average
Remaining
Contractual
Term
   
Aggregate
Intrinsic
Value
 
Outstanding at January 1, 2010
    109,500     $ 22.14              
Exercised
    ---       ---              
Forfeited or expired
    ---       ---              
Outstanding September 30, 2010
    109,500     $ 22.14       4.74     $ 401  
Exercisable at September 30, 2010
    109,500     $ 22.14       4.74     $ 401  

During the nine months ended September 30, 2010, there were no stock options exercised. During the first nine months of 2009, 4,000 shares were exercised with an intrinsic value of $47. There were no stock options granted in the first nine months of 2010.


 
12

 

Note 3:                      Allowance for Loan Losses, Nonperforming Assets and Impaired Loans

   
Nine Months ended
September 30,
   
Year ended
December 31,
 
   
2010
   
2009
   
2009
 
Balance at beginning of period
  $ 6,926     $ 5,858     $ 5,858  
Provision for loan losses
    2,209       953       1,634  
Loans charged off
    (1,459 )     (422 )     (647 )
Recoveries of loans previously charged off
    118       64       81  
Balance at the end of period
  $ 7,794     $ 6,453     $ 6,926  
Ratio of allowance for loan losses to the end of period loans, net of unearned income and deferred fees
    1.34 %     1.11 %     1.17 %
Ratio of net charge-offs to average loans, net of unearned income and deferred fees(1)
    0.31 %     0.08 %     0.10 %
Ratio of allowance for loan losses to nonperforming loans(2)
    102.03 %     165.97 %     102.61 %

(1)  
Net charge-offs are on an annualized basis.
(2)  
The Company defines nonperforming loans as total nonaccrual and restructured loans.  Loans 90 days past due and still accruing are excluded.

   
September 30,
   
December 31,
 
   
2010
   
2009
   
2009
 
Nonperforming assets:
                 
Nonaccrual loans
  $ 7,639     $ 3,888     $ 4,098  
Restructured loans not in nonaccrual
    ---       ---       2,652  
Total nonperforming loans
    7,639       3,888       6,750  
Other real estate owned, net
    3,026       1,944       2,126  
Total nonperforming assets
  $ 10,665     $ 5,832     $ 8,876  
Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned
    1.82 %     1.00 %     1.50 %

   
September 30,
   
December 31,
 
   
2010
   
2009
   
2009
 
Loans past due 90 days or more and still accruing
  $ 533     $ 2,153     $ 1,697  
Ratio of loans past due 90 days or more and still accruing to loans, net of unearned income and deferred fees
    0.09 %     0.37 %     0.29 %
Impaired loans:
                       
Total impaired loans
  $ 7,207     $ 5,812     $ 7,680  
Impaired loans with a valuation allowance
  $ 7,207     $ 5,812     $ 7,630  
Valuation allowance
    (1,148 )     (1,718 )     (2,495 )
Impaired loans, net of allowance
  $ 6,059     $ 4,094     $ 5,135  
Impaired loans with no valuation allowance
  $ ---     $ ---     $ 50  
Average recorded investment in impaired loans
  $ 7,928     $ 5,995     $ 7,851  
Income recognized on impaired loans
  $ 15     $ 137     $ 169  
Amount of income recognized on a cash basis
  $ ---     $ ---     $ ---  

Nonaccrual loans not subject to ASC 310-10 were $433 at September 30, 2010. There was no income recognized for these loans.

 
13

 

Note 4: Securities

The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for sale by major security type as of September 30, 2010 are as follows:

   
September 30, 2010
 
   
Amortized
Costs
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Values
 
Available for sale:
                       
U.S. Treasury
  $ 2,016     $ 205     $ ---     $ 2,221  
U.S. Government agencies
    51,693       1,149       14       52,828  
Mortgage-backed securities
    12,321       725       ---       13,046  
States and political subdivisions
    62,606       2,594       60       65,140  
Corporate
    16,914       955       ---       17,869  
Federal Home Loan Bank stock
    1,677       ---       ---       1,677  
Federal Reserve Bank stock
    92       ---       ---       92  
Other securities
    2,342       ---       235       2,107  
Total
  $ 149,661     $ 5,628     $ 309     $ 154,980  

The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type as of September 30, 2010 are as follows:

   
September 30, 2010
 
   
Amortized
Costs
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Values
 
Held to maturity:
                       
U.S. Government agencies
  $ 12,080     $ 621     $ ---     $ 12,701  
Mortgage-backed securities
    1,226       96       ---       1,322  
States and political subdivisions
    109,013       4,268       282       112,999  
Corporate
    5,161       41       4       5,198  
Total
  $ 127,480     $ 5,026     $ 286     $ 132,220  

Information pertaining to securities with gross unrealized losses at September 30, 2010 and December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

   
September 30, 2010
 
   
Less Than 12 Months
   
12 Months or More
 
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Temporarily impaired securities:
                       
U.S. Government agencies
  $ 1,986     $ 14     $ ---     $ ---  
States and political subdivisions
    11,638       199       4,145       143  
Corporate
    ---       ---       996       4  
Other securities
    ---       ---       260       235  
Total
  $ 13,624     $ 213     $ 5,401     $ 382  

 
 
14

 
 

 
   
December 31, 2009
 
   
Less Than 12 Months
   
12 Months or More
 
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Temporarily impaired securities:
                       
U.S. Government agencies
  $ 42,876     $ 1,351     $ ---     $ ---  
States and political subdivisions
    28,537       571       13,382       698  
Corporate
    662       1       3,517       483  
Other securities
    ---       ---       277       217  
Total
  $ 72,075     $ 1,923     $ 17,176     $ 1,398  

The Company had 24 securities with a fair value of $19,025 which were temporarily impaired at September 30, 2010.  The total unrealized loss on these securities was $595. Of the temporarily impaired total, nine securities with a fair value of $5,401 and an unrealized loss of $382 have been in a continuous loss position for twelve months or more. The Company has determined that these securities are temporarily impaired at September 30, 2010 for the reasons set out below.
U.S. Government agencies. The unrealized losses in this category of investments were caused by interest rate fluctuations. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments and it is not likely that the Company will be required to sell any of these investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired.
States and political subdivisions. This category’s unrealized losses are primarily the result of interest rate fluctuations and also a certain few ratings downgrades brought about by the impact of the economic downturn on states and political subdivisions. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments and it is not likely that the Company will be required to sell any of the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired.
Corporate debt securities. The Company’s unrealized losses in corporate debt securities are related to both interest rate fluctuations and ratings downgrades for a limited number of securities. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired.
Other. The Company holds an investment in an LLC and a small amount of community bank stock. The value of these investments has been negatively affected by market conditions. Because the Company does not intend to sell these investments before recovery of amortized cost basis, the Company does not consider these investments to be other-than-temporarily impaired. 
As a member of the Federal Reserve and the Federal Home Loan Bank (FHLB) of Atlanta, NBB is required to maintain certain minimum investments in the common stock of those entities. Required levels of investment are based upon NBB’s capital and a percentage of qualifying assets. In addition, NBB is eligible to borrow from the FHLB with borrowings collateralized by qualifying assets, primarily residential mortgage loans and NBB’s capital stock investment in the FHLB. Redemption of FHLB stock is subject to certain limitations and conditions. Management reviews for impairment based upon the ultimate recoverability of the cost basis of the FHLB stock, and at September 30, 2010 management did not consider there to be any impairment.
Management regularly monitors the credit quality of the investment portfolio. Changes in ratings are noted and follow-up research on the issuer is undertaken when warranted. Management intends to carefully follow any changes in bond quality. Refer to “Securities” in this report for additional information.

Note 5: Recent Accounting Pronouncements

 In June 2009, the FASB issued new guidance relating to the accounting for transfers of financial assets. The new guidance, which was issued as SFAS No. 166, “Accounting for Transfers of Financial Assets, an amendment to SFAS No. 140”, was adopted into Codification in December 2009 through the issuance of Accounting Standards Update (ASU) 2009-16. The new standard provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  ASU 2009-16 was effective for transfers on or after January 1, 2010.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
 
 
 
15

 

In June 2009, the FASB issued new guidance relating to variable interest entities.  The new guidance, which was issued as SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” was adopted into Codification in December 2009. The objective of the guidance is to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS No. 167 was effective as of January 1, 2010. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In October 2009, the FASB issued ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.” ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics – Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections to existing SEC guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residential method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring defined benefit obligation. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In February 2010, the FASB issued ASU 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements.”  ASU 2010-09 addresses both the interaction of the requirements of Topic 855 with the SEC’s reporting requirements and the intended breadth of the reissuance disclosures provisions related to subsequent events.  An entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated.  ASU 2010-09 is effective immediately. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The new disclosure guidance will significantly expand the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending on or after December 15, 2010.  Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance rollforward and modification disclosures, will be required for periods beginning or after December 15, 2010.  The Company is currently assessing the impact that ASU 2010-20 will have on its consolidated financial statements.
On September 15, 2010, the SEC issued Release No. 33-9142, “Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Non-Accelerated Filers.”  This release issued a final rule adopting amendments to its rules and forms to conform them to Section 404(c) of the Sarbanes-Oxley Act of 2002 (SOX), as added by Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  SOX Section 404(c) provides that Section 404(b) shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934. Release No. 33-9142 was effective September 21, 2010.
On September 17, 2010, the SEC issued Release No. 33-9144, “Commission Guidance on Presentation of Liquidity and Capital Resources Disclosures in Management’s Discussion and Analysis.”  This interpretive release is intended to improve discussion of liquidity and capital resources in Management’s Discussion and Analysis of Financial Condition and Results of Operations in order to facilitate understanding by investors of the liquidity and funding risks facing the registrant. This release was issued in conjunction with a proposed rule, “Short-Term Borrowings Disclosures,” that would require public companies to disclose additional information to investors about their short-term borrowing arrangements. Release No. 33-9144 was effective on September 28, 2010.

 
16

 

Note 6: Defined Benefit Plan

Components of Net Periodic Benefit Cost:

   
Pension Benefits
 
   
Nine Months ended September 30,
 
   
2010
   
2009
 
Service cost
  $ 300     $ 264  
Interest cost
    516       495  
Expected return on plan assets
    (456 )     (396 )
Amortization of prior service cost
    (75 )     (75 )
Amortization of net obligation at transition
    (9 )     (9 )
Recognized net actuarial loss
    186       252  
Net periodic benefit cost
  $ 462     $ 531  

Employer Contributions

NBI’s required minimum pension plan contribution for 2010 is $585. The contribution is being paid in quarterly installments.

Note 7: Fair Value Measurements

The Company records fair value adjustments to certain assets and liabilities and determines fair value disclosures utilizing a definition of fair value of assets and liabilities that states that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Additional considerations come into play in determining the fair value of financial assets in markets that are not active.
The Company uses a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:
 
Level 1 –
 
Valuation is based on quoted prices in active markets for identical assets and liabilities.
 
Level 2 –
 
Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
 
Level 3 –
 
Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities Available for Sale

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). The carrying value of restricted Federal Reserve Bank and Federal Home Loan Bank stock approximates fair value based upon the redemption provisions of each entity and is therefore excluded from the following table.

 
17

 


The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2010:

       
Fair Value Measurements
Using
 
Date
Description
Balance
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable Inputs
(Level 3)
 
 
Assets:
                       
September 30, 2010
Securities available for sale
  $ 153,211     $ ---     $ 153,211     $ ---  
December 31, 2009
Securities available for sale
    166,272       ---       166,272       ---  

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements:

Loans Held for Sale

Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale at September 30, 2010 or December 31, 2009. Gains and losses on the sale of loans are recorded within income from mortgage banking on the Consolidated Statements of Income.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. Troubled debt restructurings are impaired loans. The measurement of loss associated with impaired loans may be based on either the observable market price of the loan, the present value of the expected cash flows or the fair value of the collateral. Fair value of the Company’s impaired loans is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company. However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal using observable market data, if the collateral is deemed significant. If the collateral is not deemed significant, the value of business equipment is based on the net book value on the borrower’s financial statements. Likewise, values for inventory and accounts receivables collateral are based on the borrower’s financial statement balances or aging reports (Level 3). Estimated losses on impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.


 
18

 


The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis at September 30, 2010 and at December 31, 2009.

       
Carrying Value
 
Date
Description
Balance
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable Inputs
(Level 3)
 
 
Assets:
                       
September 30, 2010
Impaired loans net of valuation allowance
  $ 6,059     $ ---     $ ---     $ 6,059  
December 31, 2009
Impaired loans net of valuation allowance
    5,135       ---       ---       5,135  

Other Real Estate Owned

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell.

The following table summarizes the Company’s other real estate owned that was measured at fair value on a nonrecurring basis at September 30, 2010 and at December 31, 2009.

       
Carrying Value
 
Date
Description
Balance
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable Inputs
(Level 3)
 
 
Assets:
                       
September 30, 2010
Other real estate owned net of valuation allowance
  $ 1,148     $ ---     $ ---     $ 1,148  
December 31, 2009
Other real estate owned net of valuation allowance
    1,868       ---       ---       1,868  

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:

Cash and Due from Banks, Interest-Bearing Deposits, and Federal Funds Sold

The carrying amounts approximate fair value.

Securities

The fair value of securities, excluding restricted stock, is determined by quoted market prices or dealer quotes. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments adjusted for differences between the quoted instruments and the instruments being valued. The carrying value of restricted securities approximates fair value based upon the redemption provisions of the applicable entities.

Loans Held for Sale

The fair value of loans held for sale is based on commitments on hand from investors or prevailing market prices.

 
 
19

 
 
 
Loans

Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, real estate – commercial, real estate – construction, real estate – mortgage, credit card and other consumer loans. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories.
The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan, as well as estimates for prepayments. The estimate of maturity is based on the Company’s historical experience with repayments for loan classification, modified, as required, by an estimate of the effect of economic conditions on lending.
Fair value for significant nonperforming loans is based on estimated cash flows which are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows and discount rates are determined within management’s judgment, using available market information and specific borrower information.

Deposits

The fair value of demand and savings deposits is the amount payable on demand. The fair value of fixed maturity term deposits and certificates of deposit is estimated using the rates currently offered for deposits with similar remaining maturities.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Commitments to Extend Credit and Standby Letters of Credit

The only amounts recorded for commitments to extend credit, standby letters of credit and financial guarantees written are the deferred fees arising from these unrecognized financial instruments. These deferred fees are not deemed significant at September 30, 2010 and, as such, the related fair values have not been estimated.

The estimated fair values, and related carrying amounts, of the Company’s financial instruments are as follows:

   
September 30, 2010
   
December 31, 2009
 
   
Carrying
Amount
   
Estimated Fair
 Value
   
Carrying
Amount
   
Estimated Fair
 Value
 
Financial assets:
                       
Cash and due from banks
  $ 12,540     $ 12,540     $ 12,894     $ 12,894  
Interest-bearing deposits
    55,367       55,367       32,730       32,730  
Securities
    282,460       287,200       297,417       297,933  
Mortgage loans held for sale
    1,732       1,732       126       126  
Loans, net
    574,840       548,434       583,021       588,201  
Accrued interest receivable
    6,000       6,023       6,250       6,250  
Financial liabilities:
                               
Deposits
  $ 841,856       854,525     $ 852,112     $ 856,556  
Accrued interest payable
    304       304       336       336  


Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations
$ in thousands, except per share data

The purpose of this discussion and analysis is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly-owned subsidiaries (the Company), which are not otherwise apparent from the consolidated financial statements and other information included in this report.  Please refer to the financial statements and other information included in this report as well as the 2009 Annual Report on Form 10-K for an understanding of the following discussion and analysis.

Cautionary Statement Regarding Forward-Looking Statements

We make forward-looking statements in this Form 10-Q that are subject to significant 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, and are based upon our management’s views and assumptions as of the date of this report.  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.
 
 
20

 
 
These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, changes in:
· interest rates,
· general economic conditions,
· the legislative/regulatory climate,
·  
monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency and the Federal Reserve Board, and the impact of any policies or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 (EESA) and other financial reform legislation,
·  
the effects of increased regulation of financial service companies and banks as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
· unanticipated increases in the level of unemployment in the Company’s trade area,
· the quality or composition of the loan and/or investment portfolios,
· demand for loan products,
· deposit flows,
· competition,
· demand for financial services in the Company’s trade area,
· the real estate market in the Company’s trade area,
· the Company’s technology initiatives, and
· applicable accounting principles, policies and guidelines.
These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our “Risk Factors” in Item 1A. of our 2009 Annual Report on Form 10-K.
The Company was not negatively impacted during the initial phases of the economic slowdown in late 2008. Its markets did not experience the dramatic declines in real estate values seen in some other areas of the country. In addition, the diverse economy of the Company’s market area, including several large employers that are public colleges or universities, helped to insulate the Company from the worst effects of the recession. As the recession continued into 2009, real estate values in the Company’s trade area declined moderately. In early 2010, the Company experienced an increasing level of nonperforming assets, including nonperforming loans and other real estate owned. If the economic recovery progresses slowly or is reversed, it is likely that unemployment will continue to rise in the Company’s trade area. Because of the importance to the Company’s markets of state-funded universities, cutbacks in the funding provided by the State as a result of the recession could also negatively impact employment. This could lead to an even higher rate of delinquent loans and a greater number of real estate foreclosures. Higher unemployment and the fear of layoffs causes reduced consumer demand for goods and services, which negatively impacts the Company’s business and professional customers. In conclusion, a slow economic recovery could have an adverse effect on all financial institutions, including the Company.

Critical Accounting Policies
 
General
 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from one previously acceptable method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an accrual of estimated losses that may be sustained in our loan portfolio. The allowance is reduced by charge-offs of loans and increased by the provision for loan losses and recoveries of previously charged-off loans.  The determination of the allowance is based on two accounting principles, FASB Topic 450-25 (Contingencies) which requires that losses be accrued when occurrence is probable and the loss is reasonably estimable, and FASB Topic 310-10 (Receivables) which requires accrual of losses on impaired loans if the recorded investment exceeds fair value.
 
 
21

 
 
Probable losses are accrued through two calculations, individual evaluation of impaired loans and collective evaluation of the remainder of the portfolio. Impaired loans are larger non-homogeneous loans for which there is a probability that any contractual amounts due will be uncollectible, as well as loans whose terms have been modified in a troubled debt restructuring. Impaired loans are placed on nonaccrual status and are individually evaluated for potential loss.
Estimated loss for an impaired loan is the amount of recorded investment that exceeds the loan’s fair value. Fair value of an impaired loan is measured by one of three methods, the fair value (less cost to sell) of collateral, the present value of future cash flows, or observable market price. For non collateral-dependent loans, the potential loss is accrued in the allowance. For collateral-dependent loans, the potential loss is charged off against the allowance, instead of being accrued.
In the third quarter of 2010, the Company revised its policy for collective evaluation of non-impaired loans. The policy formalized criteria used to group loans for purposes of estimating losses; provided for analysis of trends and current levels of risk indicators; and designated loans that the Company deems to have inherently higher risk.
Non-impaired loans are grouped by portfolio segment and loan class. Loans within a segment or class have similar risk characteristics. Each segment and class is evaluated for probable loss by applying quantitative and qualitative factors, including net charge-off trends, delinquency rates, concentration trends and economic trends. The Company accrues additional estimated loss for criticized loans within each class and for loans designated high risk.
The change in methodology did not materially affect the total estimated accrual, however previously unallocated amounts became allocated with the new methodology.
The estimation of the accrual involves analysis of internal and external variables, methodologies, assumptions and our judgment and experience. Key judgments used in determining the allowance for loan losses include internal risk ratings, market and collateral values, discount rates, loss rates, and our view of current economic conditions. These judgments are inherently subjective and our actual losses could be greater or less than the estimate. Future estimates of the allowance could increase or decrease based on changes in the financial condition of individual borrowers, concentrations of various types of loans, economic conditions or the markets in which collateral may be sold. The estimate of the allowance accrual determines the amount of provision expense and directly affects our financial results.
During 2009 and 2010, we experienced increases in delinquencies and net charge-offs due to deterioration of the housing market and the economy as a whole. The estimate of the allowance considered these market conditions in determining the accrual. However, given the continued economic difficulties, the ultimate amount of loss could vary from that estimate. For additional discussion of the allowance, see Note 3 to the financial statements and “Asset Quality”, and “Provision and Allowance for Loan Losses”.

Goodwill and Core Deposit Intangibles

Goodwill is subject to at least an annual assessment for impairment by applying a fair value based test. The Company performs impairment testing in the fourth quarter. Additionally, acquired intangible assets (such as core deposit intangibles) are separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its useful life.
The Company amortizes intangible assets arising from branch transactions over their useful life. Core deposit intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used.

Overview

National Bankshares, Inc. is a financial holding company incorporated under the laws of Virginia. Located in southwest Virginia, NBI has two wholly-owned subsidiaries, the National Bank of Blacksburg and National Bankshares Financial Services, Inc. The National Bank of Blacksburg, which does business as National Bank from twenty-five office locations, is a community bank. NBB is the source of nearly all of the Company’s revenue. National Bankshares Financial Services, Inc. does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.
National Bankshares, Inc. common stock is listed on the NASDAQ Capital Market and is traded under the symbol “NKSH.”

 
22

 


Performance Summary

The following table presents NBI’s key performance ratios for the nine months ended September 30, 2010 and the year ended December 31, 2009. The measures for September 30, 2010 are annualized, except for basic net earnings per share and fully diluted net earnings per share.

   
September 30,
2010
   
December 31,
2009
 
Return on average assets
    1.60 %     1.47 %
Return on average equity
    12.32 %     12.23 %
Basic net earnings per share
  $ 1.70     $ 2.07  
Fully diluted net earnings per share
  $ 1.69     $ 2.06  
Net interest margin (1)
    4.54 %     4.23 %
Noninterest margin (2)
    1.51 %     1.55 %

(1)  
Net interest margin: Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets.
(2)  
Noninterest margin: Noninterest income (excluding securities gains and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets.

The return on average assets for the nine months ended September 30, 2010 was 1.60%, 13 basis points higher than the 1.47% for the year ended December 31, 2009. The return on average equity grew from 12.23% for the year ended December 31, 2009 to 12.32% for the nine months ended September 30, 2010. The net interest margin was a healthy 4.54% at the end of the third quarter of 2010, up 31 basis points from the 4.23% reported at year-end. The primary factor driving the increase in the net interest margin was the declining cost to fund interest-earning assets. Even though the Company had a modest decline in the yield on earning assets for the first nine months of 2010, the decline was more than offset by declining interest expense.
The noninterest margin remained relatively stable, decreasing 4 basis points from 1.55% at December 31, 2009 to 1.51% at September 30, 2010. The provision for loan losses for the nine months ended September 30, 2010 was $2,209, an increase of $1,256 from the $953 at September 30, 2009. See the discussion of “Asset Quality” in this report for additional information about the provision for loan losses.

Growth

NBI’s key growth indicators are shown in the following table:

   
September 30, 2010
   
December 31, 2009
   
Percent Change
   
Securities
  $ 282,460     $ 297,417       (5.03 ) %
Loans, net
    574,840       583,021       (1.40 ) %
Deposits
    841,856       852,112       (1.20 ) %
Total assets
    982,447       982,367       0.01   %

Securities declined by $14,957, or 5.03%, from $297,417 at December 31, 2009 to $282,460 at September 30, 2010. Net loans at September 30, 2010 were $574,840, down $8,181, or 1.4%, from $583,021 at December 31, 2009. Deposits declined slightly, from $852,112 at year-end to $841,856 at September 30, 2010, a decrease of $10,256, or 1.2%. Total assets were $982,367 at December 31, 2009 and were $982,447 at September 30, 2010, an increase of $80, or 0.01%.

 
23

 


Asset Quality

Key indicators of NBI’s asset quality are presented in the following table:

   
September 30, 2010
   
September 30, 2009
   
December 31, 2009
   
Nonperforming loans
  $ 7,639     $ 3,888     $ 6,750    
Loans past due 90 days or more, and still accruing
    533       2,153       1,697    
Other real estate owned
    3,026       1,944       2,126    
Allowance for loan losses to loans
    1.34 %     1.11 %     1.17   %
Net charge-off ratio
    0.31 %     0.08 %     0.10   %
Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned
    1.82 %     1.00 %     1.50   %
Ratio of allowance for loan losses to nonperforming loans
    102.03 %     165.97 %     102.61   %

Total nonperforming loans at September 30, 2010 were $7,639, which compares to $6,750 at December 31, 2009 and $3,888 at September 30, 2009. All restructured loans are included in nonaccrual loans, and nonaccrual loans make up the nonperforming loans category. At September 30, 2010, the ratio of nonperforming loans to loans net of unearned income and deferred fees was 1.82%.
Given the prolonged recession and the slow recovery of the national and local economies, the increase in nonperforming loans was not unexpected. The higher level of nonperforming loans impacted both the amount of the provision for loan losses and the net charge-off ratio.   Among other factors, the total of nonperforming loans is considered in calculating the Company’s allowance for loan losses, which in turn determines the amount needed in the provision for loan losses.  The provision for loan losses for the nine months ended September 30, 2009 was $953, and it was $2,209 for the nine months ended September 30, 2010. This represents an increase of $1,256, or 131.79%, when the two periods are compared.   At September 30, 2010, the ratio of the allowance for loan losses to loans was 1.34%, and it was 1.17% at December 31, 2009 and 1.11% at September 30, 2009.   The net charge-off ratio was 0.31% at September 30, 2010, 0.10% at December 31, 2009 and 0.08% at September 30, 2009. Management anticipates that loan charge-offs will continue to increase in the final quarter of 2010.  However, because known nonperforming loans have already been included in the calculation for the allowance for loan losses and further additions to the provision for loan losses are expected to be the result of the refinement of loss estimates, management does not believe that net income will be dramatically affected by these losses.
Loans past due 90 days or more and still acruing declined to $533 at September 30, 2010, from $1,697 at December 31, 2009 and $2,153 at September 30, 2009.  The decline is the result of loans being charged-off or placed on nonaccrual status.  Collateral that previously secured some charged-off loans is now in other real estate owned because of foreclosure or deeds in lieu of foreclosure.  The total of other real estate owned grew to $3,026 at September 30, 2010, from $2,126 at December 31, 2009 and $1,944 at September 30, 2009.  Because of the level of nonperforming loans, it is likely that the total of other real estate owned will increase in the final quarter of 2010, as the real estate collateral associated with some of these loans is acquired in foreclosure.  It is not possible to accurately predict the future total of other real estate owned, because property sold at foreclosure may be acquired by third parties and NBB’s other real estate owned properties are regularly marketed and sold.

 
24

 


Net Interest Income

The net interest income analysis for the nine months ended September 30, 2010 and 2009 follows:

   
Average Balance
   
Interest Income/Expense
   
Yield/Rate (Annualized)
 
   
2010
   
2009
   
2010
   
2009
   
2010
   
2009
 
Loans, Net(1) (2) (3)
 
$
587,767
   
$
576,066
   
$
28,005
   
$
28,391
     
6.37
%
   
6.59
%
Taxable Securities(3)
   
124,170
     
136,002
     
4,234
     
4,766
     
4.56
%
   
4.69
%
Nontaxable Securities(1) (3)
   
159,972
     
162,600
     
7,491
     
7,535
     
6.26
%
   
6.20
%
Federal Funds Sold
   
---
     
---
     
---
     
----
     
---
     
---
 
Interest-bearing deposits
   
49,658
     
38,706
     
85
     
73
     
0.23
%
   
0.25
%
    Total Interest-earning Assets
 
$
921,567
   
$
913,374
   
$
39,815
   
$
40,765
     
5.78
%
   
5.97
%
                                                 
Interest-bearing Demand Deposits
   
314,664
     
279,391
     
2,408
     
2,325
     
1.02
%
   
1.11
%
Savings Deposits
   
54,188
     
48,377
     
37
     
41
     
0.09
%
   
0.11
%
Time Deposits
   
357,707
     
407,946
     
6,110
     
10,194
     
2.28
%
   
3.34
%
Borrowings
   
---
     
50
     
---
     
2
     
---
     
5.74
%
    Total Interest-bearing Liabilities
 
$
726,559
   
$
735,764
   
$
8,555
   
$
12,562
     
1.57
%
   
2.28
%
                                                 
Net Interest Income Spread
                 
$
31,260
   
$
28,203
     
4.20
%
   
3.68
%
Cost to Fund Earning Assets
                                   
1.24
%
   
1.84
%
Net Interest Margin
                                   
4.54
%
   
4.13
%

(1)  
Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 35% in the two nine-month periods presented.
(2)  
Nonaccrual loans are included in average balances for yield computations.
(3)  
Daily averages are shown at amortized cost.

Net interest income on a tax equivalent basis for the nine months ended September 30, 2010 was $31,260, an increase of $3,057, or 10.84%, over the $28,203 reported for the same period last year.  This resulted in an increase in the net interest margin of 41 basis points, from 4.13% at September 30, 2009 to 4.54% at the same period in 2010.  The increase in the net interest margin resulted from a decline in the cost to fund earning assets of 60 basis points, offset by a decline in the yield on earning assets of 19 basis points.  The decline in the cost to fund earning assets came primarily from a 106 basis point reduction in the cost of time deposits and a 9 basis point reduction in the cost of interest-bearing deposits, when the nine-month periods ended September 30, 2010 and September 30, 2009 are compared.  The 19 basis point decline in the yield on earning assets can be accounted for mostly by declines in both the yields on loans and on taxable securities.  The yield on loans declined 22 basis points from September 30, 2009 to September 30, 2010, because of contractual repricing terms and the renegotiation of loan interest rates in response to competition.  The yield on taxable securities was 13 basis points lower for the nine months ended September 30, 2010, when compared with the same period in 2009.  The market yield for securities of a comparable term has declined over the past year, causing matured and called bonds to be replaced with lower yield investments.
The Company’s yield on earning assets and cost of funds are largely dependent on the interest rate environment.  In recent months, with interest rates at historic lows, funding costs declined at a faster pace than the yield on earning assets.  The Company’s cost of funding is more sensitive to interest rate changes than is the yield on earning assets.

Provision and Allowance for Loan Losses

The provision for loan losses for the nine month period ended September 30, 2010 was $2,209, compared with $953 for the first nine months of 2009. The ratio of the allowance for loan losses to total loans at the end of the third quarter of 2010 was 1.34%, which compares to 1.17% at December 31, 2009. The net charge-off ratio was 0.31% at September 30, 2010 and 0.10% at December 31, 2009. The Company increased the provision and allowance for loan losses to reflect economic and asset quality trends. See “Asset Quality” for additional information.

 
25

 


 Noninterest Income
   
Nine Months ended
         
   
September 30, 2010
   
September 30, 2009
   
Percent Change
   
Service charges on deposits
  $ 2,192     $ 2,506       (12.53 ) %
Other service charges and fees
    214       263       (18.63 ) %
Credit card fees
    2,171       2,060       5.39   %
Trust fees
    846       792       6.82   %
BOLI income
    558       554       0.72   %
Other income
    215       261       (17.62 ) %
Realized securities gains (losses)
    (1 )     55       (101.82 ) %

Service charges on deposit accounts totaled $2,192 for the nine months ended September 30, 2010. This is a 12.53% decrease of $314, when compared with the same period in 2009. The decline was in large part the result of a decrease of $314 in fees from checking account overdrafts and fees for checks returned for insufficient funds. The decline in fees for overdrafts and insufficient funds is part of a nationwide trend of depositors managing their accounts to reduce fees.
Other service charges and fees includes charges for official checks, income from the sale of checks to customers, safe deposit rent, fees for letters of credit and the income earned from commissions on the sale of credit life, accident and health insurance. Income for the nine months ended September 30, 2010 declined $49, or 18.63%, from the same period in 2009, primarily because of declines in the sale of checks and fees associated with letters of credit totaling $35.
Credit card fees for the first nine months of 2010 were $2,171. This was an increase of $111, or 5.39%, when compared with the $2,060 total reported for the same period last year. The increase was due to a higher volume of merchant transaction fees and credit card fees. Management anticipates that this category of noninterest income may be negatively affected by provisions included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. This recent legislation directs the Federal Reserve Bank to control the level of merchant fees. It is not yet known the extent to which the legislation may impact the level of credit card fees or when that impact will occur.
Income from Trust fees was $846 for the nine months ended September 30, 2010. This is a 6.82% increase from the $792 earned in the same period of 2009. Trust income varies depending on the total assets held in Trust accounts, the type of accounts under management and financial market conditions. The increase in Trust income is attributable to a combination of all of these factors.
BOLI income did not change materially from September 30, 2009 to September 30, 2010.
Other income includes net gains from the sales of fixed assets, rent from foreclosed properties, revenue from investment and insurance sales and other smaller miscellaneous components. Other income for the nine months ended September 30, 2010 was $215. This represents a decrease of $46, or 17.62%, when compared with the nine months ended September 30, 2009. This decrease came primarily from a decline in investment commissions in the Company’s financial services affiliate. These areas fluctuate with market conditions and because of competitive factors.
Realized securities losses for the nine months ended September 30, 2010 were $1, as compared with $55 in gains for the same period in 2009. Realized securities losses in the first nine months of 2010 and realized gains in the first nine months of 2009 are market driven and have come from losses and gains on called securities.

Noninterest Expense
   
Nine Months ended
         
   
September 30, 2010
   
September 30, 2009
   
Percent Change
   
Salaries and employee benefits
  $ 8,205     $ 8,409       (2.43 ) %
Occupancy, furniture and fixtures
    1,419       1,344       5.58   %
Data processing and ATM
    1,120       1,016       10.24   %
FDIC assessment
    805       1,429       (43.67 ) %
Credit card processing
    1,680       1,551       8.32   %
Intangibles amortization
    812       822       (1.22 ) %
Net costs of other real estate owned
    180       100       80.00   %
Franchise taxes
    722       666       8.41   %
Other operating expenses
    2,364       2,364       ---   %

Salary and benefits expense decreased $204, or 2.43%, from $8,409 for the nine months ended September 30, 2009 to $8,205 for the nine months ended September 30, 2010. The decline is the result of the Company’s efforts to control salary costs. There was also a decrease of $69 in net periodic pension expense associated with the Company’s defined benefit pension plan. Net periodic expense varies because of changes in the number of plan participants, the age of participants, the investment performance of the plan trust and the interest rate environment.
 
 
26

 
 
Occupancy, furniture and fixtures expense was $1,419 for the nine months ended September 30, 2010, an increase of $75, or 5.58%, from the same period last year.
Data processing and ATM expense was $1,120 for the nine months ended September 30, 2010, an increase of $104, or 10.24%, from the nine months ended September 30, 2009. Higher data processing expense in the first nine months of 2010 is associated with replacement of the Company’s host computer and increased costs for communications and maintenance.