HomeTown Bankshares (HMTA) 10-Q 2012 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended June 30, 2012.

Or

¨ 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: 333-158525

HOMETOWN BANKSHARES CORPORATION

(Exact name of the registrant as specified in its charter)

Virginia	26-4549960
(State or other jurisdiction of Incorporation or organization)	(I.R.S. Employer Identification No.)
202 South Jefferson Street, Roanoke, Virginia	24011
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number: (540) 345-6000

(Former name, former address, and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    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).    Yes  x    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 definitions of “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (do not check if a smaller reporting company)	Smaller reporting company	x

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

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

As of August 9, 2012, 3,262,518 shares of common stock, par value $5.00 per share, of the issuer were outstanding.

HOMETOWN BANKSHARES CORPORATION

Form 10-Q

INDEX

PART 1. FINANCIAL INFORMATION

Item 1.	FINANCIAL STATEMENTS
Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011		4
Consolidated Statements of Income for the Three and Six Months Ended June 30, 2012 and 2011		5
Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011		6
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011		7
Notes to Consolidated Financial Statements		8
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	19
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	24
Item 4.	CONTROLS AND PROCEDURES	24
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	Mine Safety Disclosure	25
Item 5.	Other Information	25
Item 6.	Exhibits	25
SIGNATURES		26

All schedules have been omitted because they are inapplicable or the required information is provided in the financial statements, including the notes thereto.

HOMETOWN BANKSHARES CORPORATION

Consolidated Balance Sheets

June 30, 2012 and December 31, 2011

In Thousands, Except Share and Per Share Data	June 30, 2012 (Unaudited)			December 31, 2011
Assets
Cash and due from banks	$	12,618		$	12,529
Federal funds sold		10,789			10,363
Securities available for sale, at fair value		69,097			69,207
Restricted equity securities, at cost		2,439			2,390
Loans, net of allowance for loan losses of $4,019 in 2012 and $3,979 in 2011		257,656			245,100
Property and equipment, net		9,523			9,582
Other real estate owned, net of valuation allowance of $156 in 2012 and $331 in 2011		8,888			9,562
Deferred tax asset, net		2,303			—
Accrued income		1,425			1,372
Prepaid FDIC insurance		241			473
Other assets		879			597
Total assets	$	375,858		$	361,175
Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing	$	32,458		$	26,822
Interest-bearing		287,290			280,814
Total deposits		319,748			307,636
Short term borrowings		465			449
Federal Home Loan Bank borrowings		19,000			19,000
Accrued interest payable		399			435
Other liabilities		680			567
Total liabilities		340,292			328,087
Commitments and contingencies		—			—
Stockholders’ Equity:
Preferred stock, $1,000 par value; 10,000 shares of series A and 374 shares of series B authorized, issued and outstanding at June 30, 2012 and December 31, 2011		10,374			10,374
Discount on preferred stock		(179	)		(217	)
Common stock, $5 par value; authorized 10,000,000 shares, issued and outstanding 3,262,518 (includes 29,178 restricted shares) at June 30, 2012 and 3,241,547(includes 8,207 restricted shares) at December 31, 2011		16,167			16,167
Surplus		15,472			15,458
Retained deficit		(7,423	)		(9,773	)
Accumulated other comprehensive income		1,155			1,079
Total stockholders’ equity		35,566			33,088
Total liabilities and stockholders’ equity	$	375,858		$	361,175

See Notes to Consolidated Financial Statements

4

HOMETOWN BANKSHARES CORPORATION

Consolidated Statements of Income

For the Three and Six months ended June 30, 2012 and 2011

	For the Three Months Ended June 30,					For the Six Months Ended June 30,
	2012			2011		2012			2011
In Thousands, Except Share and Per Share Data	(Unaudited)			(Unaudited)		(Unaudited)			(Unaudited)
Interest income:
Loans and fees on loans	$	3,431		$	3,552	$	6,809		$	7,065
Taxable investment securities		433			507		911			936
Nontaxable investment securities		9			—		12			—
Federal funds sold		2			8		6			16
Dividends on restricted stock		21			15		39			32
Other interest income		16			4		21			4
Total interest income		3,912			4,086		7,798			8,053
Interest expense:
Deposits		581			1,034		1,221			2,119
Preferred stock dividends		—			—		38			—
Other borrowed funds		97			132		212			265
Total interest expense		678			1,166		1,471			2,384
Net interest income		3,234			2,920		6,327			5,669
Provision for loan losses		1,088			266		1,278			514
Net interest income after provision for loan losses		2,146			2,654		5,049			5,155
Noninterest income:
Service charges on deposit accounts		64			63		138			125
ATM and interchange income		63			47		110			79
Mortgage loan brokerage fees		78			11		152			35
Gain on sales of investment securities		127			125		127			129
Other income		74			50		141			110
Total noninterest income		406			296		668			478
Noninterest expense:
Salaries and employee benefits		1,138			1,252		2,365			2,468
Occupancy and equipment expense		310			323		635			655
Data processing expense		168			146		335			283
Advertising and marketing expense		77			61		197			136
Professional fees		108			66		194			169
Bank franchise taxes		33			46		69			102
FDIC insurance expense		122			163		243			352
Loss on sales and writedowns of other real estate owned		32			17		35			35
Other real estate owned expense		72			38		177			111
Directors’ fees		61			—		117			—
Other expense		292			248		553			470
Total noninterest expense		2,413			2,360		4,920			4,781
Net income before income taxes		139			590		797			852
Income tax expense (benefit)		44			—		(2,658	)		—
Net income		95			590		3,455			852
Dividends accumulated on preferred stock		134			133		267			266
Accretion of discount on preferred stock		18			17		37			35
Net income (loss) available to common shareholders	$	(57	)	$	440	$	3,151		$	551
Earnings (loss) per common share, basic and diluted	$	(0.02	)	$	0.14	$	0.97		$	0.17
Weighted average common shares outstanding, basic and diluted		3,262,518			3,241,547		3,256,296			3,241,547

See Notes to Consolidated Financial Statements

5

HOMETOWN BANKSHARES CORPORATION

Consolidated Statements of Comprehensive Income

For the Three and Six months ended June 30, 2012 and 2011

	For the Three Months Ended June 30,								For the Six Months Ended June 30,
	2012				2011				2012				2011
In Thousands	(Unaudited)				(Unaudited)				(Unaudited)				(Unaudited)
Net income		$	95			$	590			$	3,455			$	852
Net change in net unrealized gains on securities available for sale:
Unrealized gains arising during the period			480				886				798				1,236
Reclassification adjustment for realized gains included in net income			(127	)			(125	)			(127	)			-129
Net securities gains during the period			353				761				671				1,107
Tax effect			(120	)			—				(595	)			—
Total other comprehensive income			233				761				76				1,107
Comprehensive income		$	328			$	1,351			$	3,531			$	1,959

See Notes to Consolidated Financial Statements

6

HOMETOWN BANKSHARES CORPORATION

Consolidated Statements of Cash Flows

Six months ended June 30, 2012 and 2011

In Thousands	Unaudited June 30, 2012			Unaudited June 30, 2011
Cash flows from operating activities:
Net income	$	3,455		$	852
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization		259			279
Provision for loan losses		1,278			514
Amortization of premium on securities, net		361			202
Loss on sales and writedowns of other real estate, net		35			35
Gain on sale of investment securities		(127	)		(129	)
Stock compensation expense		14			16
Changes in assets and liabilities:
Deferred tax asset		(2,926	)		—
Accrued income		(53	)		46
Other assets		(50	)		321
Accrued interest payable		(36	)		(110	)
Other liabilities		113			9
Net cash flows provided by operating activities		2,323			2,035
Cash flows from investing activities:
Net (increase) decrease in federal funds sold		(426	)		11,588
Purchases of investment securities		(14,617	)		(19,243	)
Sales, maturities, and calls of available for sale securities		15,192			12,208
(Purchase) repurchase of restricted equity securities, net		(49	)		112
Net (increase) decrease in loans		(13,903	)		2,425
Proceeds from sales of other real estate		708			147
Purchases of property and equipment		(200	)		(72	)
Net cash flows (used in) provided by investing activities		(13,295	)		7,165
Cash flows from financing activities:
Net increase in noninterest-bearing deposits		5,636			3,499
Net increase (decrease) in interest-bearing deposits		6,476			(2,761	)
Net increase (decrease) in short-term borrowings		16			(84	)
Net decrease in long-term FHLB borrowings		—			(2,350	)
Preferred stock dividend payment		(1,067	)		—
Net cash flows provided by (used in) financing activities		11,061			(1,696	)
Net increase in cash and cash equivalents		89			7,504
Cash and cash equivalents, beginning		12,529			4,479
Cash and cash equivalents, ending	$	12,618		$	11,983
Supplemental disclosure of cash flow information:
Cash payments for interest	$	1,507		$	2,494
Cash payments for income taxes	$	—		$	—
Supplemental disclosure of noncash investing activities:
Unrealized gain on securities available for sale	$	699		$	1,107
Transfer from loans to other real estate owned	$	69		$	4,127

See Notes to Consolidated Financial Statements

7

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies

Organization

On September 4, 2009, Hometown Bankshares Corporation (the “Company”) acquired all outstanding stock of Hometown Bank (the “Bank”) in an exchange for shares of the Registrant on a one-for-one basis to become a single-bank holding company with the Bank becoming a wholly-owned subsidiary. The Bank was organized and incorporated under the laws of the State of Virginia on November 9, 2004 and commenced operations on November 14, 2005. The Bank currently serves Roanoke City, Virginia, the County of Roanoke, Virginia, the City of Salem, Virginia, Christiansburg, Virginia, and surrounding areas. As a state chartered bank which is a member of the Federal Reserve System, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions, the Federal Deposit Insurance Corporation and the Federal Reserve Board.

Basis of Presentation

The consolidated financial statements as of June 30, 2012 and for the periods ended June 30, 2012 and 2011 included herein, have been prepared by HomeTown Bankshares Corporation, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. The first quarter of 2012 included the recognition of cumulative deferred tax assets. The amount of the net tax benefit recognized in the first quarter is a non-recurring, cumulative adjustment that includes the net tax benefit generated from prior years, as well as the current year. The results for the six months ended June 30, 2012, are not necessarily indicative of results expected for the calendar year. Management believes that all other interim adjustments are of a normal recurring nature. In the opinion of management, the information furnished in the interim consolidated financial statements reflects all adjustments necessary to present fairly the Company’s financial position, results of operations and cash flows for such interim periods. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and the notes thereto as of December 31, 2011, included in the Company’s Form 10-K for the year ended December 31, 2011.

The accounting and reporting policies of the Company follow generally accepted accounting principles and general practices within the financial services industry.

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary HomeTown Bank. All significant intercompany accounts and transactions associated with the Company’s wholly-owned subsidiary have been eliminated.

Our accounting policies and basic principles have not changed since the summary disclosure of these in our Annual Report on Form 10-K. Please refer to the Form 10-K for these policies.

Note 2. Investment Securities

The amortized cost and fair value of securities available for sale as of June 30, 2012 and December 31, 2011, are as follows:

(Dollars In Thousands)	June 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U. S. Government agency securities	$	30,006	$	872	$	(18	)	$	30,860
Mortgage-backed securities		27,109		489		(18	)		27,580
Municipal securities		10,204		513		(60	)		10,657
	$	67,319	$	1,874	$	(96	)	$	69,097

(Dollars In Thousands)	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
U. S. Government agency securities	$	33,558	$	480	$	(16	)	$	34,022
Mortgage-backed securities		26,673		495		(19	)		27,149
Municipal securities		7,897		235		(96	)		8,036
	$	68,128	$	1,210	$	(131	)	$	69,207

8

U.S. Government and federal agency securities. The unrealized losses on 5 of the Company’s investments in obligations of the U.S. government were caused by increases in market interest rates over the yields available at the time the securities were purchased. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Company does not intend to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2012.

Mortgage-backed securities. The unrealized losses in 7 of the Company’s investments in government-sponsored entity mortgage-backed securities were caused by increases in market interest rates over the yields available at the time the securities were purchased. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2012.

Municipal securities. The unrealized losses on the Company’s 8 investments in obligations of municipal securities were caused by increases in market interest rates over the yields available at the time the securities were purchased. All municipal securities are investment grade. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2012.

The following tables demonstrate the unrealized loss position of securities available for sale at June 30, 2012 and December 31, 2011.

	June 30, 2012
	Less than 12 months				12 months or more					Total
(Dollars In Thousands)	Estimated Fair Value		Unrealized Loss		Estimated Fair Value		Unrealized Loss			Estimated Fair Value		Unrealized Loss
U. S. Government agency securities	$	—	$	—	$	2,944	$	(18	)	$	2,944	$	(18	)
Mortgage-backed securities		—		—		5,167		(18	)		5,167		(18	)
Municipal securities		—		—		2,941		(60	)		2,941		(60	)
	$	—	$	—	$	11,052	$	(96	)	$	11,052	$	(96	)

	December 31, 2011
	Less than 12 months					12 months or more					Total
(Dollars In Thousands)	Estimated Fair Value		Unrealized Loss			Estimated Fair Value		Unrealized Loss			Estimated Fair Value		Unrealized Loss
U.S. Government agency securities	$	6,201	$	(16	)	$	—	$	—		$	6,201	$	(16	)
Mortgage-backed securities		2,957		(14	)		725		(5	)		3,682		(19	)
Municipal securities		3,371		(96	)		—		—			3,371		(96	)
	$	12,529	$	(126	)	$	725	$	(5	)	$	13,254	$	(131	)

There are 20 debt securities with fair values totaling $11.1 million considered temporarily impaired at June 30, 2012.  As of June 30, 2012, the Company does not consider any bond in an unrealized loss position to be other than temporarily impaired.

The Company realized gains on sales of securities of $127 thousand for the first six months of 2012 compared to $129 thousand for the same period last year.

The amortized cost and estimated fair values of investment securities available for sale at June 30, 2012, by contractual maturity are as follows:

(Dollars In Thousands)	Amortized Cost		Estimated Fair Value
One year or less	$	—	$	—
Over one through five years		824		850
Over five through ten years		9,672		9,894
Greater than 10 years		56,823		58,353
	$	67,319	$	69,097

9

Note 3. Loans Receivable

The major classifications of loans in the consolidated balance sheets at June 30, 2012 and December 31, 2011 were as follows:

(Dollars In Thousands)	June 30, 2012			December 31, 2011
Construction:
Residential	$	4,756		$	3,695
Land acquisition, development & commercial		19,920			23,911
Real Estate:
Residential		66,445			58,070
Commercial		106,696			102,312
Commercial, industrial & agricultural		38,809			36,297
Equity lines		19,802			19,018
Consumer		5,247			5,776
Total		261,675			249,079
Less allowance for loan losses		(4,019	)		(3,979	)
Loans, net	$	257,656		$	245,100

The past due and nonaccrual status of loans as of June 30, 2012 was as follows:

(Dollars In Thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans		Nonaccrual Loans
Construction:
Residential	$	—	$	—	$	—	$	—	$	4,756	$	4,756	$	—
Land acquisition, development & commercial		416		—		—		416		19,504		19,920		506
Real Estate:
Residential		—		349		532		881		65,564		66,445		716
Commercial		—		—		1,575		1,575		105,121		106,696		1,575
Commercial, industrial & agricultural		9		—		—		9		38,800		38,809		—
Equity lines		60		25		272		357		19,445		19,802		475
Consumer		—		4		—		4		5,243		5,247		—
Total	$	485	$	378	$	2,379	$	3,242	$	258,433	$	261,675	$	3,272

The past due and nonaccrual status of loans as of December 31, 2011 was as follows:

(Dollars In Thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans		Nonaccrual Loans
Construction:
Residential	$	—	$	—	$	—	$	—	$	3,695	$	3,695	$	—
Land acquisition, development & commercial		—		464		632		1,096		22,815		23,911		632
Real Estate:										—
Residential		—		535		179		714		57,356		58,070		714
Commercial		—		—		—		—		102,312		102,312		—
Commercial, industrial & agricultural		55		—		43		98		36,199		36,297		43
Equity lines		—		—		643		643		18,375		19,018		643
Consumer		—		—		—		—		5,776		5,776		—
Total	$	55	$	999	$	1,497	$	2,551	$	246,528	$	249,079	$	2,032

There were no loans past due ninety days or more and still accruing at June 30, 2012 or December 31, 2011.

10

Impaired loans and the related allowance at June 30, 2012, were as follows:

With no related allowance: (Dollars In Thousands)	Recorded Investment in Loans		Unpaid Principal Balance		Related Allowance		Average Balance Total Loans		Interest Income Recognized
Construction:
Residential	$	—	$	—	$	—	$	—	$	—
Land acquisition, development & commercial		835		878		—		630		16
Real Estate:
Residential		58		58		—		122		6
Commercial		6,185		6,664		—		5,149		100
Commercial, industrial & agricultural		1,536		1,536		—		1,217		30
Equity lines		272		440		—		136		—
Consumer		—		—		—		—		—
Total loans with no allowance	$	8,886	$	9,576	$	—	$	7,254	$	152

With an allowance recorded: (Dollars In Thousands)	Recorded Investment in Loans		Unpaid Principal Balance		Related Allowance		Average Balance Total Loans		Interest Income Recognized
Construction:
Residential	$	—	$	—	$	—	$	—	$	—
Land acquisition, development & commercial		1,550		1,550		38		1,783		53
Real Estate:
Residential		658		658		152		596		3
Commercial		3,095		3,095		285		4,053		132
Commercial, industrial & agricultural		—		—		—		—		—
Equity lines		202		202		150		420		8
Consumer		—		—		—		—		—
Total loans with an allowance	$	5,505	$	5,505	$	625	$	6,852	$	196

11

Impaired loans and the related allowance at December 31, 2011 were as follows:

With no related allowance: (Dollars In Thousands)	Recorded Investment in Loans		Unpaid Principal Balance		Related Allowance		Average Balance Total Loans		Interest Income Recognized
Construction:
Residential	$	—	$	—	$	—	$	917	$	—
Land acquisition, development & commercial		2,174		3,300		—		2,815		100
Real Estate:
Residential		714		714		—		1,868		27
Commercial		8,508		8,508		—		7,201		383
Commercial, industrial & agricultural		—		—		—		218		—
Equity lines		439		439		—		175		5
Consumer		—		—		—		—		—
Total loans with no allowance	$	11,835	$	12,961	$	—	$	13,194	$	515

With an allowance recorded: (Dollars In Thousands)	Recorded Investment in Loans		Unpaid Principal Balance		Related Allowance		Average Balance Total Loans		Interest Income Recognized
Construction:
Residential	$	—	$	—	$	—	$	288	$	—
Land acquisition, development & commercial		801		801		249		3,024		38
Real Estate:
Residential		—		—		—		137		—
Commercial		3,080		3,080		292		2,386		183
Commercial, industrial & agricultural		—		—		—		—		—
Equity lines		203		203		88		108		5
Consumer		—		—		—		—		—
Total loans with an allowance	$	4,084	$	4,084	$	629	$	5,943	$	226

Included in certain loan categories are troubled debt restructurings (“TDRs”). At June 30, 2012 and December 31, 2011 there were 3 loans classified as TDRs totaling $7.9 million. At June 30, 2012, one of the loans was past due over 90 days and on nonaccrual status.  The others were performing in accordance with their restructured terms. At December 31, 2011, all were performing in accordance with their restructured terms and none were on nonaccrual status. The amount of the valuation allowance related to total TDRs was $0 at June 30, 2012, and $277 thousand as of December 31, 2011. For the six months ended June 30, 2012, no loans were modified in a TDR.

As a result of adopting the amendments in ASU 2011-02, “Receivables (Topic 310) – A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring,” The Company reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are considered TDRs under the amended guidance using review procedures in effect at that time.

Management considers troubled debt restructurings and subsequent defaults in restructured loans in the determination of the adequacy of the Company’s allowance for loan losses. When identified as a TDR, a loan is evaluated for potential loss based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs if the loan is collateral dependent. Loans identified as TDRs frequently are on non-accrual status at the time of the restructuring and, in some cases, partial charge-offs may have already been taken against the loan and a specific allowance may have already been established for the loan. As a result of any modification as a TDR, the specific reserve associated with the loan may be increased. Additionally, loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future defaults. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. As a result, any specific allowance may be increased, adjustments may be made in the allocation of the total allowance balance, or partial charge-offs may be taken to further write-down the carrying value of the loan. Management exercises significant judgment in developing estimates for potential losses associated with TDRs.

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Note 4. Allowance for Loan Losses

The following table presents, as of June 30, 2012, the total allowance for loan losses, the allowance by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment), the total loans and loans by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment).

	Allowance for loan losses																Loans
Class of Loan In thousands of dollars	Beginning balance		Charge- offs			Recoveries		Provisions			Ending balance		Ending balance: individually evaluated for impairment		Ending balance: collectively evaluated for impairment		Ending balance		Ending balance: individually evaluated for impairment		Ending balance: collectively evaluated for impairment
Construction loans:
Residential	$	90	$	—		$	—	$	19		$	109	$	—	$	109	$	4,756	$	—	$	4,756
Land acquisition, development & commercial		953		(502	)		—		520			971		38		933		19,920		2,385		17,535
Real estate:
Residential		538		(56	)		—		204			686		152		534		66,445		716		65,729
Commercial		1,314		(478	)		—		454			1,290		285		1,005		106,696		9,280		97,416
Commercial, industrial & agricultural		628		(35	)		—		(169	)		424		—		424		38,809		1,536		37,273
Equity lines		313		(167	)		—		287			433		150		283		19,802		474		19,328
Consumer		143		—			—		(37	)		106		—		106		5,247		—		5,247
Total	$	3,979	$	(1,238	)	$	—	$	1,278		$	4,019	$	625	$	3,394	$	261,675	$	14,391	$	247,284

The following table presents, as of December 31, 2011, the total allowance for loan losses, the allowance by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment), the total loans and loans by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment).

Allowance for loan losses:

	Allowance for loan losses																Loans
Class of Loan In thousands of dollars	Beginning balance		Charge- offs			Recoveries		Provisions			Ending balance		Ending balance: individually evaluated for impairment		Ending balance: collectively evaluated for impairment		Ending balance		Ending balance: individually evaluated for impairment		Ending balance: collectively evaluated for impairment
Construction loans:
Residential	$	121	$	(150	)	$	—	$	119		$	90	$	—	$	90	$	3,695	$	—	$	3,695
Land acquisition, development & commercial		1,802		(1,500	)		—		651			953		249		704		23,911		2,975		20,936
Real estate:
Residential		785		(170	)		—		(77	)		538		—		538		58,070		714		57,356
Commercial		1,556		(356	)		—		114			1,314		292		1,022		102,312		11,588		90,724
Commercial, industrial & agricultural		702		(139	)		—		65			628		—		628		36,297		—		36,297
Equity lines		222		(158	)		—		249			313		88		225		19,018		642		18,376
Consumer	$	40		(1	)		3		101			143		—		143		5,776		—		5,776
Total	$	5,228	$	(2,474	)	$	3	$	1,222		$	3,979	$	629	$	3,350	$	249,079	$	15,919	$	233,160

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Loans by credit quality indicators as of June 30, 2012 were as follows:

(Dollars In Thousands)	Pass		Special Mention		Substandard		Substandard Nonaccrual		Doubtful Nonaccrual		Total
Construction:
Residential	$	4,756	$	—	$	—	$	—	$	—	$	4,756
Land acquisition, development & commercial		17,446		—		1,968		506		—		19,920
Real Estate:
Residential		64,962		583		184		716		—		66,445
Commercial		96,989		427		7,705		1,575		—		106,696
Commercial, industrial & agricultural		37,039		202		1,568		—		—		38,809
Equity lines		19,327		—		—		475		—		19,802
Consumer		5,247		—		—		—		—		5,247
Total	$	245,766	$	1,212	$	11,425	$	3,272	$	—	$	261,675

Loans by credit quality indicators as of December 31, 2011 were as follows:

(Dollars In Thousands)	Pass		Special Mention		Substandard		Substandard Nonaccrual		Doubtful Nonaccrual		Total
Construction:
Residential	$	3,695	$	—	$	—	$	—	$	—	$	3,695
Land acquisition, development & commercial		21,039		—		2,240		433		199		23,911
Real Estate:
Residential		56,767		589		—		714		—		58,070
Commercial		90,421		2,721		9,170		—		—		102,312
Commercial, industrial & agricultural		35,136		178		940		43		—		36,297
Equity lines		18,375		—		—		643		—		19,018
Consumer		5,776		—		—		—		—		5,776
Total	$	231,209	$	3,488	$	12,350	$	1,833	$	199	$	249,079

At June 30, 2012 and December 31, 2011, the Company had no loans classified as Loss.

Note 5. Stock Based Compensation

The Company has a 2005 Stock Option Plan (the Plan) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan authorizes grants of options to purchase up to 550,000 shares of the Company’s authorized but unissued common stock. Accordingly, options for the purchase of 485,760 shares of authorized common stock have been issued under the Plan and 64,240 shares of authorized common stock are available for issue under the Plan. There are options for 485,760 shares granted currently outstanding as of June 30, 2012, of which, all options are vested. All stock options have been granted with an exercise price equal to the stock’s fair market value at the date of the grant. As of June 30, 2012, no options have been exercised. The Company recorded compensation expense of $14 thousand for the six months ended June 30, 2012 and $16 thousand for the six months ended June 30, 2011. The aggregate intrinsic value of outstanding stock options was $0 at June 30, 2012. The weighted average remaining contractual term of outstanding options was 4.0 years at June 30, 2012.

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The Board of Directors adopted a Restricted Stock Plan (“the Plan”) in September 2009 whereby 120,000 shares of the Company’s authorized but unissued common stock was set aside to be granted by the Board of Directors in its discretion. The principal purpose of the Plan was to make shares available for issue to the executive officers of the Company and the Bank in payment of incentives earned under the Incentive Compensation Plan. Because the Company is a TARP participant, the Company’s most highly paid employee cannot be paid a cash bonus. However, the Treasury regulations permit payment of such a bonus in restricted stock. Even though the restriction would only apply to the CEO in the case of the Company and the Bank, each of the executive officers of the Company and the Bank have elected to take their bonuses in stock rather than cash.

The restrictions attached to stock issued under the Plan restrict transfer of the shares during the time TARP funding is outstanding and provide for vesting over a five-year period. During the first six month period of 2012, the Company issued 20,971 shares of stock under the Plan. None were issued during 2011.

The remaining unamortized compensation expense for restricted stock was $111 thousand at June 30, 2012 and will be recognized over the next 4.7 years. All compensation expense for stock options has been recognized.

Note 6. Fair Value Measurement

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).

Derivative assets: Derivative assets 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 assets by using pricing models that consider observable market data (Level 2).

Derivative liabilities: Derivative liabilities 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 liabilities by using pricing models that considers observable market data (Level 2).

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011:

(Dollars In Thousands)			Carrying value at June 30, 2012
Description	Balance as of June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
U. S. Government agency securities	$	30,860		$	30,860
Mortgaged-backed securities		27,580			27,580
Municipal securities		10,657			10,657
Derivative assets		133			133
Liabilities:
Derivative liabilities	$	133		$	133

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(Dollars In Thousands)			Carrying value at December 31, 2011
Description	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
U. S. Government agency securities	$	34,022		$	34,022
Mortgaged-backed securities		27,149			27,149
Municipal securities		8,036			8,036
Derivative assets		170			170
Liabilities:
Derivative liabilities	$	170		$	170

Certain assets are measured at fair value on a nonrecurring basis in accordance with generally accepted accounting principles (GAAP). Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or writedowns of individual assets.

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

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. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value 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 using observable market data (Level 2). 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 if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Significant unobservable inputs used in the fair value measurement of appraisals over two years old (Level 3) involve applying discount factors of between 5 and 20 percent based on the condition of the property and management’s assessment of current marketability of the property. 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 Statements of Income.

Other Real Estate Owned (OREO): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the OREO as nonrecurring Level 2. When the appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the OREO as nonrecurring Level 3.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis as of June 30, 2012 and December 31, 2011.

(Dollars In Thousands)			Carrying value at June 30, 2012
Description	Balance as of June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired Loans, net of valuation allowance	$,	4,880		$	3,812	$	1,068
Other real estate owned	$	8,888		$	8,888

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(Dollars In Thousands)			Carrying value at December 31, 2011
Description	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired Loans, net of valuation allowance	$	3,455		$	2,387	$	1,068
Other real estate owned	$	9,562		$	9,562

The changes in Level 3 assets measured at estimated fair value on a nonrecurring basis during the six months ended June 30, 2012, were as follows (dollars in thousands):

	Carrying value at June 30, 2012
	Impaired Loans
Balance – December 31, 2011	$	1,068
Decrease in carrying value		—
Transfers into Level 3		—
Transfers out of Level 3		—
Balance – June 30, 2012	$	1,068
Change in unrealized gains (losses) included in earnings for the period, attributable to assets and liabilities still held at June 30, 2012	$	—

At June 30, 2012 and December 31, 2011, the Company did not have any liabilities measured at fair value on a nonrecurring basis.

The following table displays quantitative information about Level 3 Fair Value Measurements for June 30, 2012 (dollars in thousands):

	Quantitative information about Level 3 Fair Value Measurements for June 30, 2012
Assets	Fair Value		Valuation Technique(s)	Unobservable input	Range
Impaired loans	$	1,068	Discounted appraised value	Selling cost		5%	-	10	%
				Discount for lack of marketability and age of appraisal		0%	-	10	%

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

Cash and due from banks: The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.

Federal funds sold: Federal funds sold consist of overnight loans to other financial institutions and mature within one to three days. Management believes the carrying value of federal funds sold approximates estimated market value.

Available-for-sale and restricted equity securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of restricted equity securities approximate fair values, based on the redemption provisions of the entities.

Loans receivable: For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of deposit to a schedule of aggregated contractual maturities on such time deposits.

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Short term borrowings: Short term borrowings consist of overnight borrowings and mature within one to three days.

Management believes the carrying value of securities sold under agreements to repurchase approximates estimated market value.

FHLB borrowings: The fair values for long term borrowings are estimated using a discounted cash flow calculation that applies interest rates currently being offered on long term borrowings to the contractual maturities on such long term borrowings.

Accrued interest: The carrying amount of accrued interest receivable and payable approximates its fair value.

Off-balance sheet financial instruments: The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements. At June 30, 2012 and December 31, 2011, the fair value of loan commitments and standby letters of credit were deemed to be immaterial.

The carrying amounts and approximate fair values of the Company’s financial instruments are as follows at June 30, 2012 and December 31, 2011:

			Fair Value Measurements at June 30, 2012 using
(Dollars in Thousands)	Carrying Amounts		Quoted Prices in Active Markets for Identical Assets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Approximate Fair Values
Financial assets
Cash and due from banks	$	12,618	$	12,618	$		$		$	12,618
Federal funds sold		10,789		10,789						10,789
Securities available-for-sale		69,097				69,097				69,097
Restricted equity securities		2,439				2,439				2,439
Loans, net		257,656				258,631		1,068		259,699
Accrued income		1,425				1,425				1,425
Derivative assets		133				133				133
Financial liabilities
Total deposits		319,748				320,153				320,153
Short term borrowings		465				465				465
FHLB borrowings		19,000				19,823				19,823
Accrued interest payable		399				399				399
Derivative liabilities		133				133				133

(Dollars in Thousands)	December 31, 2011
	Carrying Amounts		Approximate Fair Values
Financial assets
Cash and due from banks	$	12,529	$	12,529
Federal funds sold		10,363		10,363
Securities available-for-sale		69,207		69,207
Restricted equity securities		2,390		2,390
Loans, net		245,100		246,601
Accrued income		1,372		1,372
Derivative assets		170		170
Financial liabilities
Total deposits		307,636		308,105
Short term borrowings		449		449
FHLB borrowings		19,000		19,760
Accrued interest payable		435		435
Derivative liabilities		170		170

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ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Forward-looking Statements

HomeTown Bankshares makes forward-looking statements in this report. These forward-looking statements may include: statements of goals, intentions, earnings expectations, and other expectations; estimates of risks and of future costs and benefits; assessments of probable loan and lease losses; assessments of market risk; and statements of the ability to achieve financial and other goals. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “project” and other similar words and expressions. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date they are made. The Company does not assume any duty and does not undertake to update its forward-looking statements. Because forward-looking statements are subject to assumptions and uncertainties, actual results or future events could differ, possibly materially, from those that the Company anticipated in its forward-looking statements, and future results could differ materially from historical performance.

The Company’s forward-looking statements are subject to the following principal risks and uncertainties: general economic conditions and trends, either nationally or locally; conditions in the securities markets; changes in interest rates; changes in deposit flows, and in the demand for deposit, loan, and investment products and other financial services; changes in real estate values; changes in the quality or composition of the Company’s loan or investment portfolios; changes in competitive pressures among financial institutions or from non-financial institutions; the Company’s ability to retain key members of management; changes in legislation, regulation, and policies; and a variety of other matters which, by their nature, are subject to significant uncertainties. The Company provides greater detail regarding some of these factors in its Form 10-K for the year ended December 31, 2011. The Company’s forward-looking statements may also be subject to other risks and uncertainties, including those that it may discuss elsewhere in this report or in its other filings with the SEC.

Our Business

HomeTown Bankshares provides a full complement of consumer and commercial banking services to its primary service area which includes the City of Roanoke, Roanoke County, Christiansburg, and Salem, Virginia and contiguous counties, including Bedford and Franklin, Virginia. We place an emphasis on personal service and offer a broad range of commercial and retail banking products and services including checking, savings and time deposits, individual retirement accounts, residential and commercial mortgages, home equity loans, consumer installment loans, commercial loans, lines and letters of credit. In addition to its main office, the Company has offices in Franklin County, Virginia at Westlake, in the town of Christiansburg, Virginia at 1540 and 1655 Roanoke Street, in Roanoke County, Virginia at the intersection of Colonial Avenue and Virginia Route 419, and in the City of Roanoke, Virginia at 3521 Franklin Road.

The following is a discussion of factors that significantly affected the financial condition and results of operations of HomeTown Bankshares Corporation. This discussion should be read in connection with the financial statements presented herein.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in Note 1 of the Notes to Financial Statements in the Annual Report for the year ended December 31, 2011. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues and expenses.

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: (i) that losses be accrued when they are probable of occurring and are capable of estimation and (ii) that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio.

The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Management reviews the past due reports and risk-rated loans and discusses individually the loans on these reports with the responsible loan officers. Management uses these tools and provides a detailed quarterly analysis of the allowance based on our historical loan loss experience, risk-rated loans, past dues, concentrations of credit, unsecured loans, loan exceptions, and the economic trend. These are generally grouped by homogeneous loan pools. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. This allowance, then, is designated as a specific reserve. Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term. However, the amount of the change that is reasonably possible cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms.

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Discussion of Operations

Six Months Ended June 30, 2012

The Company had net income of $3.5 million for the six months ended June 30, 2012 compared with net income of $852 thousand for the six months ended June 30, 2011.   Pre-tax earnings from operations for the first half of 2012 were $797 thousand compared to a pre-tax profit of $852 thousand for the same period a year ago. The recognition of deferred tax assets added a net tax benefit of $2.9 million to net income. Deferred tax assets represent future potential tax deductions that result from timing differences between tax laws and generally accepted accounting principles (GAAP). Recognition of the deferred tax assets requires positive evidence of sufficient future taxable income to realize the benefit of the deferred tax asset, according to GAAP. After preferred dividends of $304 thousand, net income available to common shareholders for the first half of 2012 was $3.2 million compared to $551 thousand for the same period last year. On a per share basis, net income from operations available to common shareholders was $0.97 per share for the six months ended June 30, 2012. The $0.97 per share included $.90 per common share for the recognition of $2.9 million of prior year deferred tax assets in the first quarter of 2012.

Steady improvement in the Company’s net interest margin enhanced earnings in 2012 with net interest income increasing $658 thousand or 12% over the same period last year.  The Company’s net interest margin increased to 3.82% for the first half of 2012 from 3.38% for the first half of 2011.  Continued growth in lower cost core deposits and a corresponding reduction in funding costs contributed to the improved margin for the first six months of 2012.

Noninterest income was up $190 thousand or 40% for the six months ended June 30, 2012 compared to the first six months of 2011 due to an increase in mortgage loan brokerage fees as well as an increase in transaction account income from the growth in demand deposit accounts.

These increases in net interest income and noninterest income were the primary contributors to the Company’s year-to-date financial performance for 2012 compared to 2011, and were partially negated by a higher provision for loan losses and noninterest expense.  The provision for loan losses for the six months ended June 30, 2012 was $764 thousand above the same period last year as the result of increasing the specific reserves on impaired loans during the 1st half of 2012 compared to 2011.  Noninterest expense for the six months ended June 30, 2012 was $139 thousand or 2.9% higher than last year.  Effective January 1, 2012, the Board adopted a compensation plan for its non-employee members.  Through June 30, 2012, noninterest expense included $117 thousand for fees earned by the board of directors.  Discretionary spending on advertising and marketing was up $61 thousand or 45% for the first half of 2012 compared to the first half of 2011. Other real estate owned expenses rose $66 thousand or 59% due to the carrying costs of a higher level of foreclosed properties.  Data processing expense was up $52 thousand or 18% for the six months ended June 30, 2012 compared to the same period last year due to higher costs associated with software enhancements and upgrading of the core processor in mid-2011.  The Company realized the benefit of favorable variances in several noninterest expense categories, which partially offset the aforementioned increases.  Bank franchise taxes for the first half of 2012 were $33 thousand less than the prior year. The Commonwealth of Virginia avoids double taxation by allowing for the deduction of real estate property in determining net taxable capital subject to the bank franchise tax. The amount of property subject to real estate taxes is up over the prior year due to the increase in foreclosed properties held by the bank. The real estate taxes on foreclosed properties are included in other real estate owned expenses and accounted for the majority of the $66 thousand dollar increase discussed previously.

Effective January 1, 2012, the Company recognized deferred tax assets resulting in an income tax benefit of $2.9 million and began recording tax expense on current period income before taxes. The decision to record deferred tax assets was based on an assessment of the Company’s profitable operations over the last five quarters and projections of future taxable income. The projections of future taxable income include provisions for loans losses based on the Company’s provision expense trended over the last five quarters of operations and an assessment of the credit risk present in the loan portfolio at June 30, 2012.

For the six months ended June 30, 2012, the Company recorded an income tax benefit of $2.7 million comprised of recognition of deferred tax assets of $2.9 million as of January 1, 2012 and income tax expense of $267 thousand on net income before income taxes of $797 thousand. No income tax expense was recorded for the six months ended June 30, 2011 as the Company was not recording deferred income tax expense or benefit at that time.

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Three Months Ended June 30, 2012

Net income for the second quarter of 2012 totaled $95 thousand compared to $590 thousand for the same quarter last year.  Net income before tax was $139 thousand for three months ended June 30, 2012 compared to $590 thousand earned in the same period in the prior year.   As discussed previously, at the same time the Company began recognizing deferred tax assets in 2012, the Company also began recording tax expense on current period income before taxes.  After preferred dividends of $152 thousand, net loss available to common shareholders for the second quarter of 2012 was $57 thousand compared to net income of $440 thousand for the same quarter last year. On a per share basis, loss from operations available to common shareholders were ($0.02) per share for the three months ended June 30, 2012.

Net interest income has increased for five consecutive quarters and the second quarter of 2012 was $141 thousand higher than the first quarter and $314 thousand over the same quarter last year.  The net interest margin was 3.86% for the second quarter of 2012, up 9 basis points from the 3.77% for the first quarter of 2012, and up 39 basis points from the 3.47% for the second quarter of 2011.  The improvement in the margin was due primarily to lower rates paid on deposits in the lower interest rate environment.

The provision for loan losses was $1.1 million for the three months ended June 30, 2012 compared to $266 thousand for the same period in 2011.

During the three months ended June 30, 2012, noninterest income totaled $406 thousand, an increase of $110 thousand or 37% over the same period in the prior year.  Mortgage loan brokerage fees totaled $78 for the second quarter of 2012 compared to $11 thousand last year, as the result of the Company’s expansion of mortgage operations.

Noninterest expense increased $53 thousand or 2.4% to $2.4 million for the three months ended on June 30, 2012, when compared to the same period in 2011.  The second quarter of 2012 includes $61 thousand for fees earned by the board of directors compared to none in the prior year.

Financial Condition

At June 30, 2012, the Company had total assets of $376 million compared to $361 million at December 31, 2011.   At June 30, 2012, assets were comprised principally of loans, cash and due from banks, federal funds sold, and investment securities. The Company’s management, under the direction of the Asset/Liability Committee (ALCO) of the Board of Directors, reviews the mix of monetary assets and liabilities to ensure the Company maintains an adequate level of liquidity while maximizing interest rate spreads.

Since March the yield on the 2 year Treasury has fallen seven basis points and the yield on the 10 year Treasury has fallen 70 basis points, resulting in a significant flattening of the yield curve.  With the European economy in trouble, funds have left Europe for the safety of the U.S. Treasury bond and the U.S. dollar.  Over the past year, yields on securities available for purchase have declined from the 3½ to 4 ½% range to 2 to 2½%.  As a result, the Company’s planned growth allocated to investments shifted to loans.  As a result net loans rose $13 million or 5.4% from $245 million at December 31, 2011 to $258 million at June 30, 2012.  Loan growth was funded primarily by the expansion of noninterest bearing deposits.

As discussed previously, the Company, based on the increased likelihood of being able to realize the benefit of reducing future taxable income by the amount of prior year net operating loss carry forwards and other timing differences, recognized a net deferred tax asset in the first quarter on 2012. At June 30, 2012, net deferred tax assets were $2.3 million compared to none in the prior year.

The Company’s liabilities at June 30, 2012 totaled $340 million compared to $328 million at December 31, 2011, an increase of $12.5 million or 3.8%.  Interest-bearing deposits increased $6.5 million or 2.3%; the utilization of longer term brokered deposits as a funding source accounted for $4.1 million of the growth.   Noninterest-bearing deposits were up $5.6 million thousand or 21% from year end 2011 to June 30, 2012.

At June 30, 2012 and December 31, 2011, the Company had stockholders’ equity of $35.6 million and $33.1 million, respectively, an increase of $2.5 million or 7.5%. The change in stockholders’ equity in the first half of 2012 was mainly the result of net income of $3.5 million.  The increase was partially offset by the payment of $1.1 million of dividends on the Troubled Asset Relief Program (TARP) preferred stock.  The $1.1 million of TARP dividends paid in 2012 included $800 thousand for dividends accumulated from prior years.  Stock awarded to executives increased stockholder’s equity an additional $14 thousand.

On September 18, 2009, as part of the TARP Capital Purchase Program, the Company entered into a Letter Agreement and Securities Purchase Agreement with the United States Department of the Treasury pursuant to which the Company issued 10 thousand shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A for a purchase price of $10 million in cash and issued a warrant to purchase 374.37437 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B for a per share price of $1.00 per share, which was exercised immediately.

Management believes the Company has sufficient capital to fund its operations. At June 30, 2012, the Company was in compliance with all regulatory capital requirements. Management believes that the Company has sufficient liquidity on a short-term basis to meet any funding needs it may have, and expects that its long term liquidity needs can be achieved through deposit growth, however there can be no assurance that such growth will develop.

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Non-performing Assets

Non-performing assets consist of loans past-due ninety days or more and still accruing interest, non-accrual loans and repossessed and foreclosed assets.  There were no loans past due ninety days or more and still accruing interest at June 30, 2012 or December 31, 2011.   Nonaccrual loans totaled $3.3 million at the end of the second quarter of 2012, compared to $2.0 million at December 31, 2011.

The major classifications of other real estate owned in the consolidated balance sheets at June 30, 2012 and December 31, 2011 were as follows:

(Dollars In Thousands)	June 30, 2012		December 31, 2011
Construction:
Residential	$	1,300	$	1,447
Land acquisition, development & commercial		3,785		3,805
Real Estate:
Residential		404		612
Commercial		1,620		1,919
Commercial, industrial & agricultural		1,215		1,215
Equity lines		564		564
	$	8,888	$	9,562

The activity in other real estate owned for the first quarter of 2012 was as follows:

(Dollars In Thousands)	Other Real Estate Owned			Valuation Allowance			Net
Balance at the beginning of the year	$	9,893		$	(331	)	$	9,562
Additions		69			—			69
Writedowns		—			—			—
Sales		(918	)		175			(743	)
Balance at the end of the year	$	9,044		$	(156	)	$	8,888

Losses on sales of other real estate owned totaled $35 thousand for the first six months of 2012.

Allowance for Loan Losses

The allowance for loan losses is increased by charges to income and decreased by charge-offs, net of recoveries. Management’s periodic evaluation of the adequacy of the allowance is based on the Company’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

Specific loss reserves for loans individually evaluated for impairment totaled $625 thousand at June 30, 2012 compared to $629 thousand at December 31, 2011. Impaired loans declined $1.5 million from $15.9 million at December 31, 2011 to $14.4 million at June 30, 2012.   Based on the general reserves established on loans collectively evaluated for impairment and the specific reserves for loans individually evaluated for impairment, the Company recorded a provision for loan losses of $1.3 million in the first half of 2012.   Based on this evaluation, the percentage of the allowance for loan losses to total loans was 1.54%, 1.67%, and 1.60% at June 30, 2012, March 31, 2012, and December 31, 2011, respectively.  The decline in the percentage from the end of March to the end of June is primarily attributable to loans with identified losses that were charged off in the second quarter along with improvement in the qualitative factors related to the economy.   Housing starts rose 6.9% in June 2012 to a seasonally adjusted annual rate of 760 thousand units, the highest rate since October 2008, the Commerce Department reported. Single-family home starts increased 4.7% to a 539 thousand annual rate. Starts for multifamily homes, such as townhouses and apartments, rose 12.8% to a 221 thousand rate. This information seems to indicate stabilization in the housing market and the value of the collateral. The most recent economic activity report, dated July 18, 2012 from the Federal Reserve (the Beige Book), indicated that the national economy continued to expand at a modest to moderate pace in June and early July.

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Liquidity

Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets.  Liquid assets include cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities and loans maturing within one year.  As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.

At June 30, 2012, cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, loans maturing within one year, and expected maturities, calls and principal repayments from the securities portfolio within one year totaled $98 million. At June 30, 2012, 26% or $67 million of the loan portfolio would mature within one year. At June 30, 2012, non-deposit sources of available funds totaled $27 million, which included $7.9 million immediately available from FHLB. During the first three months of 2012 there was no borrowing activity.

Capital Requirements

The maintenance of appropriate levels of capital is a priority and is continually monitored. Banks are subject to various regulatory capital requirements administered by the federal and state banking agencies. Quantitative measures established by regulations to ensure capital adequacy require the Company to maintain minimum capital ratios. Failure to meet minimum capital ratios can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. The following are the Company’s and Bank’s capital ratios:

(in thousands except for percentages)	Actual					Minimum Capital Requirement					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2012
Total Capital (to Risk-Weighted Assets)
Consolidated	$	37,719		13.9	%	$	21,654		8.0	%		N/A		N/A
HomeTown Bank	$	35,367		13.1	%	$	21,654		8.0	%	$	27,067		10.0	%
Tier I Capital (to Risk-Weighted Assets)
Consolidated	$	34,411		12.7	%	$	10,827		4.0	%		N/A		N/A
HomeTown Bank	$	31,974		11.8	%	$	10,827		4.0	%	$	16,240		6.0	%
Tier I Capital (to Average Assets)
Consolidated	$	34,411		9.4	%	$	10,827		4.0	%		N/A		N/A
HomeTown Bank	$	31,974		8.7	%	$	10,827		4.0	%	$	18,343		5.0	%

Financial Instruments With Off-Balance-Sheet Risk

In the normal course of business to meet the financing needs of its customers, the Company is a party to financial instruments with off-balance-sheet risk. These financial instruments involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk.

At June 30, 2012 outstanding commitments to extend credit including letters of credit were $49.1 million. There are no commitments to extend credit on impaired loans.

Commitments to extend credit are agreements to lend to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments may expire without ever being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash outlays for the Company.

Recent Accounting Pronouncements

In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU were effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

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In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards (IFRS). The amendments were effective for interim and annual periods beginning after December 15, 2011 with prospective application. The Company has included the required disclosures in its consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The objective of this ASU is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The single statement of comprehensive income should include the components of net income, a total for net income, the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present all the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The amendments do not change the items that must be reported in other comprehensive income, the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, or the calculation or reporting of earnings per share. The amendments in this ASU should be applied retrospectively. The amendments were effective for fiscal years and interim periods within those years beginning after December 15, 2011. The amendments do not require transition disclosures. The Company has included the required disclosures in its consolidated financial statements.

In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company does not expect the adoption of ASU 2011-11 to have a material impact on its consolidated financial statements.

In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220) – Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The amendments are being made to allow the Board time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the Board is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05. All other requirements in ASU 2011-05 are not affected by ASU 2011-12, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company has included the required disclosures in its consolidated financial statements.

ITEM 3.         QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable to smaller reporting companies.

ITEM 4.         CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based upon an evaluation of the effectiveness of disclosure controls and procedures, the Company’s Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures, as defined under Exchange Act Rule 13a-15(e) and 15d-15(e), were effective to provide reasonable assurance that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC and is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

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Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting that occurred during the three months ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II OTHER INFORMATION

Item 1.         Legal Proceedings.

In the normal course of business, the Company becomes involved in litigation arising from the banking, financial and other activities it conducts. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising from these matters will have a material effect on the Company’s financial condition, operating results or liquidity.

Item 1A.       Risk Factors.

Not applicable to smaller reporting companies.

Item 2.         Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.         Defaults Upon Senior Securities

None

Item 4.         Mine Safety Disclosure

Not applicable.

Item 5.         Other Information

None

Item 6.         Exhibits

(a) Exhibits

Exhibit No.
10.1	Amendment to Employment Agreement dated March 1, 2006 between HomeTown Bank and S. K. Still.
31.1	Certification of Chief Executive of Officer (302 Certification).
31.2	Certification of Chief Financial Officer (302 Certification).
32	Certification pursuant to 18 U.S.C. Section 1350 (906 Certification).

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SIGNATURES

Pursuant to the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

HOMETOWN BANK
Date: August 20, 2012	By:	/S/ SUSAN K. STILL
		Susan K. Still
		President
		Chief Executive Officer
Date: August 20, 2012	By:	/S/ CHARLES W. MANESS, JR.
		Charles W. Maness, Jr.
		Executive Vice President
		Chief Financial Officer

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HOMETOWN BANK

FORM 10Q

INDEX TO EXHIBITS

Exhibit	Description
10.1	Amendment to Employment Agreement dated March 1, 2006 between HomeTown Bank and S. K. Still.
31.1	Certification of Chief Executive of Officer (302 Certification).
31.2	Certification of Chief Financial Officer (302 Certification).
32	Certification pursuant to 18 U.S.C. Section 1350 (906 Certification).

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