================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 ------------------ FORM 10-Q ------------------ Quarterly Report Pursuant to Section 13 or 15(d) Of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2002 ------------------ Commission file number 0-15204 National Bankshares, Inc. (Exact name of registrant as specified in its charter) ------------------ State or other jurisdiction of incorporation or organization - Virginia Internal Revenue Service - Employer Identification No. 54-1375874 101 Hubbard Street, P.O. Box 90002, Blacksburg, VA 24062-9002 (540) 951-6300 ------------------ 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 requirements for the past 90 days. 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 Outstanding at August 1, 2002 - -------------------------------- ----------------------------- Common Stock, $2.50 Par Value 3,511,377 (This report contains 25 pages) 1 26 NATIONAL BANKSHARES, INC. AND SUBSIDIARIES Form 10-Q Index Page Part I Financial Information Item 1 - Financial Statements Consolidated Balance Sheets, June 30, 2002 3-4 and December 31, 2001 Consolidated Statements of Income for the 5-6 Three Months Ended June 30, 2002 and 2001 Consolidated Statements of Income for the 7-8 Six Months Ended June 30, 2002 and 2001 Consolidated Statements of Changes in 9 Stockholders' Equity, Six Months Ended June 30, 2002 and 2001 Consolidated Statements of Cash Flows, 10-11 Six Months Ended June 30, 2002 and 2001 Item 2 - Management's Discussion and Analysis of 16-22 Financial Condition and Results of Operations Item 3 - Quantitative and Qualitative Disclosures about 23 Market Risk Part II Other Information Items 1 - 3 - Legal Proceedings; Changes in 24 Securities and Use of Proceeds; Defaults Upon Senior Securities Item 4 - Submission of Matters to a Vote of 24 Security Holders Item 5 - Other Information 24 Item 6 - Exhibits and Reports on Form 8-K 24 Signatures 25 - ---------- 2 National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets June 30, 2002 and December 31, 2001 (Unaudited) (Audited) June 30, December 31, ($000's except share and per share data) 2002 2001 ================ =============== Assets Cash and due from banks $11,632 12,293 Interest-bearing deposits 3,972 15,510 Federal funds sold 4,229 1,080 Securities available for sale 97,014 88,667 Securities held to maturity (fair value $96,367 in 2002 and $103,234 in 2001) 94,000 102,809 Mortgage loans held for sale 391 1,145 Loans: Real estate construction loans 22,885 19,573 Real estate mortgage loans 80,525 77,339 Commercial and industrial loans 208,046 189,764 Loans to individuals 105,155 113,413 ---------------- --------------- Total loans 416,611 400,089 Less unearned income and deferred fees (1,522) (1,775) --------------- --------------- Loans, net of unearned income and deferred fees 415,089 398,314 Less: allowance for loan losses (4,843) (4,272) --------------- -------------- Loans, net 410,246 394,042 --------------- --------------- Bank premises and equipment, net 9,907 10,132 Accrued interest receivable 5,206 4,917 Other real estate owned, net 301 211 Intangible assets 11,388 11,866 Other assets 1,537 1,951 --------------- --------------- Total assets $ 649,823 644,623 ================ =============== Liabilities and stockholders' equity Noninterest-bearing demand deposits $76,628 71,751 Interest-bearing demand deposits 147,039 134,230 Savings deposits 48,974 48,827 Time deposits 305,396 321,810 ---------------- --------------- Total deposits 578,037 576,618 ---------------- --------------- Other borrowed funds 321 203 Accrued interest payable 773 1,101 Other liabilities 1,214 1,440 ---------------- --------------- Total liabilities 580,345 579,362 ---------------- --------------- 3 Stockholders' equity Preferred stock of no par value. Authorized 5,000,000 shares; none issued and outstanding --- --- Common stock of $2.50 par value. Authorized 5,000,000 shares; issued and outstanding 3,511,377 shares in 2002 and 3,511,377 shares in 2001 8,778 8,778 Retained earnings 58,952 55,917 Accumulated other comprehensive gain 1,748 566 ---------------- --------------- Total stockholders' equity 69,478 65,261 Commitments and contingent liabilities ---------------- --------------- Total liabilities and Stockholders' equity $ 649,823 644,623 ================ =============== See accompanying notes to the consolidated financial statements 4 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Three Months Ended June 30, 2002 and 2001 (Unaudited) June 30, June 30, ($000's except share and per share data) 2002 2001 =============================================== ============= ============== Interest income - --------------- Interest and fees on loans $ 8,107 $ 8,371 Interest on interest-bearing deposits 53 171 Interest on federal funds sold 10 196 Interest on securities - taxable 1,369 2,080 Interest on securities - nontaxable 1,106 864 ============================================== ------------- --------------- Total interest income 10,645 11,682 ============================================== ------------- --------------- Interest expense - ---------------- Interest on time deposits $100,000 or more 867 1,223 Interest on other deposits 3,092 4,961 Interest on borrowed funds 1 1 ============================================== ------------- --------------- Total interest expense 3,960 6,185 ============================================== ------------- --------------- Net interest income 6,685 5,497 Provision for loan losses 546 332 ============================================== ------------- --------------- Net interest income after provision for loan losses 6,139 5,165 ============================================== ------------- --------------- Noninterest income - ------------------ Service charges on deposit accounts 569 575 Other service charges and fees 79 73 Credit card fees 378 335 Trust income 241 287 Other income 94 26 Realized securities gains, net 185 --- ------------- --------------- Total noninterest income 1,546 1,296 ============================================== ------------- --------------- Noninterest expense - ------------------- Salaries and employee benefits 2,216 2,047 Occupancy and furniture and fixtures 427 427 Data processing and ATM 302 348 Credit card processing 227 265 Intangibles and goodwill amortization 240 199 Net costs of other real estate owned 39 16 Other operating expenses 897 983 ============================================== ------------- --------------- Total noninterest expense 4,348 4,285 ============================================== ------------- --------------- Income before income tax expense 3,337 2,176 Income tax expense (790) (495) ============================================== ------------- --------------- Net income $ 2,547 1,681 ============================================== ============= =============== Net income per share, basic and diluted $ 0.72 0.48 ============= =============== Weighted average number of common shares outstanding 3,511,377 3,511,377 Dividends declared per share $ 0.46 0.43 ============= =============== See accompanying notes to consolidated financial statements. 5 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Six Months Ended June 30, 2002 and 2001 (Unaudited) June 30, June 30, ($000's except share and per share data) 2002 2001 ============================================ ============= ============== Interest income - --------------- Interest and fees on loans $16,166 $16,603 Interest on interest-bearing deposits 98 375 Interest on federal funds sold 19 540 Interest on securities - taxable 2,772 4,067 Interest on securities - nontaxable 2,184 1,478 ============================================ --------------- -------------- Total interest income 21,239 23,063 ============================================ --------------- -------------- Interest expense - ---------------- Interest on time deposits $100,000 or more 1,787 2,423 Interest on other deposits 6,436 9,756 Interest on borrowed funds 3 4 ============================================ --------------- -------------- Total interest expense 8,226 12,183 ============================================ --------------- -------------- Net interest income 13,013 10,880 ============================================ Provision for loan losses 1,192 664 ============================================ --------------- -------------- Net interest income after provision for loan losses 11,821 10,216 ============================================ --------------- -------------- Noninterest income - ------------------ Service charges on deposit accounts 1,104 1,085 Other service charges and fees 134 145 Credit card fees 683 596 Trust income 480 565 Other income 349 126 Realized securities gains (losses), net 165 (26) --------------- -------------- Total noninterest income 2,915 2,491 ============================================ --------------- -------------- Noninterest expense - ------------------- Salaries and employee benefits 4,443 3,966 Occupancy and furniture and fixtures 824 843 Data processing and ATM 586 709 Credit card processing 484 502 Intangibles and goodwill amortization 478 436 Net costs of other real estate owned 123 20 Other operating expenses 1,799 1,870 ============================================ --------------- -------------- Total noninterest expense 8,737 8,346 ============================================ --------------- -------------- Income before income tax expense 5,999 4,361 Income tax expense (1,348) (1,064) ============================================ ---------------- -------------- Net income $ 4,651 3,297 ============================================ =============== ============== Net income per share, basic and diluted $ 1.32 0.94 =============== ============== Weighted average number of common shares outstanding 3,511,377 3,511,383 Dividends declared per share $ 0.46 0.43 =============== ============== See accompanying notes to consolidated financial statements. 6 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Six Months Ended June 30, 2002 and 2001 (Unaudited) Accumulated Other ($000's, except for per Common Retained Comprehensive Comprehensive share data) Stock Earnings Income (Loss) Income Total =========== ============= ================ ================ ============ Balances, December 31, 2000 $ 8,780 51,629 (575) --- 59,834 Net income --- 3,297 --- 3,297 3,297 Dividend ($0.43 per share) --- (1,510) --- --- (1,510) Other comprehensive income, net of tax: Unrealized gains on securities available for sale, net of income tax expense $690 --- --- --- 1,340 --- Reclass adjustment net of tax $9 --- --- --- 17 --- --------------- Other comprehensive income --- --- 1,357 1,357 1,357 ----------- ------------- ---------------- ---------------- ------------ Comprehensive income --- --- --- 4,654 --- ----------- ------------- ---------------- ---------------- ------------ Stock repurchase (1) (2) (6) --- --- (8) ----------- ------------- ----------------- --------------- ------------ Balances, June 30, 2001 $ 8,778 53,410 782 --- 62,970 =========== ============= ================= =============== ============ Balances, December 31, 2001 $ 8,778 55,917 566 65,261 Net income --- 4,651 --- 4,651 4,651 Dividend ($0.46 per share) --- (1,616) --- --- (1,616) Other comprehensive income, net of tax Unrealized gains on securities available for sale, net of income tax expense $661 --- --- --- 1,283 --- Reclass adjustment net of income tax $52 --- --- --- (101) --- ---------------- Other comprehensive income --- --- 1,182 1,182 1,182 ----------- ------------- ---------------- ---------------- ------------ Comprehensive income --- --- --- 5,833 --- ----------- ------------- ---------------- ---------------- ------------ Stock repurchase --- --- --- --- --- ----------- -------------- --------------- ---------------- ------------ Balances, June 30,2002 $ 8,778 58,952 1,748 --- 69,478 =========== ============= ================ ================ ============ (1) Represents the repurchase of 500 shares at $16.25 per share. See accompanying notes to consolidated financial statements. 7 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows Six Months Ended June 30, 2002 and 2001 (Unaudited) June 30, June 30, ($000's) 2002 2001 ================ ================= Cash flows from operating activities Net income $ 4,651 3,297 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,192 664 Depreciation of bank premises and equipment 499 558 Amortization of intangibles 478 435 Amortization of premiums and accretion of discount, net 196 142 Gains on sales of bank premises and equipment --- (1) (Gains)losses on sales and calls of securities available for sale, net (153) 26 Gains on calls of securities held to (12) --- maturity Losses and write-downs on other real estate owned 94 4 (Increase) decrease in: Mortgage loans held for sale 754 (254) Accrued interest receivable (289) (408) Other assets (195) (227) Increase (decrease) in: Accrued interest payable (328) 22 Other liabilities (226) (218) ----------------- ----------------- Net cash provided by operating activities 6,661 4,040 ---------------- ----------------- Cash flows from investing activities Net (increase) decrease in federal funds sold (3,149) 17,973 Net decrease in interest-bearing deposits 11,538 3,621 Proceeds from calls, maturities and principal payments of securities available for sale 7,087 24,518 Proceeds from sales of securities available for sale 404 --- Proceeds from calls, maturities and principal payments of securities held to maturity 8,715 8,937 Purchases of securities available for sale (13,984) (13,096) Purchases of securities held to maturity --- (65,534) Purchases of loan participations (3,200) (3,114) Collections of loan participations 2,225 2,474 Purchase of loans from acquisition --- (9,255) Net increase in loans to customers (16,717) (15,716) Proceeds from disposal of other real estate owned 35 210 Recoveries on loans charged off 77 57 Purchase of bank premises and equipment (274) (668) Proceeds from disposal of bank premises and equipment --- 16 ---------------- ---------------- Net cash used in investing activities (7,243) (49,577) ----------------- ---------------- 8 Cash flows from financing activities Deposits purchased net of premium paid --- 29,885 Net increase (decrease) in time deposits (16,414) 1,152 Net increase in other deposits 17,833 17,206 Net decrease in other borrowed funds 118 92 Dividends paid on common stock (1,616) (1,510) Repurchase of common stock --- (8) ---------------- ------------------ Net cash provided by (used in) financing activities (79) 46,817 ---------------- ----------------- Net increase (decrease) in cash and due from banks (661) 1,280 Cash and due from banks at beginning of period 12,293 11,130 ---------------- ------------------ Cash and due from banks at end of period $11,632 12,410 ================ ================== Supplemental disclosure of cash flow information Cash paid for interest $ 8,554 12,161 ================ ================== Cash paid for income taxes $ 1,439 1,263 ================ ================== Loans charged to the allowance for loan losses $ 698 620 ================ ================== Loans transferred to other real estate owned $ 219 73 ================ ================== Unrealized gains on securities available for sale $ 1,791 2,056 ================ ================== See accompanying notes to consolidated financial statements. 9 National Bankshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements June 30, 2002 (Unaudited) Note (1) The consolidated financial statements of National Bankshares, Inc. (Bankshares) and its wholly-owned subsidiaries, The National Bank of Blacksburg (NBB), Bank of Tazewell County (BTC) and National Bankshares Financial Services Inc. (NBFS), (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 six months ended June 30, 2002 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 herein should be read in conjunction with the notes to consolidated financial statements included in the Company's 2001 Annual Report to Stockholders and additional information supplied in the 2001 Form 10-K. 10 Note (2) Allowance for Loan Losses, Nonperforming Assets and Impaired Loans For the periods ended June 30, December 31, 2002 2001 2001 ============== ============== ================ ($000's, except for % data) Balance at beginning of period $ 4,272 3,886 3,886 Provision for loan losses 1,192 664 1,408 Loans charged off (698) (620) (1,128) Recoveries 77 57 106 -------------- -------------- ---------------- Balance at the end of period $ 4,843 3,987 4,272 ============== ============== ================ Ratio of allowance for loan losses to the end of period loans net of unearned income and deferred fees 1.17% 1.04% 1.07% =============== ============== ================ Ratio of net charge-offs (recoveries) to average loans, net of unearned income and deferred fees(1) .31% .31% .27% =============== ============== ================ Ratio of allowance for loan losses to nonperforming loans(2) 36.44% 2,345.29% 1,206.78% =============== ============== ================ (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. June 30, December 31, 2002 2001 2001 ============= ============ ================ ($000's, except for % data) Nonperforming Assets Nonaccrual loans $579 170 354 Restructured loans --- --- --- ------------- ------------ ---------------- Total nonperforming loans 579 170 354 Foreclosed property 301 399 211 ------------- ------------ ---------------- Total nonperforming assets $880 569 565 ============= ============ ================ Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned .21% .15% .14% ============= ============ ================ 11 June 30, December 31, 2002 2001 2001 ============= ============ ================ Accruing Loans Past Due 90 Days or More Past due 90 days or more and still accruing $876 1,400 980 ============= ============ ================ Ratio of loans past due 90 days or more to loans, net of unearned income and deferred fees .21% .36% .25% ============= ============ ================ Impaired Loans Total impaired loans $682 721 340 ============= ============ ================ Impaired loans with a valuation allowance $231 --- 65 Valuation allowance (110) --- (39) ------------- ------------ ----------------- Impaired loans net of allowance $121 --- 26 ============= ============ ================ Impaired loans with no valuation allowance $451 721 275 ============= ============ ================ Average recorded investment in impaired loans $486 591 671 ============= ============ ================ Income recognized on impaired loans $ 6 29 57 ============= ============ ================ Amount of income recognized on a cash basis --- --- --- ============= ============ ================ 12 Note (3) Securities The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for the sale by major security type as of June 30, 2002 are as follows: June 30, 2002 Gross Gross Amortized Unrealized Unrealized Fair ($ in thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ Available for sale: U.S. Treasury $ 5,247 210 --- 5,457 U.S. Government agencies and corporations 2,400 45 --- 2,445 State and political subdivisions 58,358 1,410 48 59,720 Mortgage-backed securities 11,801 404 2 12,203 Corporate debt securities 13,227 224 15 13,436 Federal Reserve Bank stock 208 --- --- 208 Federal Home Loan Bank stock 1,656 --- --- 1,656 Other securities 1,469 420 --- 1,889 ----------------- ----------------- ----------------- ------------------ Total securities available for sale $94,366 2,713 65 97,014 ================= ================= ================= ================== The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type as of June 30, 2002 are as follows: June 30, 2002 Gross Gross Amortized Unrealized Unrealized Fair ($ in thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ Held to Maturity: U.S. Government agencies and corporations $13,020 137 --- 13,157 State and political subdivisions 46,900 1,085 34 47,951 Mortgage-backed securities 11,260 234 13 11,481 Corporate securities 22,820 1,040 82 23,778 ----------------- ----------------- ----------------- ------------------ Total securities held to maturity $94,000 2,496 129 96,367 ================= ================= ================= ================== 13 National Bankshares, Inc. and Subsidiaries (In 000's, except for per share data) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The purpose of this discussion 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. Reference should be made to the financial statements and other information included in this report as well as the 2001 Annual Report and Form 10-K for an understanding of the following discussion and analysis. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements. 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 either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Allowance for Loan Losses The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values in inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. 14 Core deposit intangibles In July, 2001, the Financial Accounting Standards Board issued two statements - Statement 141, Business Combinations, and Statement 142, Goodwill and Other Intangible Assets, which could potentially impact the accounting for goodwill and other intangible assets. Statement 141 eliminated the pooling method of accounting for business combinations and required that intangible assets that meet certain criteria be reported separately from goodwill. Statement 142 eliminated the amortization of goodwill and other intangibles that are determined to have an indefinite life. The Statement requires, at a minimum, annual impairment tests for goodwill and other intangible assets that are determined to have an indefinite life. Subsequent to the effective date of SFAS 142 an apparent conflict with SFAS 72 was raised as an issue, which allows certain intangibles arising from Bank and Thrift acquisitions to be amortized over their estimated useful lives. In late June of 2002, the Financial Accounting Standards Board announced that existing core deposit intangibles would continue to be amortized under SFAS No.72, subject to periodic impairment testing. Intangibles arising from future transactions would be subject to the provisions of SFAS No.142. Analysis of Financial Condition and Results of Operations for the Six Months Ended June 30,2002 - -------------------------------------------------------------------------------- Net income for the six months ended June 30, 2002 was $4,651, which represents an increase of $1,354 or 41.1% when compared to the same period in 2001. The annualized return on average assets for the six months ended June 30 2002 was 1.46% and 1.06% for June 30, 2001. The annualized return on average equity was 13.86% for the period ended June 30, 2002 and 10.77% for June 30, 2001. Earnings per share for the period ended June 30, 2002 was $1.32 and $0.94 in 2001 for the same period. Net Interest Income Net interest income at the end of the second quarter of 2002 was $13,013, an increase of $2,133 or 19.6%. Interest income decreased $1,824 or 7.9%, when the periods ended June 30, 2002 and 2001 are compared. Interest expense decreased $3,957, or 32.5%, when the two periods are compared. The yield on earning assets was 7.44%, decreasing 71 basis points from June 30, 2001. The cost to fund earning assets for the period ended June 30, 2002 was 2.73% or a 142 basis point decrease from the same period in 2001. This resulted in a increase in the net interest margin. As seen by this data, substantially lower funding costs due to the low rate environment accounted for most of the improvement. Management believes that the current rate environment is unsustainable over a long period of time without having an adverse effect on the general economy. Accordingly, rate increases are expected by the end of 2002 or the first part of 2003. While the Company's yield on earning assets would improve in a higher rate scenerio, it would likely be offset by a greater increase in funding costs in the near term. The ultimate impact on the Company's net interest margin will be dependent on several factors. The timing of rate increases and the extent of such will be a primary factor. However, the effect of the rate increase could be mitigated by asset and liability management practices. 15 Additional uncontrollable events that may effect the general economy and rate levels include the ongoing terrorist threat, interruption of the nation's oil supplies, and other potential side effects from problems in the Middle East. Recent accounting scandals and their effect on the stock markets may also have an adverse effect on the general economy. While management can plan for various scenerios or rate environments it cannot predict the ultimate outcome in the potentially volatile environment currently being experienced. Provision and Allowance for Loan Losses The ratio of the allowance for loan losses to loans net of unearned income was 1.17% at June 30 2002. This compares to 1.04% at June 30, 2001. The provision for the first six months of 2002 was $1,192, up $528 over the same period the prior year. While management continues to believe that overall credit quality remains sound, net charge-offs are expected to be at slightly higher levels in 2002, due in part to an increasing loss exposure in the consumer loan portfolio. With much of the growth in commercial loans the Company's exposure to losses resulting from defaults in a small number of large size credits has also increased. The ratio of the allowance for loan losses to loans at December 31, 2001 was 1.07%. The combined effect of loan growth and additional provisions in 2002 resulted in a nominal 10 basis point increase in this ratio. Noninterest Income Noninterest income is an important source of the Company's income. This category is comprised of service charges on deposit accounts, other service charges and fees, credit card fees, trust income and other income. Net securities gains and losses are also included in this category. Noninterest income for the period ended June 30, 2002 was $2,915, an increase of $424 or 17.0%. Credit card fees increased $87 and 14.6%. This increase was primarily due to volume. Trust income decreased by 15.0% when compared to the first six months of 2001. Trust income is dependent on market conditions as well as the types of accounts being handled at any given point in time. The level of estate business, for example, cannot be predicted with any degree of precision. Market conditions, which control values of assets managed and in turn trust fees, have been less favorable. With the current market volatility, management believes that market conditions, though unpredictable, will tend to have an adverse affect on trust fees. Realized securities gains/(losses) were $165 for the period ended June 30, 2002. In the second quarter of 2002 the Company sold one third of its investment in a local bank holding company, which produced a gain of approximately $157. Also included in realized net gains and losses are the result of called securities and write-downs in investments in limited liability companies (LLC). The LLC investments allow the company to derive income from title insurance, life & casualty insurance and investment products. The write-downs represent an adjustment of the Company's equity investment in these companies. Subsequent to June 30, 2002, an additional one third of its interest in the previously mentioned local bank holding company was sold. A gain of approximately $177 was realized and will be reflected in the Company's third quarter operating results. Other income contained some nonrecurring or infrequent items as well as two new forms of revenues, which accounted for a portion of the $223 increase over 2001. Contributing to this increase were nontaxable proceeds from a life insurance policy, which was approximately $36 and a recovery of legal fees of $14 incurred in a prior year. In addition, there was a nonrecurring adjustment to fees for approximately $48. Other income also included commissions from the sale of securities and insurance products in the amount of $135, which compares to $4 at June 30, 2001. 16 Noninterest Expense Noninterest expense for the period ended June 30 2002 was $8,737, an increase of $391 or 4.7%. Salaries and employee benefits increased by $477 or 12.0% when the periods ended June 30, 2002 and 2001 are compared. This increase was due in part to the acquisition of a branch in late March 2001. Due to the timing of the purchase the full impact of the additional expense was not experienced in 2001. Also, included in the 2002 expense is the full effect of salaries and employee benefits associated with the Company's financial services affiliate. Routine merit salary and promotional salary increases also contributed to the increase in this category. Data processing costs decreased $123 or 17.4%. This decline was primarily due to a reduction achieved in maintenance costs and the absence of conversion costs associated with the 2001 branch acquisition that has been discussed. Credit card processing decreased $18 or 3.6% due to volume. Included in credit card expense for 2002 were two nonrecurring items. The first was a rebate of processing charges of approximately $42. The second was a rebate for $10 received as a signing bonus for a new processor. These increases were offset in part by higher expenses related to volume. Intangibles expense for the second quarter of 2002 was $478 compared to $436 during the same period last year. This increase was related to the branch acquisition that occurred in the latter part of March 2001. Since the transaction occurred late in the first quarter of 2001 intangibles expense was prorated. Balance Sheet Total assets at June 30, 2002 were $649,823, an increase of $5,200 or 0.8% from period end assets at December 31, 2001. Securities Securities available for sale increased by 9.4%, while securities held to maturity decreased 8.6%. (Refer to the table previously presented for portfolio composition.) Loans Loans net of unearned income grew by $16,775 or 4.2% from December 31, 2001. Since December 31, 2001, construction loans increased by $3,312 or 16.9% with real estate mortgage loans increasing $3,186 or 4.1%. The largest increase, however was experienced in the commercial loan category which grew by $18,282 or 9.6% due to demand. The only category to show a decrease was loans to individuals, which declined by $8,258 or 7.3%. Given the general economic conditions, it is not known to what extent loans to individuals will ultimately decline or when growth in this area will resume. Loans to individuals generally produce higher yields than other loan categories. A prolonged and substantial run-off of these loans could have a measurable impact on the Company's net interest margin. 17 Deposits Total deposits decreased $1,419 or 0.3% when June 30 2002 and December 31, 2001 are compared. Noninterest-bearing demand deposits increased $4,877 or 6.8%, when June 30, 2002 and December 31, 2001 are compared. During the same period interest-bearing demand deposits increased by 9.5%, while savings deposits were up 0.3%. Management believes that the increase in interest-bearing demand deposits is in part due to the customers' expectation of higher interest rates in the near to intermediate term. Hence, the Company's customers are not committing their funds for longer terms. The largest decrease in deposits took place in time deposits, which declined by $16,414 or 5.1%, as management has allowed higher cost time deposits to run-off. Daily Averages Daily averages for the major categories are as follows: (000's) June 30,2002 December 31,2001 ------------------- --------------------- Loans, net $406,812 380,970 Securities available for sale 87,937 109,682 Securities held to maturity 98,876 79,127 Total assets 642,400 635,692 Total deposits 572,071 569,139 Stockholders' equity 67,651 63,460 Liquidity Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. Cash from operating activities was $6,661. The primary sources were net income and net sales of real estate loans held for sale. Cash used in investing activities was $7,243. As can be seen from the cash flow statement the principal use of cash was for lending activities. Financing activities during the period was a user of cash, mainly due to a decline in in the area of time deposits previously noted. Management is not aware of any commitments that will result in, or are likely to result in, a material and adverse decline in liquidity. Branching Activity The Company's NBB affiliate announced in the second quarter its plans to establish a new branch in Christiansburg, Virginia. The new branch will be located in the downtown area and is expected to be opened in the first quarter of 2003. 18 Analysis of the Financial Condition and Results of Operations for the Three Months Ended June 30, 2002 - -------------------------------------------------------------------------------- Net income for the three months ended June 30, 2001 was $2,547, a increase of $866 or 51.5% over the same period in 2001. The annualized return on average assets for the second quarter of 2002 was 1.58% and 1.04% for the second quarter of 2001. The annualized return on average equity for the second quarter of 2002 was 14.93%. This compares to 10.83% for the same period in 2000. Basic earnings per share for the three months ended June 30,2002 was $0.72, an increase of $0.24 from the second quarter of 2001. Net interest income Net interest income for the quarter ended June 30, 2002 was $6,685 or a 21.6% increase from the same quarter in 2001. As previously discussed the Company continues to benefit from the low interest rate environment. Provision for loan losses The provision for loan losses for the second quarter of 2002 was $546. This compares to $332 for the same period the prior year. The increase in the provision was necessitated in part by loan growth and a higher level of charge-offs. As previously mentioned, an increasing concern for loss exposure, in the consumer loan portfolio exists. The shift in the loan portfolio mix as discussed previously also contributed to the need for an increased provision. Noninterest income Noninterest income for the second quarter of 2002 was $1,546, an increase of $250 over the period ending June 30, 2001. Previously mentioned securities gains accounted for the majority of this increase. Service charges on deposits remained relativity unchanged decreasing $6 or 1.0% when the quarter-ended June 30, 2002 is compared to the same period in 2001. Credit card income also showed slight improvement due to volume. Trust income decreased by 16.0% when the two periods are compared. As previously discussed various factors contribute to the level of trust income. Market values of assets managed are dependent on market valuations, which as of late have been generally down. Noninterest expense Noninterest expense for the quarter ended June 30, 2002 was $4,348. This represents an increase of $63 or 1.5% when compared to the quarter ended June 30, 2001. This category contains two nonrecurring items related to credit card expense. Please refer to the year-to- date discussion for details. 19 Balance Sheet Total average assets for the quarter ended June 30, 2002 were $646,533, which represents an increase of $358 or 0.1% over total assets at June 30, 2001. A comparison of selected quarterly averages follows. ($000) June 30, 2002 June 30, 2001 ------------- ------------- Federal funds sold $ 2,448 16,934 Federal Home Loan Bank deposits 12,397 16,476 Securities available for sale 89,285 115,613 Securities held to maturity 97,023 85,938 Loans net of unearned income and fees 406,119 371,907 Noninterest-bearing deposits 74,917 66,527 Interest-bearing deposits 500,833 515,149 Borrowed money 97 246 20 Item 3. Quantitative and Qualitative Disclosures about Market Risk Derivatives The Company is not a party to derivative financial instruments with off-balance sheet risks such as futures, forwards, swaps and options. The Company is a party to financial instruments with off-balance sheet risks such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business to meet the financing needs of its customers. Management does not plan any future involvement in high risk derivative products. The Company has limited amounts of collateralized mortgage obligations, structured notes and other similar instruments that are included in securities available for sale and securities held to maturity. Interest Rate Sensitivity The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income to adverse movement in interest rates. Interest rate shock analyses provides management with an indication of potential economic loss due to future rate changes. There have not been any changes, which would significantly alter the results disclosed as of December 31, 2001. 21 National Bankshares, Inc. and Subsidiaries Part II Other Information Items 1-3. Legal Proceedings; Changes in Securities and Use of Proceeds; Defaults upon Senior Securities None for the three months ended June 30, 2002. Item 4. Submission of Matters to a Vote of Security Holders Three class 3 Directors of the Company were elected by a vote of the security holders for a term of three years each. (a) This matter was submitted to a vote at the Company's Annual Meeting of Stockholders held on April 9, 2002. (b) The name of each director elected at the meeting follows: James A. Deskins, Sr. William T. Peery James M. Shuler The name of each director whose term of office continued after the meeting is listed: L. Allen Bowman Alonso A. Crouse Paul A. Duncan Cameron L. Forrester James G. Rakes Jeffrey R. Stewart (c) The number votes cast for or against each nominee is provided below. There were no abstaining votes and broker non-votes. Election of directors Director Votes For Votes Against -------- --------- ------------- James A. Deskins, Sr. 2,657,077 15,480 William T. Peery 2,659,268 13,289 James M. Shuler 2,664,050 8,507 Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K The Company had no filings on Form 8-K for the quarter ended June 2002. See the index to exhibits for items incorporated by reference to this filing. 22 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. National Bankshares, Inc. (Registrant) Date: 08/14/2002 /s/ James G. Rakes -------------- ------------------------------------- James G. Rakes, Chairman President and Chief Executive Officer Date: 08/14/2002 /s/ J. Robert Buchanan ------------ ------------------------------------- J. Robert Buchanan, Treasurer (principal financial officer) 23 Index to Exhibits Page No. in Exhibit No. Description Sequential System - ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, of (incorporated National Bankshares, Inc. herein by reference to Exhibit 3(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 4(i) Specimen copy of certificate for National (incorporated Bankshares, Inc. common stock, $2.50 par herein by value reference to Exhibit 4(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 4(i) Article Fourth of the Articles of (incorporated Incorporation of National Bankshares, Inc. herein by included in Exhibit No. 3(a)) reference to Exhibit 4(b) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated (incorporated June 18, 1990, by and between Information herein by Technology, Inc. and The National Bank of reference to Blacksburg Exhibit 10(e) of the Annual Report on Form 10K for fiscal year ended December 31, 1992) *10(iii)(A) Employment Agreement dated January 1, 2002, by and between National Bankshares, Inc. and James G. Rakes *10(iii)(A) Capital Accumulation Plan (included in Exhibit No. 10(iii)(A) 24 *10(iii)(A) National Bankshares, Inc. 1999 Stock Option (incorporated Plan herein by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on June 4, 1999) 99(a) Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 99(b) Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 25