UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended Commission file number
December 31, 2003 0-15204
National Bankshares, Inc.
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(Exact name of Registrant as specified in its charter)
Virginia 54-1375874
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
101 Hubbard Street
Blacksburg, Virginia 24060 24060
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(Address of principal executive offices) Zip Code
Securities registered pursuant to Section 12(b) of the Act: None (540) 951-6300
Securities registered pursuant to Section 12(g) of the Act:Registrant's
telephone number, including area code
Common Stock, Par Value $2.50 per Share
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(Title of Class)
Indicate by a check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form
10-K. X
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Indicate by check mark whether the registrant is an accelerated filer as defined
in Rule 12b-2 of the Act). Yes X No ____ The aggregate market value of the
voting common equity held by nonaffiliates of the Registrant at $39.65 the price
at which the common equity was sold as of June 30, 2003 the last business day of
Registrant's most recently completed second quarter, was $133,033,046.
Indicate the number of shares outstanding of each of the Registrant's classes of
common stock, as of the latest practicable date.
Class Outstanding at February 15, 2004
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Common Stock 3,515,377
$2.50 Par Value
DOCUMENTS INCORPORATED BY REFERENCE
Selected information from the Registrant's Proxy Statement for the Annual
Meeting to be held April 13, 2004 and filed with the Securities and Exchange
Commission pursuant to Regulation 14A, is incorporated by reference into Part
III of this report.
(This report contains 64 pages.)
(The Index of Exhibits is on page 61.)
1
Table of Contents
Page
Part I
Item 1. Business 3
Item 2. Properties 11
Item 3. Legal Proceedings 11
Item 4. Submission of Matters to a Vote of
Security Holders 11
Part II
Item 5. Market for Registrant's Common
Equity and Related Stockholder Matters 11
Item 6. Selected Financial Data 12
Item 7. Management's Discussion and Analysis
of Financial Condition and Results
of Operations 12
Item 7A. Quantitative and Qualitative
Disclosures About Market Risk 29
Item 8. Financial Statements and
Supplementary Data 30
Item 9. Changes in and Disagreements with
Accountants on Accounting and
Financial Disclosure 53
Item 9A Controls and Procedures 53
Part III
Item 10. Directors and Executive Officers of
the Registrant 53
Item 11. Executive Compensation 54
Item 12. Security Ownership of Certain
Beneficial Owners and Management 54
Item 13. Certain Relationships and Related
Transactions 54
Item 14. Principal Accounting Fees and Services 54
Part IV
Item 15. Exhibits, Financial Statement 55
Schedules, and Reports on Form 8-K
Signatures 56
Index of Exhibits 61
2
Part I
$ In thousands, except per share data.
Item 1. Business
History and Business
National Bankshares, Inc. (Bankshares) is a financial holding company
organized under the laws of Virginia in 1986 and registered under the Bank
Holding Company Act (BHCA). Bankshares conducts the majority of its business
operations through its two wholly-owned bank subsidiaries, The National Bank of
Blacksburg (NBB) and Bank of Tazewell County (BTC), and through National
Bankshares Financial Services, Inc. (NBFS), doing business as National
Bankshares Investment Services and National Bankshares Insurance Services,
collectively referred to as "The Company". Bankshares posts all reports required
to be filed under the Securities Exchange Act of 1934 on its web site at
www.nationalbankshares.com.
The National Bank of Blacksburg
The National Bank of Blacksburg was originally chartered as the Bank of
Blacksburg in 1891. Its state charter was converted to a national charter in
1922 and it became The National Bank of Blacksburg. NBB operates a full-service
banking business from its headquarters in Blacksburg, Virginia, and its thirteen
area branch offices. NBB offers general retail and commercial banking services
to individuals, businesses, local government units and institutional customers.
These products and services include accepting deposits in the form of checking
accounts, money market deposit accounts, interest-bearing demand deposit
accounts, savings accounts and time deposits; making real estate, commercial,
revolving, consumer and agricultural loans; offering letters of credit;
providing other consumer financial services, such as automatic funds transfer,
collections, night depository, safe deposit, travelers checks, savings bond
sales and utility payment services; and providing other miscellaneous services
normally offered by commercial banks. NBB also conducts a general trust
business. Through its trust operation, NBB offers a variety of personal and
corporate trust services.
NBB makes loans in all major loan categories, including commercial,
commercial and residential real estate, construction and consumer loans.
At December 31, 2003, NBB had total assets of $401,274. Total deposits at
this date were $356,838. NBB's net income for 2003 was $7,416 which produced a
return on average assets of 1.90% and a return on average stockholders' equity
of 18.04%. Refer to Note 12 of the Notes to Consolidated Financial Statements
for NBB's risk-based capital ratios.
Bank of Tazewell County
The antecedents of BTC are in a charter issued on September 28, 1889 for
Clinch Valley Bank. On December 22, 1893, a second charter was issued in
substantially the same form for Bank of Clinch Valley. In 1929, Bank of Clinch
Valley merged with Farmers Bank under the charter of the former, and the name of
the new institution became Farmers Bank of Clinch Valley. Bank of Tazewell
County resulted from the 1964 merger of Bank of Graham, Bluefield, Virginia with
Farmers Bank of Clinch Valley. BTC provides general retail and commercial
banking services to individuals, businesses and local government units. These
services include commercial, real estate and consumer loans. Deposit accounts
offered include demand deposit accounts, interest-bearing demand deposit
accounts, money market deposit accounts, savings accounts and certificates of
deposit. Other services include automatic funds transfer, collections, night
depository, safe deposit, travelers checks, savings bond sales and utility
payment services; and providing other miscellaneous services normally offered by
commercial banks. BTC also conducts a general trust business.
At December 31, 2003, BTC had total assets of $303,171. Total deposits at
this same date were $269,176. BTC's net income for 2003 was $4,137 which
produced a return on average assets of 1.37% and a return on average
stockholders' equity of 12.70%. Refer to Note 12 of the Notes to Consolidated
Financial Statements of BTC's risk-based capital ratios.
National Bankshares Financial Services
On April 9, 2001, National Bankshares Financial Services Inc., a
wholly-owned subsidiary began offering non-deposit investment products and
insurance products for sale to the public. NBFS is working with Bankers
Insurance, LLC, a joint effort of Virginia Banks originally sponsored by the
Virginia Bankers Association. In another cooperative effort, NBFS is working
with UVEST Financial Services Group, Inc. to offer investment services. In the
first quarter of 2004, NBFS expects to end its association with UVEST Financial
Services Group, Inc. and to begin offering investment services through Bankers
Investments, LLC.
Commercial Loans
NBB and BTC make both secured and unsecured loans to businesses and to
individuals for business purposes. Loan requests are granted based upon several
factors including credit history, past and present relationships with the bank,
marketability of collateral and the cash flow of the borrowers. Unsecured
commercial loans must be supported by a satisfactory balance sheet and income
statement. Collateralized business loans may be secured by a security interest
3
in marketable equipment, accounts receivable, business equipment and/or general
intangibles of the business. In addition, or as an alternative, the loan may be
secured by a deed of trust lien on business real estate.
The risks associated with commercial loans are related to the strength of
the individual business, the value of loan collateral and the general health of
the economy.
Residential Real Estate Loans
Loans secured by residential real estate are originated by both bank
subsidiaries. NBB sells a substantial percentage of the residential real estate
loans it originates in the secondary market on a servicing released basis. There
are occasions when a borrower or the real estate do not qualify under secondary
market criteria, but the loan request represents a reasonable credit risk. Also,
an otherwise qualified borrower may choose not to have their mortgage loan sold.
On these occasions, if the loan meets NBB's internal underwriting criteria, the
loan will be closed and placed in NBB's portfolio. Some residential loans
originated by BTC are held in the bank's loan portfolio and others are sold in
the secondary market. In their secondary market operations, NBB and BTC
participate in insured loan programs sponsored by the Department of Housing and
Urban Development, the Veterans Administration and the Virginia Housing
Development Authority.
Residential real estate loans carry risk associated with the continued
credit-worthiness of the borrower and changes in the value of the collateral.
Construction Loans
NBB makes loans for the purpose of financing the construction of business
and residential structures to financially responsible business entities and
individuals. These loans are subject to the same credit criteria as commercial
and residential real estate loans. Although BTC offers construction loans, its
involvement in this area of lending is more limited than NBB's due to the nature
of its market area.
In addition to the risks associated with all real estate loans, construction
loans bear the risks that the project will not be finished according to
schedule, the project will not be finished according to budget and the value of
the collateral may at any point in time be less than the principal amount of the
loan. Construction loans also bear the risk that the general contractor, who may
or may not be the bank's loan customer, is unable to finish the construction
project as planned because of financial pressures unrelated to the project.
Loans to customers that are made as permanent financing of construction loans
may likewise under certain circumstances be affected by external financial
pressures.
Consumer Loans
NBB and BTC routinely make consumer loans, both secured and unsecured. The
credit history, cash flow and character of individual borrowers is evaluated as
a part of the credit decision. Loans used to purchase vehicles or other specific
personal property and loans associated with real estate are usually secured with
a lien on the subject vehicle or property.
Negative changes in a customer's financial circumstances due to a large
number of factors, such as illness or loss of employment, can place the
repayment of a consumer loan at risk. In addition, deterioration in collateral
value can add risk to consumer loans.
Sales and Purchases of Loans
NBB and BTC will occasionally buy or sell all or a portion of a loan. These
purchases and sales are in addition to the secondary market residential mortgage
loans regularly sold by the banks.
Both banks will consider selling a loan or a participation in a loan, if:
(i) the full amount of the loan will exceed the bank's legal lending limit to a
single borrower; (ii) the full amount of the loan, when combined with a
borrower's previously outstanding loans, will exceed the bank's legal lending
limit to a single borrower; (iii) the Board of Directors or an internal Loan
Committee believes that a particular borrower has a sufficient level of debt
with the bank; (iv) the borrower requests the sale; (v) the loan to deposit
ratio is at or above the optimal level as determined by bank management; and/or
(vi) the loan may create too great a concentration of loans in one particular
location or in one particular type of loan.
The banks will consider purchasing a loan, or a participation in a loan,
from another financial institution (including from another subsidiary of the
Company) if the loan meets all applicable credit quality standards and (i) the
bank's loan to deposit ratio is at a level where additional loans would be
desirable; and/or (ii) a common customer requests the purchase.
The following table sets forth, for the three fiscal years ended December
31, 2003, 2002 and 2001 the percentage of total operating revenue contributed by
each class of similar services which contributed 15% or more of total operating
revenues of the Company during such periods.
4
Percentage of
Period Class of Service Total Revenues
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December 31, 2003 Interest and Fees on Loans 68.59%
Interest on Investments 23.35%
December 31, 2002 Interest and Fees on Loans 66.90%
Interest on Investments 20.65%
December 31, 2001 Interest and Fees on Loans 55.84%
Interest on Investments 21.37%
Market Area
The National Bank of Blacksburg Market Area
NBB's primary market area consists of all of Montgomery County, all of Giles
County, all of Pulaski County, the City of Radford, the City of Galax and
adjacent portions of Carroll and Grayson Counties, Virginia. This area includes
the towns of Blacksburg and Christiansburg in Montgomery County, the towns of
Pearisburg, Pembroke, Narrows and Rich Creek, in Giles County, and the towns of
Dublin and Pulaski in Pulaski County. The local economy is diverse and is
oriented toward higher education, retail and service, light manufacturing and
agriculture.
Montgomery County's largest employer is Virginia Polytechnic Institute and
State University (VPI & SU) located in Blacksburg. VPI & SU is the
Commonwealth's land grant college and also its largest university. Employment at
VPI & SU has remained relatively stable over the past three years, and it is not
expected to change materially in the next few years. A second state supported
university, Radford University, is located in NBB's service area. It too has
provided stable employment opportunities in the region. The State of Virginia
has implemented significant cuts in financial support to both universities. To
date, these cuts have not translated into large reductions in employment.
Giles County's primary employer is the Celanese plant, a manufacturer of
acetate fibers. Employment at this plant has remained relatively stable over the
past several years.
Pulaski County's major employer is the Volvo Heavy Trucks production
facility. Employment trends at this facility have been positive over the past
three years. The county also has several large furniture plants, most notably
Pulaski Furniture and Ethan Allen. Furniture manufacturing has recently been
negatively impacted by growing furniture imports.
The City of Galax is located in the Virginia-North Carolina
furniture-manufacturing region. Three furniture companies, Vaughan Bassett
Furniture Company, Vaughan Furniture Company, Inc. and Webb Furniture Company
together employ the largest percentage of the area's work force. The Galax
economy is stable, but recently furniture manufacturing has been negatively
affected.
Several other small manufacturing concerns are located in Montgomery, Giles
and Pulaski Counties and in the City of Galax. These concerns manufacture
diverse products and are not dependent on one sector of the economy. Agriculture
and tourism are also important to the region, especially in Giles County and in
the area near Galax.
Montgomery County has developed into a regional retail center, with the
construction of several large shopping areas. Two area hospitals, each of which
are affiliated with different large health care systems, have constructed
additional facilities attracting health care providers to Montgomery County,
making it a center for basic health care services. VPI & SU's Corporate Research
Center has brought small high tech companies to Blacksburg, and further
expansion is planned.
NBB's primary market area offers the advantages of a good quality of life,
scenic beauty, moderate climate and the cultural attractions of two major
universities. The region has marketed itself as a retirement destination, and it
has had some recent success attracting retirees, particularly from the Northeast
and urban Northern Virginia. These marketing efforts are expected to continue.
Bank of Tazewell County Market Area
Most of BTC's business originates from Tazewell County, Virginia and Mercer
County, West Virginia. This includes the towns of Tazewell, Richlands and
Bluefield, Virginia and Bluefield, West Virginia. BTC also has offices located
in the Towns of Wytheville, Marion and Abingdon located in Wythe, Smyth and
Washington Counties, Virginia, respectively. BTC's primary market area has
largely depended on the coal mining industry and farming for its economic base.
In recent years, coal companies have mechanized, reducing the number of
individuals required for the production of coal. However, there are still a
number of support industries for the coal mining business that continue to
provide employment in the area. Additionally, several new businesses have been
established in the area, and Bluefield, West Virginia has emerged as a regional
medical center. Real estate values remain stable and comparable to other areas
in Southwest Virginia. BTC's expanded market areas in Wythe, Smyth and
Washington Counties have a diverse economic base, with manufacturing,
agriculture, education and service industries all represented.
5
Competition
The banking and financial service business in Virginia, generally, and in
NBB's and BTC's market areas specifically, is highly competitive. The
increasingly competitive environment is a result of changes in regulation,
changes in technology and product delivery systems and new competition from
non-traditional financial services. The Company's bank subsidiaries compete for
loans and deposits with other commercial banks, savings and loan associations,
securities and brokerage companies, mortgage companies, money market funds,
credit unions and other nonbank financial service providers. Many of these
competitors are much larger in total assets and capitalization, have greater
access to capital markets and offer a broader array of financial services than
NBB and BTC. In order to compete, NBB and BTC rely upon service-based business
philosophies, personal relationships with customers, specialized services
tailored to meet customers' needs and the convenience of office locations. In
addition, the banks are generally competitive with other financial institutions
in their market areas with respect to interest rates paid on deposit accounts,
interest rates charged on loans and other service charges on loans and deposit
accounts.
Registrant's Organization and Employment
Bankshares, NBB, BTC and NBFS are organized in a holding company/subsidiary
structure. Until January 1, 2002, Bankshares had no employees, except for
officers, and it conducted substantially all of its operations through its
subsidiaries. Until January 1, 2002, all compensation paid to Bankshares
officers was paid by the subsidiary banks, except for fees paid to Chairman,
President and Chief Executive Officer James G. Rakes for his service as a
director of the Company. On January 1, 2002, several administrative functions
that serve multiple subsidiaries were moved to the holding company level. These
functions include audit, compliance, loan review and human resources. Employees
performing these functions who were formerly employed at the bank level are now
employed at the holding company level.
At December 31, 2003, NBB employed 134.5 full time equivalent employees at
its main office, operations center and branch offices. BTC at December 31, 2003
employed 100.5 full time equivalent employees in its various offices and
operational areas. Bankshares had 14 and NBFS had 3 full time employees at
December 31, 2003.
Certain Regulatory Considerations
Bankshares, NBB and BTC are subject to various state and federal banking
laws and regulations which impose specific requirements or restrictions on and
provide for general regulatory oversight with respect to virtually all aspects
of operations. As a result of the substantial regulatory burdens on banking,
financial institutions, including Bankshares, NBB and BTC, are disadvantaged
relative to other competitors who are not as highly regulated, and their costs
of doing business are much higher. The following is a brief summary of the
material provisions of certain statutes, rules and regulations which affect
Bankshares, NBB and/or BTC. This summary is qualified in its entirety by
reference to the particular statutory and regulatory provisions referred to
below and is not intended to be an exhaustive description of the statutes or
regulations which are applicable to the businesses of Bankshares, NBB and/or
BTC. Any change in applicable laws or regulations may have a material adverse
effect on the business and prospects of Bankshares, NBB and/or BTC.
National Bankshares, Inc.
Bankshares is a bank holding company within the meaning of the BHCA and
Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act).
The activities of Bankshares also are governed by the Gramm-Leach-Bliley Act of
1999.
The Bank Holding Company Act. The BHCA is administered by the Federal
Reserve Board, and Bankshares is required to file with the Federal Reserve Board
an annual report and any additional information the Federal Reserve Board may
require under the BHCA. The Federal Reserve Board also is authorized to examine
Bankshares and its subsidiaries. The BHCA requires every bank holding company to
obtain the approval of the Federal Reserve Board before (i) it or any of its
subsidiaries (other than a bank) acquires substantially all the assets of any
bank; (ii) it acquires ownership or control of any voting shares of any bank if
after the acquisition it would own or control, directly or indirectly, more than
5% of the voting shares of the bank; or (iii) it merges or consolidates with any
other bank holding company.
The BHCA and the Change in Bank Control Act, together with regulations
promulgated by the Federal Reserve Board, require that, depending on the
particular circumstances, either Federal Reserve Board approval must be obtained
or notice must be furnished to the Federal Reserve Board and not disapproved
prior to any person or company acquiring "control" of a bank holding company,
such as Bankshares, subject to certain exemptions. Control is conclusively
presumed to exist if an individual or company acquires 25% or more of any class
of voting securities of Bankshares. Control is rebuttably presumed to exist if a
person acquires 10% or more, but less than 25%, of any class of voting
securities of Bankshares. The regulations provide a procedure for challenging
the rebuttable control presumption.
Under the BHCA, a bank holding company is generally prohibited from engaging
in, or acquiring direct or indirect control of more than 5% of the voting shares
of any company engaged in nonbanking activities, unless the Federal Reserve
Board, by order or regulation, has found those activities to be so closely
related to banking or managing or controlling banks as to be incident to
6
banking. Under recent amendments to the BHCA, included in the Gramm-Leach-Bliley
Act of 1999 (see below), any bank holding company, all the depository
institution subsidiaries of which are well-capitalized, well managed (as those
terms are defined in the BHCA) and have a satisfactory or better rating under
the Community Reinvestment Act as of their last examination, may file an
election with the Federal Reserve Board to become a Financial Holding Company. A
Financial Holding Company may engage in any activity that is (i) financial in
nature (ii) incidental to a financial activity or (iii) complementary to a
financial activity. The BHCA provides a long list of "financial activities",
including: insurance underwriting; securities dealing and underwriting;
providing financial, investment or economic arising services; and merchant
banking activities. Financial Holding Companies may also engage in other
activities that the Federal Reserve Board has determined are permissible under
the BHCA, by regulation or order.
The Federal Reserve Board imposes certain capital requirements on Bankshares
under the BHCA, including a minimum leverage ratio and a minimum ratio of
"qualifying" capital to risk-weighted assets. Subject to its capital
requirements and certain other restrictions, Bankshares can borrow money to make
a capital contribution to NBB or BTC, and these loans may be repaid from
dividends paid from NBB or BTC to Bankshares (although the ability of NBB or BTC
to pay dividends are subject to regulatory restrictions). Bankshares can raise
capital for contribution to NBB and BTC by issuing securities without having to
receive regulatory approval, subject to compliance with federal and state
securities laws.
The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the GLBA), enacted
on November 12, 1999, broadly rewrote financial services legislation. The GLBA
permits significant combinations among different sectors of the financial
services industry; allows for significant expansion of financial service
activities by Bank holding companies and provides for a regulatory framework by
various governmental authorities responsible for different financial activities;
and offers certain financial privacy protections to consumers. The GLBA repealed
affiliation and management interlock prohibitions of the Depression-era
Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added
new substantive provisions to the non-banking activities permitted under the
BHCA with the creation of the financial holding company. The GLBA preempts most
state laws that prohibit financial holding companies from engaging in insurance
activities. The GLBA permits affiliations between banks and securities firms
within the same holding company structure, and the Act permits financial holding
companies to directly engage in a broad range of securities and merchant banking
activities.
The Gramm-Leach-Bliley Act has led to important changes in the manner in
which financial services are delivered in the United States. Bank holding
companies and their subsidiary banks are able to offer a much broader array of
financial services; however, there is greater competition in all sectors of the
financial services market.
The Virginia Banking Act. All Virginia bank holding companies must register
with the Virginia State Corporation Commission (the Commission) under the
Virginia Banking Act. A registered bank holding company must provide the
Commission with information with respect to the financial condition, operations,
management and intercompany relationships of the holding company and its
subsidiaries. The Commission also may require such other information as is
necessary to keep itself informed about whether the provisions of Virginia law
and the regulations and orders issued under Virginia law by the Commission have
been complied with, and may make examinations of any bank holding company and
its subsidiaries. The Virginia Banking Act allows bank holding companies located
in any state to acquire a Virginia bank or bank holding company if the Virginia
bank or bank holding company could acquire a bank holding company in their state
and the Virginia bank or bank holding company to be acquired has been in
existence and continuously operated for more than two years. The Virginia
Banking Act permits bank holding companies from throughout the United States to
enter the Virginia market, subject to federal and state approval.
NBB and BTC
General. NBB is a national banking association incorporated under the laws
of the United States and is subject to examination by the Office of the
Comptroller of the Currency (the OCC). Deposits in NBB are insured by the FDIC
up to a maximum amount (generally $100,000 per depositor, subject to aggregation
rules). The OCC and the FDIC regulate or monitor all areas of NBB's operations,
including security devices and procedures, adequacy of capitalization and loss
reserves, loans, investments, borrowings, deposits, mergers, issuances of
securities, payment of dividends, interest rates payable on deposits, interest
rates or fees chargeable on loans, establishment of branches, corporate
reorganizations and maintenance of books and records. The OCC requires NBB to
maintain certain capital ratios. NBB is required by the OCC to prepare quarterly
reports on NBB's financial condition and to conduct an annual audit of its
financial affairs in compliance with minimum standards and procedures prescribed
by the OCC. NBB also is required by the OCC to adopt internal control structures
and procedures in order to safeguard assets and monitor and reduce risk
exposure. While appropriate for safety and soundness of banks, these
requirements impact banking overhead costs.
BTC is organized as a Virginia-chartered banking corporation and is
regulated and supervised by the Bureau of Financial Institutions (BFI) of the
Virginia State Corporation Commission. In addition, as a federally insured bank,
BTC is regulated and supervised by the Federal Reserve Board, which serves as
its primary federal regulator and is subject to certain regulations promulgated
by the FDIC. Under the provisions of federal law, federally insured banks are
subject, with certain exceptions, to certain restrictions on extensions of
credit to their affiliates, on investments in the stock or other securities of
affiliates and on the taking of such stock or securities as collateral from any
borrower. In addition, these banks are prohibited from engaging in certain
tie-in arrangements in connection with any extension of credit or the providing
of any property of service.
The Virginia State Corporation Commission and the Federal Reserve Board
conduct regular examinations of BTC reviewing the adequacy of the loan loss
reserves, quality of the loans and investments, propriety of management
practices, compliance with laws and regulations and other aspects of the bank's
operations. In addition to these regular examinations, Virginia chartered banks
7
must furnish to the Federal Reserve Board quarterly reports containing detailed
financial statements and schedules.
Community Reinvestment Act. NBB and BTC are subject to the provisions of the
Community Reinvestment Act of 1977 (the CRA), which requires the appropriate
federal bank regulatory agency, in connection with its regular examination of a
bank, to assess the bank's record in meeting the credit needs of the community
served by the bank, including low and moderate-income neighborhoods. The focus
of the regulations is on the volume and distribution of a bank's loans, with
particular emphasis on lending activity in low and moderate-income areas and to
low and moderate-income persons. The regulations place substantial importance on
a bank's product delivery system, particularly branch locations. The regulations
require banks, including NBB and BTC, to comply with significant data collection
requirements. The regulatory agency's assessment of the bank's record is made
available to the public. Further, this assessment is required for any bank which
has applied to, among other things, establish a new branch office that will
accept deposits, relocate an existing office, or merge, consolidate with or
acquire the assets or assume the liabilities of a federally regulated financial
institution. It is likely that banks' compliance with the CRA, as well as other
fair lending laws, will face ongoing government scrutiny and that costs
associated with compliance will continue to increase.
Both NBB and BTC have received "Satisfactory" CRA ratings in the last
examination by bank regulators. Federal Deposit Insurance Corporation
Improvement Act of 1991. The difficulties encountered nationwide
by financial institutions during 1990 and 1991 prompted federal legislation
designed to reform the banking industry and to promote the viability of the
industry and of the deposit insurance system. FDICIA, which became effective on
December 19, 1991, bolsters the deposit insurance fund, tightens bank regulation
and trims the scope of federal deposit insurance.
The legislation bolsters the bank deposit insurance fund with $70 billion in
borrowing authority and increases to $30 billion from $5 billion the amount the
FDIC can borrow from the U.S. Treasury to cover the cost of bank failures. The
loans, plus interest, would be repaid by premiums that banks pay on domestic
deposits over the next fifteen years.
Among other things, FDICIA requires the federal banking agencies to take
"prompt corrective action" in respect to banks that do not meet minimum capital
requirements. FDICIA establishes five capital tiers: "well capitalized,"
"adequately capitalized," "undercapitalized," "significantly undercapitalized"
and "critically undercapitalized."
If a depository institution's principal federal regulator determines that an
otherwise adequately capitalized institution is in an unsafe or unsound
condition or is engaging in an unsafe or unsound practice, it may require the
institution to submit a corrective action plan, restrict its asset growth and
prohibit branching, new acquisitions and new lines of business. An institution's
principal federal regulator may deem the institution to be engaging in an unsafe
or unsound practice if it receives a less than satisfactory rating for asset
quality, management, earnings or liquidity in its most recent examination.
Among other possible sanctions, an undercapitalized depository institution
may not pay dividends and is required to submit a capital restoration plan to
its principal federal regulator. In addition, its holding company may be
required to guarantee compliance with the capital restoration plan under certain
circumstances. If an undercapitalized depository institution fails to submit or
implement an acceptable capital restoration plan, it can be subject to more
severe sanctions, including an order to sell sufficient voting stock to become
adequately capitalized. More severe sanctions and remedial actions can be
mandated by the regulators if an institution is considered significantly or
critically undercapitalized.
In addition, FDICIA requires regulators to draft a new set of non-capital
measures of bank safety, such as loan underwriting standards and minimum
earnings levels. The legislation also requires regulators to perform annual
on-site bank examinations, places limits on real estate lending by banks and
tightens auditing requirements. In April 1995, the regulators adopted safety and
soundness standards as required by FDICIA in the following areas: (i)
operational and managerial; (ii) asset quality earnings and stock valuation; and
(iii) employee compensation.
FDICIA reduces the scope of federal deposit insurance. The most significant
change ended the "too big to fail" doctrine, under which the government protects
all deposits in most banks, including those exceeding the $100,000 insurance
limit. The FDIC's ability to reimburse uninsured deposits--those over $100,000
and foreign deposits--has been sharply limited. Since December 1993, the Federal
Reserve Board's ability to finance undercapitalized banks with extended loans
from its discount window has been restricted. In addition, only the best
capitalized banks will be able to offer insured brokered deposits without FDIC
permission or to insure accounts established under employee pension plans.
Branching. In 1986, the Virginia Banking Act was amended to remove the
geographic restrictions governing the establishment of branch banking offices.
Subject to the approval of the appropriate federal and state bank regulatory
authorities, BTC as a state bank, may establish a branch office anywhere in
Virginia.
National banks, like NBB, are required by the National Bank Act to adhere to
branch banking laws applicable to state banks in the states in which they are
located. Under current Virginia law, NBB may open branch offices throughout
Virginia with the prior approval of the OCC. In addition, with prior approval of
the OCC, NBB will be able to acquire existing banking operations in Virginia. As
a state bank, BTC is subject to Virginia state branching laws, with state
banking regulatory and Federal Reserve Bank approval, BTC is able to acquire
existing banking operations in the state.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
Interstate Act) allows bank holding companies to acquire banks in any state,
without regard to state law, except that if the state has a minimum requirement
for the amount of time a bank must be in existence, that law must be preserved.
Under the Virginia Banking Act, a Virginia bank or all of the subsidiaries of
Virginia holding companies sought to be acquired must have been in continuous
operation for more than two years before the date of such proposed acquisition.
The Interstate Act also permits banks to acquire out-of-state branches through
interstate mergers, if the state has not opted out of interstate branching. De
novo branching, where an out-of-state bank holding company sets up a new branch
in another state, requires a state's specific approval. An acquisition or merger
is not permitted under the Interstate Act if the bank, including its insured
8
depository affiliates, will control more than 10% of the total amount of
deposits of insured depository institutions in the United States, or will
control 30% or more of the total amount of deposits of insured depository
institutions in any state.
Virginia has, by statute, elected to opt-in fully to interstate branching
under the Interstate Act. Under the Virginia statute, Virginia state banks may,
with the approval of the Virginia State Corporation Commission, establish and
maintain a de novo branch or acquire one or more branches in a state other than
Virginia, either separately or as part of a merger. Procedures also are
established to allow out-of-state domiciled banks to establish or acquire
branches in Virginia, provided the "home" state of the bank permits Virginia
banks to establish or acquire branches within its borders. The activities of
these branches are subject to the same laws as Virginia domiciled banks, unless
such activities are prohibited by the law of the state where the bank is
organized. The Virginia State Corporation Commission has the authority to
examine and supervise out-of-state state banks to ensure that the branch is
operating in a safe and sound manner and in compliance with the laws of
Virginia. The Virginia statute authorizes the Bureau of Financial Institutions
to enter into cooperative agreements with other state and federal regulators for
the examination and supervision of out-of-state banks with Virginia operations,
or Virginia domiciled banks with operations in other states. Likewise, national
banks, with the approval of the OCC, may branch into and out of the state of
Virginia. Any Virginia branch of an out-of-state national bank is subject to
Virginia law (enforced by the OCC) with respect to intrastate branching,
consumer protection, fair lending and community reinvestment as if it were a
branch of a Virginia bank, unless preempted by federal law.
The Interstate Act permits banks and bank holding companies from throughout
the United States to enter Virginia markets through the acquisition of Virginia
institutions and makes it easier for Virginia bank holding companies and
Virginia state and national banks to acquire institutions and to establish
branches in other states. Competition in market areas served by the Company has
increased as a result of the Interstate Act and the Virginia interstate banking
statutes.
Deposit Insurance. The FDIC establishes rates for the payment of premiums by
federally insured financial institutions. A Bank Insurance Fund (the BIF) is
maintained for commercial banks, with insurance premiums from the industry used
to offset losses from insurance payouts when banks fail. Beginning in 1993,
insured depository institutions like NBB and BTC paid for deposit insurance
under a risk-based premium system. Beginning in 1997, all banks, including NBB
and BTC, were subject to an additional FDIC assessment which funds interest
payments for bank issues to resolve problems associated with the savings and
loan industry. This assessment will continue until 2018-2019. The assessment
will vary over the period from 1.29 cents to 2.43 cents per $100 of deposits.
Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act of 1999 (the GLBA) allows
national banks, with OCC approval, to acquire financial subsidiaries to engage
in any activity that is financial in nature or incidental to a financial
activity, as defined in the Bank Holding Act, except (i) insurance underwriting,
(ii) merchant or insurance portfolio investments, and (iii) real estate
development or investment. Well-capitalized national banks are also given the
authority to engage in municipal bond underwriting.
To establish or acquire a financial subsidiary, a national bank must be
well-managed, and the consolidated assets of its financial subsidiary must not
exceed the lesser of 45% of the consolidated total assets of the bank or $50
billion. The relationship between a national bank and a financial subsidiary are
subject to a variety of supervisory enhancements from regulators. The GLBA also
provides that state banks that establish or acquire financial subsidiaries are
required to comply with the same safeguards imposed on the financial
subsidiaries of national banks.
USA Patriot Act. The USA Patriot Act became effective in late 2001. It was
passed to facilitate the sharing of information among government entities and
financial institutions to combat terrorism and money laundering. The USA Patriot
Act creates an obligation on banks to report customer activities that may
involve terrorist activities or money laundering.
Government Policies. The operations of NBB and BTC are affected not only by
general economic conditions, but also by the policies of various regulatory
authorities. In particular, the Federal Reserve Board regulates money and credit
and interest rates in order to influence general economic conditions. These
policies have a significant influence on overall growth and distribution of
loans, investments and deposits and affect interest rates charged on loans or
paid for time and savings deposits. Federal Reserve Board monetary policies have
had a significant effect on the operating results of commercial banks in the
past and are expected to continue to do so in the future.
Limits on Dividends and Other Payments. As a national bank, NBB, may not pay
dividends from its capital; all dividends must be paid out of net profits then
on hand, after deducting expenses, losses, bad debts, accrued dividends on
preferred stock, if any, and taxes. In addition, a national bank is prohibited
from declaring a dividend on its shares of common stock until its surplus equals
its stated capital, unless there has been transferred to surplus no less than
one-tenth of the bank's net profits of (i) the preceding two consecutive
half-year periods (in the case of an annual dividend) or (ii) the preceding
half-year period (in the case of a quarterly or semi-annual dividend). The
approval of the OCC is required if the total of all dividends declared by a
national bank in any calendar year exceeds the total of its net profits for that
year combined with its retained net profits for the preceding two years, less
any required transfers to surplus or to fund the retirement of preferred stock.
The OCC has promulgated regulations that became effective on December 13,
1990, which significantly affect the level of allowable dividend payments for
national banks. The effect is to make the calculation of national banks'
dividend-paying capacity consistent with generally accepted accounting
principles. The allowance for loan and lease losses will not be considered an
element of "undivided profits then on hand" and provisions to the allowance are
treated as expenses and therefore not part of "net profits." Accordingly, a
national bank with an allowance greater than its statutory bad debts may not
include the excess in calculating undivided profits for dividend purposes.
Further, a national bank may be able to use a portion of its earned capital
surplus account as "undivided profits then on hand," depending on the
composition of that account.
As a state member bank subject to the regulations of the Federal Reserve
Board, BTC must obtain the approval of the Federal Reserve Board for any
dividend if the total of all dividends declared in any calendar year would
exceed the total of its net profits, as defined by the Federal Reserve Board,
9
for that year, combined with its retained net profits for the preceding two
years. In addition, a state member bank may not pay a dividend in an amount
greater than its undivided profits then on hand after deducting its losses and
bad debts. For this purpose, bad debts are generally defined to include the
principal amount of loans which are in arrears with respect to interest by six
months or more, unless such loans are fully secured and in the process of
collection. Moreover, for purposes of this limitation, a state member bank is
not permitted to add the balance in its allowance for loan losses account to its
undivided profits then on hand; however, it may net the sum of its bad debts as
so defined against the balance in its allowance for loan losses account and
deduct from undivided profits only bad debts as so defined in excess of that
account.
In addition, the Federal Reserve Board is authorized to determine, under
certain circumstances relating to the financial condition of a state member
bank, that the payment of dividends would be an unsafe or unsound practice and
to prohibit payment thereof. The payment of dividends that depletes a bank's
capital base could be deemed to constitute such an unsafe or unsound practice.
The Federal Reserve Board has indicated that banking organizations should
generally pay dividends only out of current operating earnings.
Virginia law also imposes restrictions on the ability of BTC to pay
dividends. A Virginia state bank is permitted to declare a dividend out of its
"net undivided profits", after providing for all expenses, losses, interest and
taxes accrued or due by the bank. In addition, a deficit in capital originally
paid in must be restored to its initial level, and no dividend can be paid which
could impair the bank's paid in capital. The Bureau of Financial Institutions
further has authority to limit the payment of dividends by a Virginia bank if it
determines the limitation is in the public interest and is necessary to ensure
the bank's financial soundness.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
provides that no insured depository institution may make any capital
distribution (which would include a cash dividend) if, after making the
distribution, the institution would not satisfy one or more of its minimum
capital requirements.
Capital Requirements. The Federal Reserve Board has adopted risk-based
capital guidelines which are applicable to Bankshares and BTC. The Federal
Reserve Board guidelines redefine the components of capital, categorize assets
into different risk classes and include certain off-balance sheet items in the
calculation of risk-weighted assets. The minimum ratio of qualified total
capital to risk-weighted assets (including certain off-balance sheet items, such
as standby letters of credit) is 8.0%. At least half of the total capital must
be comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to
risk-weighted assets of 4.0%. The remainder may consist of a limited amount of
subordinated debt, other preferred stock, certain other instruments and a
limited amount of loan and lease loss reserves. The OCC has adopted similar
regulations applicable to NBB.
In addition, the Federal Reserve Board has established minimum leverage
ratio (Tier 1 capital to total average assets less intangibles) guidelines that
are applicable to Bankshares and BTC. The OCC has adopted similar regulations
applicable to NBB. These guidelines provide for a minimum ratio of 4.0% for
banks that meet certain specified criteria, including that they have the highest
regulatory CAMELS rating and are not anticipating or experiencing significant
growth and have well-diversified risk. All other banks will be required to
maintain an additional cushion of at least 100 to 200 basis points, based upon
their particular circumstances and risk profiles. The guidelines also provide
that banks experiencing internal growth or making acquisitions will be expected
to maintain strong capital positions substantially above the minimum supervisory
levels, without significant reliance on intangible assets.
Bank regulators from time to time have indicated a desire to raise capital
requirements applicable to banking organizations beyond current levels. In
addition, the number of risks which may be included in risk-based capital
restrictions, as well as the measurement of these risks, is likely to change,
resulting in increased capital requirements for banks. Bankshares, NBB and BTC
are unable to predict whether higher capital ratios would be imposed and, if so,
at what levels and on what schedule.
Other Legislative and Regulatory Concerns
Other legislative and regulatory proposals regarding changes in banking and
the regulation of banks, thrifts and other financial institutions are
periodically considered by the executive branch of the federal government,
Congress and various state governments, including Virginia. New proposals could
significantly change the regulation of banks and the financial services
industry. It cannot be predicted what might be proposed or adopted or how these
proposals would affect the Company.
Other Business Concerns
The banking industry is particularly sensitive to interest rate
fluctuations, as the spread between the rates which must be paid on deposits and
those which may be charged on loans is an important component of profit. In
addition, the interest which can be earned on a bank's invested funds has a
significant effect on profits. Rising interest rates typically reduce the demand
for new loans, particularly the real estate loans which represent a significant
portion of NBB's and BTC's loan demand, as well as certain NBB loans in which
BTC participates.
Company Website
National Bankshares maintains a website at www.nationalbankshares.com.
Beginning with this Form 10-K, the Company will make available through its
website its annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and all amendments to those reports as soon as reasonably
practicable after the material is electronically filed with the Securities and
Exchange Commission.
10
Item 2. Properties
Bankshares' headquarters and one branch office of NBB are located at 101
Hubbard Street, Blacksburg, Virginia. NBB's Main Office is at 100 South Main
Street, Blacksburg, Virginia. In addition to the Bank's Main Office location and
the Hubbard Street branch office, NBB owns twelve branch offices: Three in the
Town of Blacksburg; two in the Town of Christiansburg; three in the County of
Giles; two in Pulaski County; one in the City of Radford; and one in the City of
Galax.
Bank of Tazewell County owns the land and buildings of seven of its ten
offices. The bank leases the land and buildings for three offices. The Main
Office is located at 309 East Main Street, Tazewell, Virginia. Three additional
branches are located in Tazewell, and two are located in Bluefield, Virginia.
The bank also has branch offices in Richlands, Wytheville, Abingdon, and Marion,
Virginia. Management believes that its existing facilities are adequate to meet
present needs and any anticipated growth.
NBB owns all its computer and data processing hardware and is a licensee of
the software it utilizes. BTC utilizes this same system for data processing.
Item 3. Legal Proceedings
Bankshares, NBB, BTC, and NBFS are not currently involved in any material
pending legal proceedings, other than routine litigation incidental to NBB's and
BTC's banking business.
Item 4. Submission of Matters to a Vote of Security Holders
None
Part II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Common Stock Information and Dividends
National Bankshares, Inc.'s common stock is traded on the Nasdaq SmallCap
Market under the symbol "NKSH". As of December 31, 2003, there were 1099 record
stockholders of Bankshares common stock. The following is a summary of the
market price per share and cash dividend per share of the common stock of
National Bankshares, Inc. for 2003 and 2002.
Common Stock Market Prices
2003 2002 Dividends per share
- -------------------------- ------------------------ ----------------------- ------------------------------
High Low High Low 2003 2002
- -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
First Quarter $ 39.48 29.52 23.00 20.03 --- ---
- -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
Second Quarter 44.97 37.86 30.00 22.00 0.54 0.46
- -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
Third Quarter 47.75 38.00 28.45 26.00 --- ---
- -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
Fourth Quarter 51.19 41.75 31.15 26.75 0.59 0.51
- -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
NBI's primary source of funds for dividend payments is dividends from its
subsidiaries, NBB and BTC. Bank regulatory agencies restrict dividend payments
of the subsidiaries, as more fully disclosed in Note 11 of Notes to Consolidated
Financial Statements.
11
Item 6. Selected Financial Data
National Bankshares, Inc. and Subsidiaries
Selected Consolidated Financial Data
$ In thousands, except per share data.
Years ended December 31,
2003 2002 2001 2000 1999
- ---------------- ------------------------- ---------- ----------- ----------- ---------- ----------
Selected Interest income $ 41,081 42,747 45,527 38,358 33,603
Income Interest expense 12,252 15,764 22,771 18,163 14,203
Statement ------------------------- ---------- ----------- ----------- ---------- ----------
Data: Net interest income 28,829 26,983 22,756 20,195 19,400
------------------------- ---------- ----------- ----------- ---------- ----------
Provision for loan 1,691 2,251 1,408 1,329 1,400
losses
------------------------- ---------- ----------- ----------- ---------- ----------
Noninterest income 6,186 5,712 5,204 4,082 3,512
------------------------- ---------- ----------- ----------- ---------- ----------
Noninterest expense 18,646 17,427 16,953 12,876 11,868
------------------------- ---------- ----------- ----------- ---------- ----------
Income taxes 3,236 3,003 2,285 2,763 2,556
------------------------- ---------- ----------- ----------- ---------- ----------
Net income 11,442 10,014 7,314 7,309 7,088
------------------------- ---------- ----------- ----------- ---------- ----------
------------------------- ---------- ----------- ----------- ---------- ----------
Per Share Basic net income $ 3.26 2.85 2.08 2.08 1.96
Data: ------------------------- ---------- ----------- ----------- ---------- ----------
Diluted net income 3.24 2.85 2.08 2.08 1.96
------------------------- ---------- ----------- ----------- ---------- ----------
Cash dividends declared 1.13 0.97 0.86 0.85 0.80
------------------------- ---------- ----------- ----------- ---------- ----------
Book value per share 22.94 20.82 18.59 17.04 14.99
------------------------- ---------- ----------- ----------- ---------- ----------
------------------------- ---------- ----------- ----------- ---------- ----------
Selected Loans, net $401,428 404,247 394,042 355,795 291,562
Balance ------------------------- ---------- ----------- ----------- ---------- ----------
Sheet Data Total securities 230,154 219,294 191,476 156,344 137,492
at End of ------------------------- ---------- ----------- ----------- ---------- ----------
Year: Total assets 708,560 684,935 644,623 593,497 472,134
------------------------- ---------- ----------- ----------- ---------- ----------
Total deposits 625,378 608,271 576,618 530,648 407,187
------------------------- ---------- ----------- ----------- ---------- ----------
Stockholders' equity 80,641 73,101 65,261 59,834 52,723
------------------------- ---------- ----------- ----------- ---------- ----------
------------------------- ---------- ----------- ----------- ---------- ----------
Selected Loans, net $405,696 404,717 380,970 310,624 266,431
Balance ------------------------- ---------- ----------- ----------- ---------- ----------
Sheet Daily Total securities 229,004 191,493 188,809 142,686 151,424
Averages: ------------------------- ---------- ----------- ----------- ---------- ----------
Total assets 697,012 655,783 635,692 500,381 454,189
------------------------- ---------- ----------- ----------- ---------- ----------
Total deposits 616,823 583,298 569,139 433,673 391,583
------------------------- ---------- ----------- ----------- ---------- ----------
Stockholders' equity 77,486 69,895 63,460 55,682 56,196
------------------------- ---------- ----------- ----------- ---------- ----------
------------------------- ---------- ----------- ----------- ---------- ----------
Selected Return on average assets 1.64% 1.53% 1.15% 1.46% 1.56%
Ratios: ------------------------- ---------- ----------- ----------- ---------- ----------
Return on average equity 14.77% 14.33% 11.53% 13.13% 12.61%
------------------------- ---------- ----------- ----------- ---------- ----------
Dividend payout ratio 34.71% 34.01% 41.29% 40.87% 39.70%
------------------------- ---------- ----------- ----------- ---------- ----------
Average equity to
average assets 11.12% 10.63% 9.98% 11.13% 12.37%
------------------------- ---------- ----------- ----------- ---------- ----------
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations $ In thousands, except per share data.
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 and other information included in this report.
This Annual Report on Form 10-K 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 form 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 when earning income,
recognizing an expense, recovering an asset or relieving a liability. The
Company uses historical loss factors as one factor in determining the inherent
loss that may be present in the loan portfolio. Actual losses could differ
12
significantly from one previously acceptable method to another method. Although
the economics of the Company's transactions would be the same, the timing of
events that would impact the transactions could change.
Allowance for the 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 are estimable 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 is 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 either in the formula or in the specific
allowance.
Core deposit intangibles
Effective January 1, 2002, the Company adopted Financial Accounting
Standards Board Statement No. 142, Goodwill and Other Intangible Assets.
Accordingly, goodwill is no longer subject to amortization over its estimated
useful life, but is subject to at least an annual assessment for impairment by
applying a fair value based test. Additionally, Statement 142 requires that
acquired intangible assets (such as core deposit intangibles) be separately
recognized if the benefit of the asset can be sold, transferred, licensed,
rented, or exchanged, and amortized over its estimated useful life. Branch
acquisition transactions were outside the scope of the Statement and therefore
any intangible asset arising from such transactions remained subject to
amortization over their estimated useful life.
In October 2002, the Financial Accounting Standards Board issued Statement
No. 147, Acquisitions of Certain Financial Institutions. The Statement amends
previous interpretive guidance on the application of the purchase method of
accounting to acquisitions of financial institutions, and requires the
application of Statement No. 141, Business Combinations, and Statement No. 142
to branch acquisitions if such transactions meet the definition of a business
combination. The provisions of the Statement do not apply to transactions
between two or more mutual enterprises. In addition, the Statement amends
Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to
include in its scope core deposit intangibles of financial institutions.
Accordingly, such intangibles are subject to a recoverability test based on
undiscounted cash flows, and to the impairment recognition and measurement
provisions required for other long-lived assets held and used. The Company has
determined that the acquisitions that generated the intangible assets and
goodwill on the consolidated balance sheets in the amount of $9,958 and $10,912
at December 31, 2003 and 2002, respectively, did not constitute the acquisition
of a business, and therefore will continue to be amortized.
Overview
National Bankshares, Inc. (NBI) is a financial holding company located in
Southwest Virginia. It conducts operations primarily through two full service
banking affiliates, the National Bank of Blacksburg and Bank of Tazewell County.
It also has one nonbanking affiliate, National Bankshares Financial Services,
Inc., which offers investment and insurance products. Revenues and net income
derived from the nonbanking affiliate are not significant at this time, nor are
they expected to be significant in the foreseeable future. Management
characterizes NBI as a "community bank" operation.
13
Performance Summary
The following table shows NBI's key performance ratios for the period ended
December 31, 2003 and 2002:
12/31/03 12/31/02
------------ ------------
Return on average assets 1.64% 1.53%
Return on average equity 14.77% 14.33%
Basic net earnings per share $ 3.26 $ 2.85
Fully diluted net earnings per share $ 3.24 $ 2.85
Net interest margin (1) 4.82% 4.74%
Noninterest margin (2) 1.81% 1.84%
(1) Net Interest Margin - Year-to-date tax equivalent net interest income
divided by year-to-date average earning assets.
(2) Noninterest Margin - Noninterest income (excluding securities gain and
losses) less noninterest expense (excluding the provision for bad debts
and income taxes) divided by average year-to-date assets.
The Company has shown improvement in all of its key ratios when 2003 and
2002 are compared. Future performance is dependent on the general state of the
local and national economy. Economic conditions dictate interest rate levels and
loan growth, both of which directly impact the Company's performance. An
increase in interest rates, as is predicted in late 2004 by some economists and
financial commentators, would at least temporarily have an adverse affect on the
net interest margin.
(See the discussion in "Net Interest Income" below.)
Growth
The following table shows NBI's key growth indicators:
For the period ending
12/31/03 12/31/02
------------ -------------
Securities $230,154 $219,294
Loans net 401,428 404,247
Deposits 625,378 608,271
Total assets 708,560 684,935
With the exception of loans, all categories show growth. The largest
decrease in loan totals was in the category of loans to individuals, which
declined $14,020.
In April 2004 NBI, through its BTC subsidiary, expects to complete an
acquisition of certain loans and deposits from another financial institution.
This is expected to add approximately $8.0 million in loans and approximately
$18.6 million in deposits. NBI's NBB subsidiary has entered into an agreement to
acquire substantially all of the assets and assume substantially all of the
liabilities of another national bank. The transaction is subject to regulatory
approval and it is expected to close in the first half of 2004. It is
anticipated to add approximately $53.0 in deposits and approximately $67.8
million in total assets.
Asset Quality
Key asset quality indicators are shown below:
12/31/03 12/31/02
------------- ------------
Nonperforming loans $354 $288
Loans past due over 90 days 931 977
Other real estate owned 1,663 537
Allowance for loan losses to loans 1.32% 1.24%
Net charge-off ratio .34% .35%
Other real estate owned has increased substantially. Based on current
information it is expected that this category will increase in 2004, before it
will begin to decline. For further information see the discussion under
"Provision and Allowances for Loan Losses".
14
Net Interest Income
2003 vs 2002
Net interest income for 2003 was $28,829, an increase of $1,846 over 2002.
During 2003 interest income decreased $1,666 as assets repriced downward.
Interest-bearing liabilities repriced downward at a faster pace, causing a
decline in interest expense. The net result of these events was a slight
increase in the net interest margin to 4.82% from 4.74% in 2002. The current
trend is the result of an unusually long period of low interest rates. Based on
currently available data, management believes that interest rates will rise as
the economy continues to recover. Such increases could occur as early as the
third or fourth quarter of 2004. Rising rates would at least have a temporarily
negative effect on the net interest margin. The ultimate effect would depend on
the exact timing, amount and number of rate increases experienced. (For
additional information see the comments under "Derivatives and Market Risk
Exposures".)
The investment portfolio, in particular, would be affected by an interest
rate increase, as many of the Company's investments are long term. In a rising
rate environment it might become impractical to sell available for sale
securities. Substantial additions to the held to maturity category over the past
few years also tends to make the Company's balance sheet less responsive to
interest rate fluctuations. Finally, call features of certain bonds held in both
the available for sale and held to maturity portfolios would be less likely to
be activated in a rising rate environment.
2002 vs 2001
Net interest income for 2002 was $26,983, an increase of $4,227 or 18.58%
over 2001. This increase was primarily the result of the low interest rate
environment the Company experienced throughout all of 2002. The yield on earning
assets for 2002 was 7.27%, declining 64 basis points during the year. During the
same period, the cost to fund earning assets decreased by 144 basis points.
These combined to produce an increase in the net interest margin of 63 basis
points. The cost to fund earning assets declined at a faster rate than the yield
on earning assets.
While the current rate environment continues to be generally favorable to
the Company's overall profitability, it is the opinion of management that
current rate levels are not sustainable over a long period of time. It is
believed that, as the general economy recovers, interest rates can be expected
to increase to negate or control inflationary pressures. Rising interest rates
generally have a short to intermediate term adverse effect on the Company's net
interest income and profitability.
In the meantime, while interest rates remain at low levels, it is expected
that the Company's yield on earning assets will gradually decline as older,
higher rate loans and investments mature or are called. In particular,
longer-term investments purchased during the period to replace those matured or
called may ultimately have a negative impact on net interest income. As
indicated by the statement of cash flows, approximately $44,995 in securities
available for sale were purchased in 2002. These securities consisted
predominately of securities with maturities in excess of five years.
In purchasing these securities, the Company has increased the level of
interest rate risk in its balance sheet. While the securities have been
classified as available for sale, a future rising rate environment and the
accompanying decrease in asset value could make the sale of the securities
undesirable from a profitability perspective. (In addition, with callable
securities purchased during a period of low interest rate levels, the
expectation of the call feature being activated is somewhat diminished). Hence,
in a rising rate scenario the Company's ability to reprice these assets could be
limited and result in a negative impact on the Company's net interest margin.
15
Analysis of Net Interest Earnings
The following table shows the major categories of interest-earning assets
and interest-bearing liabilities, the interest earned or paid, the average
yield or rate on the daily average balance outstanding, net interest income
and net yield on average interest-earning assets for the years indicated.
--------------------------------------------------------------------------------------------------------------
December 31, 2003 December 31, 2002 December 31, 2001
--------------------------------------------------------------------------------------------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
($ in thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate
--------------------------------------------------------------------------------------------------------------
Interest-earning
assets:
Loans, net $412,261 $29,915 7.26% $410,437 $32,556 7.93% $381,778 $33,584 8.80%
(1)(2)(3)
Taxable securities 101,426 5,668 5.59% 92,697 5,490 5.92% 115,529 7,501 6.56%
Nontaxable
securities (1) 124,274 8,263 6.65% 98,796 6,885 6.97% 73,280 5,091 6.95%
Federal funds sold 1,320 16 1.21% 2,644 42 1.59% 18,419 652 3.54%
Interest bearing
deposits 21,958 230 1.05% 17,765 276 1.55% 10,986 577 5.25%
--------------------------------------------------------------------------------------------------------------
Total interest-
earning assets $661,239 $44,092 6.67% $622,339 $45,249 7.27% $599,992 $47,405 7.91%
==============================================================================================================
Interest-bearing
liabilities:
Interest-bearing
demand deposits $167,428 $ 1,571 0.94% $147,749 $ 2,219 1.50% $116,529 $ 2,518 2.16%
Savings deposits 51,646 323 0.63% 49,151 508 1.03% 47,175 919 1.95%
Time deposits 317,989 10,356 3.26% 312,129 13,032 4.18% 338,642 19,326 5.71%
Short-term
borrowings 194 2 1.03% 311 5 1.61% 295 8 2.71%
--------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------
Total interest-
bearing
liabilities $537,257 $12,252 2.28% $509,340 $15,764 3.09% $502,641 $22,771 4.53%
==============================================================================================================
Net interest
income and
interest rate
spread $31,840 4.39% $29,485 4.18% $24,634 3.38%
===============================================================================================================
Net yield on
average
interest-earning
assets 4.82% 4.74% 4.11%
===============================================================================================================
(1) Interest on nontaxable loans and securities is computed on a fully
taxable equivalent basis using a Federal income tax rate of 35% in 2003 and
34% for 2002 and 2001.
(2) Loan fees of $716 in 2003, $660 in 2002 and $608 in 2001 are included in
total interest income. (3) Nonaccrual loans are included in average balances
for yield computations.
16
Analysis of Changes in Interest Income and Interest Expense
The Company's primary source of revenue is net interest income, which is
the difference between the interest and fees earned on loans and
investments and the interest paid on deposits and other funds. The
Company's net interest income is affected by changes in the amount and
mix of interest-earning assets and interest-bearing liabilities and by
changes in yields earned on interest-earning assets and rates paid on
interest-bearing liabilities. The following table sets forth, for the
years indicated, a summary of the changes in interest income and
interest expense resulting from changes in average asset and liability
balances (volume) and changes in average interest rates (rate).
==============================================================================================
2003 Over 2002 2002 Over 2001
----------------------------------------------------------------------------------------------
Changes Due To Changes Due To
------------------------------- -------------------------------
Net Dollar Net Dollar
($ in thousands) Rates(2) Volume(2) Change Rates(2) Volume(2) Change
==============================================================================================================================
Interest income:(1)
Loans $(2,785) $ 144 $ (2,641) $ (3,442) $ 2,414 $ (1,028)
Taxable securities (321) 499 178 (619) (1,392) (2,011)
Nontaxable securities (328) 1,706 1,378 16 1,778 1,794
Federal funds sold (8) (18) (26) (239) (371) (610)
Interest-bearing deposits (102) 56 (46) (540) 239 (301)
- ------------------------------------------------------------------------------------------------------------------------------
Increase(decrease) in income
on interest-earning assets $(3,544) $ 2,387 $ (1,157) $ (4,824) $ 2,668 $ (2,156)
- ------------------------------------------------------------------------------------------------------------------------------
Interest expense:
Interest-bearing demand
deposits $ (915) $ 267 $ (648) $ (877) $ 578 $ (299)
Savings deposits (210) 25 (185) (448) 37 (411)
Time deposits (2,916) 240 (2,676) (4,873) (1,421) (6,294)
Short-term borrowings (1) (2) (3) (3) --- (3)
Long-Term Borrowings --- --- --- --- --- ---
- ------------------------------------------------------------------------------------------------------------------------------
(Decrease) in expense of
interest-bearing liabilities $(4,042) $ 530 $ (3,512) $ (6,201) $ (806) $ (7,007)
- ------------------------------------------------------------------------------------------------------------------------------
Increase in net
interest income $ 498 $ 1,857 $ 2,355 $ 1,377 $ 3,474 $ 4,851
==============================================================================================================================
(1) Taxable equivalent basis using a Federal income tax rate of 35% in
2003 and 34% for 2002 and 2001.
(2)Variances caused by the change in rate times the change in volume
have been allocated to rate and volume changes proportional to the
relationship of the absolute dollar amounts of the change in each.
17
Interest Rate Sensitivity
2003 vs 2002
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 and fair
market values to movement in interest rates. Interest rate sensitivity analyses
provides management with information related to repricing opportunities, while
interest rate shock simulations indicate potential economic loss due to future
interest rate changes.
During 2003 the overall interest rate environment remained at a historically
low level. While interest rates are expected to remain low for the first half of
2004, in the opinion of management rate increases are an inevitable consequence
of the ongoing economic recovery. Any increase in interest rates would have, at
a minimum, a temporarily negative impact on performance.
Risk factors and forward-looking statements previously discussed under "Net
Interest Income" apply. As previously stated, the Company uses simulation
analysis to forecast its balance sheet and monitor interest rate sensitivity.
One test is a shock analysis that measures the effect of a hypothetical,
immediate and parallel shift in interest rates. The following table shows the
results of a rate shock and the effects on net income and return on average
assets and return on average equity projected at December 31, 2004.
For purposes of this analysis noninterest income and expenses are assumed to
be flat.
($ in thousands, except for percent data)
- ---------------------------- ------------------------ -------------------------- --------------------------------
Rate Shift (bp) Change in Net Income ($) Return on Average Equity Return on Average Assets
- ---------------------------- ------------------------ -------------------------- --------------------------------
300 (-) (5,548) 13.65% 1.58%
- ---------------------------- ------------------------ -------------------------- --------------------------------
200 (-) (3,574) 15.78% 1.84%
- ---------------------------- ------------------------ -------------------------- --------------------------------
100 (-) (1,788) 17.66% 2.08%
- ---------------------------- ------------------------ -------------------------- --------------------------------
(-) 100 1,285 20.82% 2.49%
- ---------------------------- ------------------------ -------------------------- --------------------------------
(-) 200 737 20.26% 2.41%
- ---------------------------- ------------------------ -------------------------- --------------------------------
Simulation analysis allows the Company to test asset and liability
management strategies under rising and falling rate conditions. As a part of the
simulation process, certain estimates and assumptions must be made. These
include, but are not limited to, asset growth, the mix of assets and
liabilities, rate environment and local and national economic conditions. Asset
growth and the mix of assets can, to a degree, be influenced by management.
Other areas, such as the rate environment and economic factors, cannot be
controlled. For this reason actual results may vary materially from any
particular forecast or shock analysis.
This shortcoming is offset somewhat by the periodic reforecasting of the
balance sheet to reflect current trends and economic conditions. Shock analysis
must also be updated periodically as a part of the asset and liability
management process.
2002 vs 2001
During 1999 and 2000, interest rates rose substantially. In addition to the
adverse effects on the net interest margin, the rising rates reduced the
Company's ability to respond to interest rate movements. At December 31, 2000,
the Company's investment portfolio contained a substantial amount of longer-term
securities with call features. Due to the higher interest rate levels, the
securities were not called as anticipated. At the time, the net unrealized
losses made the sale of the securities impractical, thereby restricting one of
management's primary means of controlling the effects of interest rate changes.
With the onset of the declining rate environment that began in January 2001,
both of the aforementioned problems began to abate. Interest expense, which had
been at high levels at the beginning of 2001, declined rapidly and market values
of the securities rebounded making the sale of the securities feasible, if
deemed necessary.
During 2002, the Company continued to benefit from the low interest rate
environment. While this favorable interest rate level is expected to continue
into 2003, it is not within management's ability to predict the timing or extent
of any future interest rate increases.
Noninterest Income
2003 vs 2002
Noninterest income for 2003 was $6,186 an 8.30% increase from 2002.
Service charges on deposits increased by $368. The increase was the result
of changes in the terms of certain demand deposit products and the associated
service charges. Service charges in 2004 are expected to increase, as the
changes in service charge structure were not in effect for all of 2003. Volume
increases due to acquisitions are expected. (See the discussion under
"Acquisitions".)
Credit card fees were up $203 over 2002 due to volume increases in merchant
and interchange fees. Future increases will also be volume related.
Trust income increased by $164 when compared to 2002. Trust income is
dependent market conditions as well as the type of account being handled at any
given point in time. In 2003 market conditions improved, resulting in additional
fees. The number of estates handled also increased.
Net securities gains and losses were down $216 from 2002. In the second and
third quarter of 2002 the Company sold certain investments owned by the parent
company for a total gain of approximately $335. There were no similar sales in
2003.
18
2002 vs 2001
Noninterest income for 2002 was $5,712, an increase of $508 or 9.76%. The
largest increase occurred in realized gains and losses on securities and other
income categories. Non-recurring income described below accounted for much of
the increase.
The level of service charges on deposits is driven by demand deposit volume,
types of accounts opened, service charge rates in effect, the level of charges
such as overdraft fees, and the fee waiver policy for these fees.
Service charges on deposit accounts were $2,229 for 2002, a decrease of $17
or 0.76% from 2001. There were no unusual factors that had a material impact on
this category in 2002.
Trust income for 2002 was $968, a decrease of $123 or 11.27% from 2001.
Trust income is dependent upon market conditions as well as the types of
accounts being handled at any given point in time. Market conditions, which
directly affect the value of trust assets managed and in turn trust fees, were
less favorable in 2002.
Credit card income is composed of several types of fees and charges,
including transaction or interchange fees, merchant discount fees, and
over-limit charges. Given the highly competitive market, which limits the amount
of set charges, revenue increases result from growth in the number of merchant
accounts processed and increases in the number of customer credit and debit card
accounts.
Credit card income for 2002 was $1,409, an increase of $182 or 14.83% when
compared to 2001, primarily due to increased volume. A portion of this increase
was due to reduced charges from the Company's credit card processor. These
charges are tiered and, having reached the next higher volume level, the charges
decreased accordingly. Increased income in this area was also in part due to
volume created by the addition of new merchants.
Other income for the year ended December 31, 2002 was $500, an increase of
$170 or 51.52%. For 2002 other income contained several nonrecurring items.
Included in this was nontaxable proceeds from a life insurance policy, which was
approximately $36 and a legal expense recovery of $14 from a prior year. Other
income also includes commissions from the sale of securities and insurance,
which totaled approximately $239 in 2002 and $99 in 2001.
Net realized gains and losses on securities was $346, an increase of $342
over 2001. In the second and third quarter of 2002, the Company sold investments
at a total gain of approximately $335. The remainder of the net increase was due
to called securities and routine equity adjustments on certain investments.
Noninterest Expense
2003 vs 2002
Noninterest expense for 2003 was $18,646, an increase of $1,219 or 6.99%
over 2002. The most significant changes occurred in the salaries and employee
benefits, credit card processing expenses and other operating expenses
categories.
Salaries and employee benefits increased by 7.36% or $656. Of that increase,
approximately $254 was due to increased pension expense. During a period of low
interest rates, rates used in actual forecasts are lower and result in higher
net periodic pension expense. When interest rates rise, the amount of expense
decreases. The remainder of the increase is due to normally expected increases
in salaries and benefits.
Credit card processing increased $208 over 2002. As previously mentioned in
"Noninterest Income" above, credit card income increased because of a greater
volume of merchant income. Credit card merchant expense moves in tandem with
merchant income.
Other operating expenses were up $291 or 8.10%. A major portion of this
increase is $101 in additional Virginia bank franchise tax which was incurred
because of an increases in Bank capital resulting from earnings. Also included
is $39 in repossession expense and $36 related to a loss on the sale of a closed
branch facility. Overall, noninterest expense is expected to increase due to
planned acquisitions in the first half of 2004. (See the discussion under
"Acquisitions".)
2002 vs 2001
Noninterest expense for 2002 was $17,427, an increase of $474 or 2.80% from
2001. The largest increase was in the salaries and employee benefits category,
which increased $827 or 10.23%. Net costs of other real estate owned increased
to $145 or 16.00%. These items are described in further detail below.
Salaries and employee benefits, as previously mentioned increased at a rate
higher than average for the company for several reasons. In the first quarter of
2001, the Company's BTC affiliate acquired a branch office in Bluefield,
Virginia. Salaries and employee benefits expense for this office were included
for nine months in 2001, as opposed to twelve months for 2002. For the first
time since it became a participating employer in the National Bankshares, Inc.
Employee Stock Ownership Plan, the Company's BTC affiliate had a contribution
expense of $120 to the ESOP in 2002. Employee health insurance, executive
compensation and other benefits also experienced increases.
Data processing expenses decreased by $247 or 18.39% when 2002 and 2001 are
compared. This decline was due to a reduction in maintenance costs and the
absence of conversion costs associated with a 2001 branch acquisition.
In 2002 the Company was advised by its host computer hardware provider that
operating system support would be terminated by the end of 2004. Given the
importance of this area, management initiated a project to determine the
appropriate course of action. Management elected to upgrade its host computer
system.
Credit card processing expenses were up $32 for 2002. An increase in volume
offset by two nonrecurring items totaling $52 combined to produce the increase.
19
Of the two nonrecurring items, one represented a refund of certain processing
charges. The second, for $10, consisted of contract signing incentives connected
with acquiring a new vendor.
Expenses related to other real estate owned were $145 for 2002. The primary
cause of this increase was a $75 write-down of certain properties. These
properties had been held for a period of more than ten years. While several
sales had taken place over the past few years, they could best be characterized
as somewhat slow. This effort, which was designed to accelerate sales of the
properties, was in large part successful.
Income Taxes
2003 vs 2002
Income tax expense for 2003 increased by $233 when compared to 2002.
In 2003 the Company became subject to the 35% marginal tax rate because of
higher income. This new rate resulted in a credit to tax expense of
approximately $146.
Tax exempt income continues to be the primary difference between the
"expected" and reported tax expense. The Company's effective tax rates for 2003,
2002 and 2001 were 22.05%, 23.07% and 23.80%, respectively.
See Note 10 of the Notes to Consolidated Financial Statements for additional
information relating to income taxes.
2002 vs 2001
Income tax expense increased in 2002 due to the increase in net income and
was offset to a degree by a higher level of investment in tax free obligations.
Tax exempt interest income continues to be the primary difference between
the "expected" and reported income tax expense.
Effects of Inflation
The Company's consolidated statements of income generally reflect the
effects of inflation. Since interest rates, loan demand, and deposit levels are
related to inflation, the resulting changes are included in net income. The most
significant item which does not reflect the effects of inflation is depreciation
expense. Historical dollar values used to determine depreciation expense do not
reflect the effects of inflation on the market value of depreciable assets after
their acquisition.
Provision and Allowance for Loan Losses
2003 vs 2002
The adequacy of the allowance for loan losses is based on management's
judgment and analysis of current and historical loss experience, risk
characteristics of the loan portfolio, concentrations of credit and asset
quality, as well as other internal and external factors, such as general
economic conditions.
An internal credit review department performs pre-credit analyses of large
credits and also conducts credit review activities that provide management with
an early warning of asset quality deterioration.
The internal credit review department also prepares regular analyses of the
adequacy of the provision for loans losses. These analyses include calculations
based upon a mathematical formula that considers identified potential losses and
makes pool allocations for historical losses for various loan types. In
addition, an amount is allocated based upon such factors as changing trends in
the loan mix, the effects of changes in business conditions, the effects of any
changes in loan policies, and the effects of competition and regulatory factors
on the loan portfolio. The internal credit review department has determined that
the Company's provision for loan losses is sufficient.
During 2003 the Company's BTC affiliate experienced a decline in asset
quality. The result to date has been an increase in foreclosed properties, as
shown by the following table. The problem has been recognized by management.
Efforts specifically designed to focus on problem loans and to work intensively
with delinquent borrowers have been undertaken. When these efforts are
unsuccessful, management is moving more quickly to liquidate loan collateral and
to institute legal collection activities. As the issues are resolved, it is
expected that the number of foreclosed properties will increase, before it
eventually declines.
To date the net charge-off rate has remained stable. Loan past due ninety
days or more were $931 at December 31, 2003, slightly lower than the $977 at
December 31, 2002, and the $980 at December 31, 2001.
2002 vs 2001
Several factors contributed to the Company's decision to increase the
provision for loan losses in 2002. While overall asset quality remained
satisfactory in 2002, the level of exposure to loss increased, particularly in
the loans to individuals' category. In addition, much of the growth in 2002 was
in the commercial loan category, which increased the Company's exposure to
losses resulting from defaults in large dollar loans. While the number of such
defaults would only constitute a small number of loans, the sizable dollar
amount of the individual credits tends to increase the possibility of greater
loss. Declining economic conditions in the Company's market area have also
contributed to a higher net charge-off ratio which rose from .21% in 2000 to
.27% in 2001 and .35% in 2002. In addition, total nonperforming assets were at
$825 on December 31, 2002, an increase of 46% from 2001.
20
IV. Summary of Loan Loss Experience
A. Analysis of the Allowance for Loan Losses
The following tabulation shows average loan balances at the end
of each period; changes in the allowance for loan losses arising
from loans charged off and recoveries on loans previously charged
off by loan category; and additions to the allowance which have
been charged to operating expense:
============================================================================
December 31,
----------------------------------------------------------------------------
($ in thousands) 2003 2002 2001 2000 1999
=====================================================================================================================
Average net loans outstanding $405,696 $404,717 $380,970 $310,624 $266,431
============================================================================
Balance at beginning of year $5,092 $4,272 $3,886 $3,231 $2,679
Charge-offs:
Commercial and industrial loans 241 276 141 55 185
Real estate mortgage loans 299 61 32 --- 33
Real estate construction loans --- --- --- --- ---
Loans to individuals 1,120 1,234 955 715 760
----------------------------------------------------------------------------
Total loans charged off 1,660 1,571 1,128 770 978
----------------------------------------------------------------------------
Recoveries:
Commercial and industrial loans 104 13 8 3 51
Real estate mortgage loans --- --- --- --- 1
Real estate construction loans --- --- --- --- ---
Loans to individuals 142 127 98 93 78
----------------------------------------------------------------------------
Total recoveries 246 140 106 96 130
----------------------------------------------------------------------------
Net loans charged off 1,414 1,431 1,022 674 848
----------------------------------------------------------------------------
Additions charged to operations 1,691 2,251 1,408 1,329 1,400
----------------------------------------------------------------------------
Balance at end of year $5,369 $5,092 $4,272 $3,886 $ 3,231
============================================================================
Net charge-offs to average net loans
outstanding 0.34% 0.35% 0.27% 0.21% 0.32%
=====================================================================================================================
Factors influencing management's judgment in determining the amount
of the loan loss provision charged to operating expense include the
quality of the loan portfolio as determined by management, the
historical loan loss experience, diversification as to type of loans in
the portfolio, the amount of secured as compared with unsecured loans
and the value of underlying collateral, banking industry standards and
averages, and general economic conditions.
21
B. Allocation of the Allowance for Loan Losses
The allowance for loan losses has been allocated according to
the amount deemed necessary to provide for anticipated losses
within the categories of loans for the years indicated as
follows:
=======================================================================================================================
December 31,
-----------------------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
-----------------------------------------------------------------------------------------------------------------------
Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in
($ in Allowance Each Allowance Each Allowance Each Allowance Each Allowance Each
thousands) Amount Category to Amount Category to Amount Category to Amount Category to Amount Category to
Total Loans Total Loans Total Loans Total Loans Total Loans
===================================================================================================================================
Commercial
and
industrial
loans $1,239 51.26% $235 50.98% $557 47.43% $255 45.29% $555 50.35%
- -----------------------------------------------------------------------------------------------------------------------------------
Real estate
mortgage
loans 970 21.56% 911 20.01% 50 19.33% 120 19.66% 119 19.83%
- -----------------------------------------------------------------------------------------------------------------------------------
Real estate
construction 125 6.88% --- 5.44% --- 4.89% --- 4.62% --- 4.94%
loans
- -----------------------------------------------------------------------------------------------------------------------------------
Loans to
individuals 2,257 20.30% 3,092 23.57% 2,909 28.35% 1,709 30.43% 978 24.88%
- -----------------------------------------------------------------------------------------------------------------------------------
Unallocated 778 854 756 1,802 1,579
- -----------------------------------------------------------------------------------------------------------------------------------
$5,369 100.00% $5,092 100.00% $4,272 100.00% $3,886 100.00% $3,231 100.00%
=======================================================================================================================
22
Balance Sheet
2003 vs 2002
Total assets for the Company increased by $23,625 or 3.45% in 2003. Total
deposits increased by $17,107 or 2.81%. Growth was from development of the
existing franchise, as there were no acquisitions in 2003. In the fourth quarter
of 2003 the Company agreed to acquire the loans and deposits of one branch
office of another bank. The acquisition is expected be completed in the first
half of 2004, increasing loans by approximately $8.0 million and deposits by
$18.6 million. No fixed assets are to be acquired. In early 2004, the Company
agreed to a second acquisition of assets (including fixed assets) and assumption
of liabilities which is planned to be completed in the first half of 2004. This
transaction is expected to add approximately $53 million in deposits and $67.8
million in total assets.
2002 vs 2001
Total assets for the Company at December 31, 2002 were $684,935. This
represents an increase of $40,312 or 6.25% when compared to 2001. Total daily
average assets were $655,783 for 2002, which compares to $635,692 for 2001.
Growth for 2002 was from the development of the Company's existing franchise, as
there were no acquisitions in 2002.
Loans
2003 vs 2002
Loans net of unearned income decreased by $2,542 or .62% in 2003. Real
estate construction and real mortgage loans both showed increases of
approximately $5.7 million, however this was offset by a slight decline in
commercial loans and a $14.0 million decline in loans to individuals. Management
believes the decline in loans to individuals is due to several reasons.
o General economic conditions and the lack of employment opportunity in
portions of the Company's market area.
o A decline in consumer requests for new car financing because of special
financing incentives offered by automobile companies.
o Consumers' use of credit cards with higher credit limits.
o Consumers taking advantage of low mortgage rates to refinance home
mortgages to obtain funds that might otherwise have been borrowed
through a consumer loan.
Reversal of this trend may occur to some extent as economic conditions
change and higher interest rates make mortgage refinancing less appealing.
However, management believes that automotive related financing offers and
competition from the credit card sector will remain.
Since loans to individuals are generally higher yielding, this trend will
not have a favorable effect on net interest income.
2002 vs 2001
Loans net of unearned income and deferred fees grew by $11,025 or 2.77%
during 2002. As can be seen by the balance sheet, the composition of the loan
portfolio shifted toward the commercial category during 2002. Loans to
individuals have experienced a moderate decline.
Securities
2003 vs 2002
Securities in the available for sale portfolio increased $9,566 when
December 31, 2003 and 2002 are compared. Securities held to maturity increased
$1,294 when the same comparison is made. In order to maximize yields, securities
are generally purchased with long term maturities. Many have call features.
As set out in the "Statement of Cash Flows", the Company sold one bond
classified as held to maturity because of credit quality concerns. The Company
liquidated its remaining investments in that issue in the first quarter of 2004.
It should be noted that over the past three years the Company has purchased
approximately $135 million in securities classified as held to maturity. When
the volume of securities purchased is considered, there have been few credit
quality concerns in the investment portfolio. Credit quality will continue to be
monitored and any necessary adjustments initiated to ensure that credit quality
remains high and that it meets regulatory standards.
2002 vs 2001
Securities available for sale at December 31, 2002 were $119,734, an
increase of $31,067 or 35.04% over 2001. Securities held to maturity totaled
$99,560 at December 31, 2002. These securities decreased by $3,249 or 3.16% from
the totals at December 31, 2001.
As can be seen in the consolidated statement of cash flows, $44,995 was
reinvested in securities available for sale and $16,953 in securities held to
maturity. Maturities for bonds purchased were generally longer term, with
maximization of yields being the primary objective.
23
A. Types of Loans
================================================================
December 31,
----------------------------------------------------------------
2003 2002 2001 2000 1999
=====================================================================================================
Commercial and industrial loans $208,997 $209,368 $189,764 $163,929 $149,386
Real estate mortgage loans 87,899 82,193 77,339 71,163 58,829
Real estate construction loans 28,055 22,294 19,573 16,726 14,669
Loans to individuals 82,742 96,762 113,413 110,176 73,825
----------------------------------------------------------------
Total loans $407,693 $410,617 $400,089 $361,994 $296,709
Less unearned income and deferred
fees (896) (1,278) (1,775) (2,313) (1,916)
----------------------------------------------------------------
Total loans, net of unearned income $406,797 $409,339 $398,314 $359,681 $294,793
Less allowance for loans losses (5,369) (5,092) (4,272) (3,886) (3,231)
----------------------------------------------------------------
Total loans, net $401,428 $404,247 $394,042 $355,795 $291,562
=====================================================================================================
B. Maturities and Interest Rate Sensitivities
===================================================
December 31, 2003
---------------------------------------------------
1 - 5 After
< 1 Year Years 5 Years Total
======================================= ============== =========== ============ ===========
Commercial and industrial $52,345 $129,660 $26,992 $208,997
Real estate construction 27,356 699 --- 28,055
- --------------------------------------- -------------- ----------- ------------ -----------
79,701 130,359 26,992 237,052
Less loans with predetermined
interest rates (10,039) (12,300) (16,124) (38,463)
-------------- ----------- ------------ -----------
Loans with adjustable rates $69,662 $118,059 $10,868 $198,589
======================================= ============== =========== ============ ===========
C. Risk Elements
Nonaccrual, Past Due and Restructured Loans
The following table presents aggregate amounts for nonaccrual loans,
restructured loans, other real estate owned net, and accruing loans which are
contractually past due ninety days or more as to interest or principal
payments.
========================================================
December 31,
--------------------------------------------------------
2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------
Nonaccrual loans:
Commercial and industrial $302 $102 $175 $ 65 $65
Real estate mortgage 44 152 11 5 33
Real estate construction --- --- --- --- ---
Loans to individuals 8 34 168 18 53
- -------------------------------------------------------------------------------------------------------
$354 $288 $354 $ 88 $151
- -------------------------------------------------------------------------------------------------------
Restructured loans:
Commercial and industrial --- --- --- --- 40
- -------------------------------------------------------------------------------------------------------
Total nonperforming loans $354 $288 $354 $ 88 $191
Other real estate owned, net 1,663 537 211 540 447
- -------------------------------------------------------------------------------------------------------
Total nonperforming assets $2,017 $825 $ 565 $628 $638
========================================================
- -------------------------------------------------------------------------------------------------------
Accruing loans past due 90 days or more:
Commercial and industrial $98 $462 $303 $242 $ 99
Real estate mortgage 619 119 277 664 704
Real estate construction --- --- --- --- ---
Loans to individuals 214 396 400 415 274
- -------------------------------------------------------------------------------------------------------
$931 $977 $980 $1,321 $1,077
=======================================================================================================
24
Loan loss and other industry indicators related to asset quality are presented
in the Loan Loss Data table.
Loan Loss Data Table
2003 2002 2001
- ------------------------------------------------- ------------------ ------------------ --------------
Provision for loan losses $ 1,691 $ 2,251 $ 1,408
- ------------------------------------------------- ------------------ ------------------ --------------
Net charge-offs to average net loans 0.34% 0.35% 0.27%
- ------------------------------------------------- ------------------ ------------------ --------------
Allowance for loan losses to loans, net of
unearned income and deferred fees 1.32% 1.24% 1.07%
- ------------------------------------------------- ------------------ ------------------ --------------
Allowance for loan losses to nonperforming loans 1,516.67% 1,768.06% 1,206.78%
- ------------------------------------------------- ------------------ ------------------ --------------
Allowance for loan losses to nonperforming
assets 266.19% 617.21% 756.11%
- ------------------------------------------------- ------------------ ------------------ --------------
Nonperforming assets to loans, net of unearned
income and deferred fees, plus other real 0.49% 0.20% 0.14%
estate owned
- ------------------------------------------------- ------------------ ------------------ --------------
Nonaccrual loans 354 288 354
- ------------------------------------------------- ------------------ ------------------ --------------
Restructured loans --- --- ---
- ------------------------------------------------- ------------------ ------------------ --------------
Other real estate owned, net 1,663 537 211
- ------------------------------------------------- ------------------ ------------------ --------------
Total nonperforming assets $ 2,017 $ 825 $ 565
- ------------------------------------------------- ================== ================== ==============
Accruing loans past due 90 days or more $ 931 $ 977 $ 980
- ------------------------------------------------- ------------------ ------------------ --------------
Note: Nonperforming loans include nonaccrual loans and restructured loans, but
do not include accruing loans 90 days or more past due.
25
B. Maturities and Associated Yields
The following table presents the maturities for those securities available
for sale and held to maturity as of December 31, 2003 and weighted average
yield for each range of maturities.
======================================================================
Maturities and Yields
December 31, 2003
----------------------------------------------------------------------
($ in thousands except <1 Year 1-5 Years 5-10 Years >10 Years None Total
for % data)
=====================================================================================================
Available for Sale:
- -------------------
U.S. Treasury $1,262 $1,078 $--- $--- $--- $2,340
5.96% 5.62% --- --- --- 5.80%
- ----------------------------------------------------------------------------------------------------
U.S. Government agencies --- --- 4,649 --- --- 4,649
--- --- 4.77% --- --- 4.77%
- ----------------------------------------------------------------------------------------------------
Mortgage-backed securities --- 813 1,397 8,670 --- 10,880
--- 3.20% 2.88% 8.16% --- 7.11%
- ----------------------------------------------------------------------------------------------------
States and political 843 107 2,472 1,753 --- 5,175
subdivision - taxable 6.87% 5.88% 4.58% 7.29% --- 5.90%
- ----------------------------------------------------------------------------------------------------
States and political 1,251 4,235 48,598 23,855 --- 77,939
subdivision 6.94% 6.71% 5.73% 6.11% --- 5.92%
- nontaxable(1)
- ----------------------------------------------------------------------------------------------------
Corporate --- 5,489 19,574 --- --- 25,063
--- 5.31% 5.06% --- --- 5.11%
- ----------------------------------------------------------------------------------------------------
Federal Home Loan Bank stock --- --- --- --- 1,646 1,646
--- --- --- --- 3.75% 3.75%
- ----------------------------------------------------------------------------------------------------
Federal Reserve Bank stock --- --- --- --- 209 209
--- --- --- --- 6.00% 6.00%
- ----------------------------------------------------------------------------------------------------
Other securities 229 --- --- --- 1,170 1,399
0.72% --- --- --- 3.01% 2.63%
- ----------------------------------------------------------------------------------------------------
Total 3,585 11,722 76,690 34,278 3,025 129,300
6.18% 5.70% 5.41% 6.69% 3.62% 5.75%
- ----------------------------------------------------------------------------------------------------
Held to Maturity: --- --- --- --- --- ---
- -----------------
U.S. Treasury --- --- --- --- --- ---
- ----------------------------------------------------------------------------------------------------
U.S. Government agencies --- 2,003 2,996 994 --- 5,993
--- 6.38% 4.11% 6.00% --- 5.18%
- ----------------------------------------------------------------------------------------------------
Mortgage-backed securities --- 25 1 4,265 --- 4,291
--- 7.64% 8.50% 6.32% --- 6.33%
- ----------------------------------------------------------------------------------------------------
States and political --- 1,349 1,675 1,000 --- 4,024
subdivision - taxable --- 6.06% 5.56% 5.34% --- 5.67%
- ----------------------------------------------------------------------------------------------------
States and political 540 2,303 34,002 15,492 --- 52,337
subdivision - nontaxable 7.64% 7.02% 6.06% 5.93% --- 6.08%
- ----------------------------------------------------------------------------------------------------
Corporate 1,000 17,768 13,440 2,001 --- 34,209
6.73% 6.08% 7.48% 5.03% --- 6.59%
- ----------------------------------------------------------------------------------------------------
Other securities --- --- --- --- --- ---
--- --- --- --- --- ---
- ----------------------------------------------------------------------------------------------------
Total $ 1,540 $23,448 $52,114 $23,752 --- $100,854
7.05% 6.20% 6.30% 5.90% --- 6.19%
====================================================================================================
(1) Rates shown represent weighted average yield on a fully taxable basis.
The majority of mortgage-backed securities and collateralized mortgage
obligations held at December 31, 2003 were backed by U.S. agencies. Certain
holdings are required to be periodically subjected to the Financial
Institution Examination Council's (FFIEC) high risk mortgage security test.
These tests address possible fluctuations in the average life and variances
caused by the change in rate times the change in volume have been allocated
to rate and volume changes proportional to the relationship of the absolute
dollar amounts of the change in each. Except for U.S. Government securities,
the Company has no securities with any issuer that exceeds 10% of
stockholders' equity.
26
Deposits
2003 vs 2002
Total deposits grew by $17,107 or 2.81% in 2003. All categories reflected
increases except time deposits, which declined by 1.19%.
In the interest-bearing deposit categories the largest dollar growth was in
interest-bearing demand deposits, which grew by $7,154. This was followed by
saving deposits, which grew by $4,128.
The decline in time deposits is a continuation of the trend of customers
being unwilling to choose longer term deposit instruments. This trend is
expected to reverse when interest rates move to higher levels, which will
provide an incentive for customers to invest for longer periods.
2002 vs 2001
Total deposits at December 31, 2002 were $608,271, an increase of $31,653 or
5.49% from December 31, 2001. Noninterest-bearing demand deposits grew by 3.18%,
while interest-bearing demand deposits grew by 23.08%. Savings deposits
increased by 0.26%, with time deposits declining by 0.54%. Management believes
that the increase in interest-bearing demand deposits is in part due to
customers' expectations of higher interest rates in the near to intermediate
term, which created a reluctance to commit to longer term deposit instruments.
A. Average Amounts of Deposits and Average Rates Paid
Average amounts and average rates paid on deposit categories in
excess of 10% of average total deposits are presented below:
=======================================================================
December 31,
-----------------------------------------------------------------------
2003 2002 2001
-----------------------------------------------------------------------
Average Average Average
Average Rates Average Rates Average Rates
($ in thousands) Amounts Paid Amounts Paid Amounts Paid
- -----------------------------------------------------------------------------------------------------
Noninterest-bearing
demand deposits $ 79,760 --- $ 74,269 --- $ 66,793 ---
Interest-bearing
demand deposits 167,428 0.94% 147,749 1.50% 116,529 2.16%
Savings deposits 51,646 0.63% 49,151 1.03% 47,175 1.95%
Time deposits 317,989 3.26% 312,129 4.18% 338,642 5.71%
- -----------------------------------------------------------------------------------------------------
Average total
deposits $616,823 2.28% $583,298 3.10% $569,139 4.53%
=====================================================================================================
B. Time Deposits of $100,000 or More
The following table sets forth time certificates of deposit and
other time deposits of $100,000 or more:
=======================================================================
December 31, 2003
=======================================================================
3 Months Over 3 Months Over 6 Months Over 12 Total
or Less Through 6 Through 12 Months
($ in thousands) Months Months
- -------------------------------------------------------------------------------------------------------
Total time
deposits of
$100,000 or more $20,582 $16,127 $21,392 $37,115 $95,216
=======================================================================================================
27
Derivatives and Market Risk Exposures
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. See Note 14 of Notes to Consolidated Financial Statements for
additional information relating to financial instruments with off-balance sheet
risk. Management does not plan any future involvement in high risk derivative
products. The Company has investments in mortgage-backed securities, principally
GNMA's, with a fair value of approximately $15,379, which includes $2,059 of
structured notes. In addition, the Company has investments in
non-mortgage-backed structured notes with fair value of approximately $1,060.
See Note 3 of Notes to Consolidated Financial Statements for additional
information relating to securities.
The Company's securities and loans are subject to credit and interest rate
risk, and its deposits are subject to interest rate risk. Management considers
credit risk when a loan is granted and monitors credit risk after the loan is
granted. The Company maintains an allowance for loan losses to absorb losses in
the collection of its loans. See Note 5 of Notes to Consolidated Financial
Statements for information relating to the allowance for loan losses. See Note
15 of Notes to Consolidated Financial Statements for information relating to
concentrations of credit risk. The Company has an asset/liability program to
manage its interest rate risk. This program provides management with information
related to the rate sensitivity of certain assets and liabilities and the effect
of changing rates on profitability and capital accounts.
The effects of changing interest rates are primarily managed through
adjustments to the loan portfolio and deposit base, to the extent competitive
factors allow. The investment portfolio is generally longer term. Adjustments
for asset and liability management concerns are addressed when securities are
called or mature and funds subsequently reinvested. Historically, sales of
securities have occurred for reasons related to credit quality or regulatory
limitations. Few, if any, securities available for sale have been disposed of
for the express purpose of managing interest rate risk.
No trading activity for this purpose is planned for the foreseeable future,
though it does remain an option.
While this planning process is designed to protect the Company over the
long-term, it does not provide near-term protection from interest rate shocks,
as interest rate sensitive assets and liabilities do not, by their nature, move
up or down in tandem in response to changes in the overall rate environment. The
Company's profitability in the near term may be temporarily affected either
positively by a falling interest rate scenario or negatively by a period of
rising rates. See Note 16 of Notes to Consolidated Financial Statements for
information relating to fair value of financial instruments and comments
concerning interest rate sensitivity.
Liquidity
2003 vs 2002
Liquidity is the ability to provide sufficient cash flow to meet financial
commitments and to fund additional loan demand or withdrawal of existing
deposits. Sources of liquidity include deposits, loan principal and interest
repayments, sales, calls and maturities of securities, and short-term
borrowings. The Company also has available a line of credit with the Federal
Home Loan Bank to provide for liquidity needs. The Company maintained an
adequate liquidity level during 2003 and 2002.
Cash flows from operating activities for 2003 were $14,794. The principal
source of cash was net income. Net cash used in investment activities was
$27,976. Included in this account are $35,818 in purchases of
securities available for sale, $23,185 in securities held to maturity and
$17,402 in interest-bearing deposits.
Each of these categories has a different effect on liquidity.
Interest-bearing deposits are overnight funds, similar to Federal Funds sold.
Securities available for sale can be a source of liquidity depending on market
conditions, which determine the level of unrealized gains and losses. Held to
maturity securities are relatively illiquid, in that they must mature or be
called to become a source of funds.
Cash provided by financing activities was $12,599 compared to $28,792 in
2002. Time deposits decreased by $3,814 in 2003 and $1,743 in 2002. Other
deposits increased $20,921 in 2003. Comments made under "Deposits" apply.
2002 vs 2001
Liquidity is the ability to provide sufficient cash flow to meet financial
commitments and to fund additional loan demand or withdrawal of existing
deposits. Sources of liquidity include deposits, loan principal and interest
repayments, sales, calls and maturities of securities, and short-term
borrowings. The Company also has available a line of credit with the Federal
Home Loan Bank to provide for liquidity needs. The Company maintained an
adequate liquidity level during 2002 and 2001.
Cash flows from operating activities for 2002 were $14,244. The principal
source of cash was net income. Net cash used in investment activities was
$43,013. While the majority of the called and maturing
securities were reinvested in the securities available for sale category, these
funds may not be available in the future to meet liquidity needs. Given the low
interest rate environment currently being experienced, a rising rate environment
would tend to erode securities values making their sale undesirable from a
profitability perspective. A rising rate scenario would further inhibit the
activation of any call features. The company experienced a similar situation in
the last period of rising rates that occurred in the 1999 and 2000 time periods.
(See additional comments under "Interest Rate Sensitivity").
28
Cash provided by financing activities was $28,792 compared to $39,133 in
2001. The majority of the difference between the two years was in deposits
purchased, which totaled $29,862 in 2001 and none in 2002. Time deposits
decreased by $1,743 in 2002 and $38,460 in 2001. Other deposits increased
$33,396 in 2002. Comments made under "Deposits" apply.
Recent Accounting Pronouncements
See Note 1 of Notes to Consolidated Financial Statements for information
relating to recent accounting pronouncements.
Acquisitions
In the first quarter of 2004 the Company announced that it had entered into
an agreement to purchase the loans and deposits of a branch bank. Approximately
$8.0 in loans and approximately $18.6 million in deposits are to be purchased in
a transaction that is expected to close in the first half of 2004. No fixed
assets are included in this transaction. A second acquisition involving
substantially all of the assets (including fixed assets) and substantially all
of the liabilities of a bank was announced early in 2004 and is planned to close
in the first half of the year. It will add approximately $53.0 million in
deposits and approximately $67.8 million in total assets.
Capital Resources
Total shareholders' equity at December 31, 2003 was $80,641, an increase of
$7,540 or 10.31%. Total average capital to total average assets was 11.12% for
2003, which compares to 10.63% in 2002. Of the increase, net income accounted
for $11,442, offset by dividends to shareholders in the amount of $3,971.
Off-Balance Sheet Arrangements
The Company's off-balance sheet arrangements are detailed in the table
below.
Payments Due by Period
Total Less Than 1-3 Years 3-5 More Than
1 Year Years 5 Years
----------- ------------ ------------ --------- ------------
Commitments to extend credit $ 85,903 85,903 --- --- ---
Standby Letters of Credit 6,557 6,557 --- --- ---
Mortgage Loans with Potential
Recourse 37,771 37,771 --- --- ---
----------- ------------ ------------ --------- ------------
Total $ 130,231 130,231 --- --- ---
=========== ============ ============ ========= ============
In the normal course of business the Company's banking affiliates extend
lines of credit to their customers. Amounts drawn upon these lines vary at any
given time depending on the business needs of the customers.
Standby letters of credit are also issued to the banks' customers. There are
two types of standby letters of credit. The first is a guarantee of payment to
facilitate customer purchases. The second type is a performance letter of credit
that guarantees a payment if the customer fails to perform a specific
obligation. Revenue from these letters was approximately $49 in 2003.
While it would be possible for customers to draw in full on approved lines
of credit and letters of credit, historically this has not occurred. In the
event of a sudden and substantial draw on these lines, the Company has its own
lines of credit on which it could draw funds. Sale of the loans would also be an
option.
The Company also sells mortgages on the secondary market for which there are
recourse agreements should the borrower default.
The following table summarizes the Company's fixed and determined contractual
obligations by payment date as of December 31, 2003.
1 Year or More Than
Total Less 1-3 Years 3-5 Years 5 Years
------------ ----------- ----------- ----------- ---------
Operating Leases $ 694 241 242 138 73
Operating leases are for buildings used in the day-to-day operations of the
Company.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See "Analysis of Interest Rate Sensitivity" set forth below. Additional
information is set forth in the "Interest Rate Sensitivity" and "Derivatives and
Market Risk Exposure" sections.
29
Item 8. Financial Statements and Supplementary Data
CONSOLIDATED BALANCE SHEETS
$ In thousands, except per share data. Years ended December 31,
2003 2002
- ---------------- ----------------------------------------------------------- -------------- -----------
Assets Cash and due from banks $ 11,733 $ 12,316
Interest-bearing deposits 36,220 18,818
Federal funds sold --- 1,724
Securities available for sale, at fair value 129,300 119,734
Securities held to maturity (fair value approximates
$105,026 at December 31, 2003 and $103,187 at
December 31, 2002) 100,854 99,560
Mortgage loans held for sale 714 846
Loans:
Real estate construction loans 28,055 22,294
Real estate mortgage loans 87,899 82,193
Commercial and industrial loans 208,997 209,368
Loans to individuals 82,742 96,762
------ ------
Total loans 407,693 410,617
Less unearned income and deferred fees (896) (1,278)
---- ------
Loans, net of unearned income and deferred
fees 406,797 409,339
Less allowance for loan losses (5,369) (5,092)
------- -------
Loans, net 401,428 404,247
------- -------
Premises and equipment, net 10,094 9,938
Accrued interest receivable 4,610 4,290
Other real estate owned, net 1,663 537
Intangible assets and goodwill 9,958 10,912
Other assets 1,986 2,013
----- -----
Total assets $ 708,560 $684,935
========== ========
Liabilities Noninterest-bearing demand deposits $ 83,671 $ 74,032
and Interest-bearing demand deposits 172,370 165,216
Stockholders' Saving deposits 53,084 48,956
Equity Time deposits 316,253 320,067
------- -------
Total deposits 625,378 608,271
------- -------
Other borrowed funds 135 748
Accrued interest payable 489 700
Other liabilities 1,917 2,115
Total liabilities 627,919 611,834
======= =======
Commitments and contingencies
Stockholders' equity:
Preferred stock, no par value, 5,000,000 shares
authorized; none issued and outstanding --- ---
Common stock of $2.50 par value. Authorized
10,000,000 shares; issued and outstanding,
3,515,377 shares - 2003, and 3,511,377 - 2002 8,788 8,778
Retained earnings 70,063 62,525
Accumulated other comprehensive income, net 1,790 1,798
Total stockholders' equity 80,641 73,101
------ ------
Total liabilities and stockholders'
equity $708,560 $ 684,935
======== ---------
The accompanying notes are an integral part of these consolidated financial
statements.
30
CONSOLIDATED STATEMENTS OF INCOME
$ In thousands, except per share data. Years ended December 31,
2003 2002 2001
- ---------------- ------------------------------------------------------- ----------- --------- ----------
Interest Interest and fees on loans $ 29,798 $ 32,420 $ 33,456
Income Interest on federal funds sold 16 42 652
Interest on interest-bearing deposits 230 276 577
Interest on securities - taxable 5,668 5,490 7,501
Interest on securities - nontaxable 5,369 4,519 3,341
----- ----- -----
Total interest income 41,081 42,747 45,527
------ ------ ------
Interest Interest on time deposits of $100,000 or more 3,016 3,470 4,605
Expense Interest on other deposits 9,234 12,289 18,158
Interest on borrowed funds 2 5 8
---- ---- ----
Total interest expense 12,252 15,764 22,771
------ ------ ------
Net interest income 28,829 26,983 22,756
Provision for loan losses 1,691 2,251 1,408
----- ----- -----
Net interest income after provision for loan
losses 27,138 24,732 21,348
------ ------ ------
Noninterest Service charges on deposit accounts 2,597 2,229 2,246
Income Other service charges and fees 267 260 306
Credit card fees 1,612 1,409 1,227
Trust income 1,132 968 1,091
Other income 448 500 330
Realized securities gains, net 130 346 4
---- ---- ----
Total noninterest income 6,186 5,712 5,204
----- ----- -----
Noninterest Salaries and employee benefits 9,568 8,912 8,085
Expense Occupancy and furniture and fixtures 1,655 1,692 1,715
Data processing and ATM 1,164 1,096 1,343
Credit card processing 1,244 1,036 1,004
Intangible assets and goodwill amortization 954 954 914
Net costs of other real estate owned 178 145 125
Other operating expenses 3,883 3,592 3,767
----- ----- -----
Total noninterest expense 18,646 17,427 16,953
------ ------ ------
Income before income taxes 14,678 13,017 9,599
Income tax expense 3,236 3,003 2,285
----- ----- -----
Net income $ 11,442 $10,014 $ 7,314
======== ======= =======
Basic net income per share $ 3.26 $2.85 $ 2.08
======= ===== ======
Fully diluted net income per share $ 3.24 $2.85 $ 2.08
======= ===== ======
The accompanying notes are an integral part of these consolidated financial
statements.
31
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY $ In thousands,
except per share data.
Common Retained Accumulated Comprehensive Total
Stock Earnings Other Income
Comprehensive
Income (Loss)
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Balance at December 31, 2000 $ 8,780 $ 51,629 $ (575) $ 59,834
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Net income --- 7,314 --- 7,314 7,314
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income:
- ---------------------------
Unrealized holding gains on
available for sale securities
net of deferred taxes of $588 --- --- --- 1,144 ---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Less: reclassification adjustment,
net of income taxes of $1 --- --- --- (3) ---
---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income, net of
tax of $587 --- --- 1,141 1,141 1,141
-----
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Total comprehensive income net of
tax of $2,872 --- --- --- 8,455 ---
=====
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Common stock repurchased (2) (6) --- (8)
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Cash dividends ($0.86 per share) --- (3,020) --- (3,020)
--- ------- --- -------
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Balance at December 31, 2001 $ 8,778 $ 55,917 $ 566 $ 65,261
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Net Income --- 10,014 --- 10,014 10,014
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income:
- ---------------------------
Unrealized holding gains on
available for sale securities
net of deferred taxes of $948 --- --- --- 1,841 ---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Less: reclassification adjustment,
net of income taxes of $118 --- --- --- (228) ---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Minimum pension liability
adjustment net of deferred --- --- --- (381) ---
taxes of $235 ------
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income, net of
tax of $596 --- --- 1,232 1,232 1,232
-----
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Total comprehensive income, --- --- --- 11,246 ---
======
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Cash dividends ($0.97 per share) --- (3,406) --- (3,406)
--- ------- --- -------
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Balance at December 31, 2002 $ 8,778 $ 62,525 $ 1,798 $ 73,101
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Net income --- 11,442 --- 11,442 11,442
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income:
- ---------------------------
Unrealized holding gains on
available for sale securities
net of deferred taxes of $28 --- --- --- 52 ---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Less: reclassification adjustment,
net of income taxes of $(46) --- --- --- (84) ---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Minimum pension liability
adjustment, net of deferred --- --- --- 24 ---
taxes of $8 ----
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Other comprehensive income, net of
tax of $(10) --- --- (8) (8) (8)
---
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Total comprehensive income --- --- --- 11,434 ---
======
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Cash dividend ($1.13 per share) --- (3,971) --- (3,971)
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Exercise of stock options 10 67 --- 77
-- -- --
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
Balance at December 31, 2003 $ 8,788 $ 70,063 $ 1,790 $ 80,641
======= ======== ======= ========
- ------------------------------------ ---------- ----------- ------------------ --------------- --------------
The accompanying notes are an integral part of these consolidated financial
statements.
32
CONSOLIDATED STATEMENTS OF CASH FLOWS
$ In thousands. Years Ended December 31,
2003 2002 2001
--------------------------------------------------- ------------ ---------- -----------
Cash Net income $ 11,442 $ 10,014 $ 7,314
Flows Adjustment to reconcile net income to net cash
from provided by operating activities:
Operating
Activities Provision for loan losses 1,691 2,251 1,408
(Benefit) from deferred income taxes (200) (551) (166)
Depreciation of premises and equipment 924 977 1,106
Amortization of intangibles 954 954 914
Amortization of premiums and accretion of
discounts, net 359 392 367
(Gains) losses on sale and calls of
securities available for sale, net (79) (331) (4)
(Gains) losses on calls of securities held
to maturity, net (51) (15) ---
Losses and writedowns on other real estate
owned 94 87 62
Originations of mortgage loans held for sale (37,039) (36,915) (28,247)
Sales of mortgage loans held for sale 37,171 37,214 27,102
(Gains) losses on sale and disposal of
fixed assets 40 (11) (2)
Net change in:
Accrued interest receivable (320) 627 132
Other assets 216 (34) 235
Accrued interest payable ( 211) (401) (437)
Other liabilities (198) (14) 233
----- ----- ----
Net cash provided by operating activities 14,793 14,244 10,017
------ ------ ------
Cash Net change in federal funds sold 1,724 (644) 28,010
Flows Net change in interest-bearing deposits (17,402) (3,308) (1,931)
from Proceeds from repayments of mortgage-backed
Investing securities available for sale 9,872 4,656 3,482
Activities Proceeds from sales of securities available for
sale 1,193 813 ---
Proceeds from calls, maturities, and principal
repayments of securities available for sale 15,127 11,042 58,403
Proceeds from calls, maturities, and principal
repayments of securities held to maturity 20,632 20,017 24,160
Proceeds from the sale of securities held to
maturity 1,093 --- ---
Purchases of securities available for sale (35,818) (44,995) (25,209)
Purchases of securities held to maturity (23,185) (16,953) (94,602)
Purchases of loan participations (6,619) (19,440) (4,296)
Collections of loan participations 9,579 3,981 4,702
Loan originations and principal collections, net (3,592) 2,190 (31,740)
Proceeds from disposal of other real estate owned 294 255 1,095
Recoveries on loans charged off 246 145 106
Additions to premises and equipment (1,527) (805) (921)
Proceeds from sale of premises and equipment 407 33 9
--- ---- ---
Net cash used by investing activities (27,976) (43,013) (47,987)
-------- -------- --------
Cash Deposits acquired, net of premium --- --- 29,862
Flows Net change in time deposits (3,814) (1,743) (38,460)
from Net change in other deposits 20,921 33,396 50,826
Financing Net change in other borrowed funds (613) 545 (67)
Activities Cash dividends paid (3,971) (3,406) (3,020)
Common stock repurchase 77 --- (8)
---- ---- -----
Net cash provided by financing activities 12,600 28,792 39,133
------ ------ ------
Supplemental Net change in cash and due from banks (583) 23 1,163
Disclosures Cash and due from banks at beginning of year 12,316 12,293 11,130
of Cash Flow ------ ------ ------
Information Cash and due from banks at end of year $ 11,733 $ 12,316 $ 12,293
======== ======== ========
Interest paid on deposits and borrowed funds $ 12,463 $ 16,165 $ 23,208
Income taxes paid 3,338 3,414 2,383
Supplemental Loans charged against the allowance for loan
Disclosures losses 1,660 1,576 1,129
of Noncash Loans transferred to other real estate owned 1,514 668 828
Activities Unrealized gain on securities available for sale 3 2,444 1,728
Minimum pension liability adjustment 41 689 ---
The accompanying notes are an integral part of these consolidated financial
statements.
33
Notes to Consolidated Financial Statements $ In thousands, except share data and
per share data.
Note 1: Summary of Significant Accounting Policies
The consolidated financial statements include the accounts 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). All significant intercompany
balances and transactions have been eliminated in consolidation.
The accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States of America and to general
practices within the banking industry. The following is a summary of the more
significant accounting policies.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and cash
equivalents include cash and due from banks.
Securities
Debt securities that management has the positive intent and ability to hold
to maturity are classified as "held to maturity" and recorded at amortized cost.
Securities not classified as held to maturity or trading, including equity
securities with readily determinable fair values, are classified as "available
for sale" and recorded at fair value, with unrealized gains and losses excluded
from earnings and reported in other comprehensive income. The Company has no
securities classified as trading securities at December 31, 2003 or 2002.
Purchase premiums and discounts are recognized in interest income using the
interest method over the terms of the securities. Declines in the fair value of
held to maturity and available for sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized losses.
Gains and losses on the sale of securities are recorded on the trade date and
are determined using the specific identification method.
Loans Held for Sale
Loans originated and intended for sale in the secondary market are carried
at the lower of cost or estimated fair value on an individual loan basis. Net
unrealized losses, if any, are recognized through a valuation allowance by
charges to income.
Loans
The Company, through its banking subsidiaries, grants mortgage, commercial,
and consumer loans to customers. A substantial portion of the loan portfolio is
represented by mortgage loans. The ability of the Company's debtors to honor
their contracts is dependent upon the real estate and general economic
conditions in the Company's market area.
Loans that management has the intent and ability to hold for the foreseeable
future, or until maturity or payoff, generally are reported at their outstanding
unpaid principal balances adjusted for the allowance for loan losses and any
deferred fees or costs on originated loans. Interest income is accrued on the
unpaid principal balance. Loan origination fees, net of certain direct
origination costs, are deferred and recognized as an adjustment of the related
loan yield using the interest method.
The accrual of interest on mortgage and commercial loans is discontinued at
the time the loan is 90 days delinquent unless the credit is well-secured and in
the process of collection. Credit card loans and other personal loans are
typically charged off no later than 180 days past due. In all cases, loans are
placed on nonaccrual or charged off at an earlier date if collection of
principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on
nonaccrual or charged off is reversed against interest income. The interest on
these loans is accounted for on the cash-basis or cost-recovery method until
qualifying for return to accrual. Loans are returned to accrual status when all
the principal and interest amounts contractually due are brought current and
future payments are reasonably assured.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
34
are charged against the allowance when management believes the uncollectibility
of a loan balance is confirmed. Subsequent recoveries, if any, are credited to
the allowance.
The allowance for loan losses is evaluated on a regular basis by management
and is based upon management's periodic review of the collectibility of the
loans in light of historical experience; the nature, volume, and risk
characteristics of the loan portfolio; adverse situations that may affect the
borrower's ability to repay; estimated value of any underlying collateral; and
prevailing economic conditions. This evaluation is inherently subjective as it
requires estimates that are susceptible to significant revision as more
information becomes available.
A loan is considered impaired when, based on current information and events,
it is probable that the Company will be unable to collect the scheduled payments
of principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan by loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loan's
effective interest rate, the loan's obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated
for impairment. Accordingly, the Company does not separately identify individual
consumer and residential loans for impairment disclosures.
Rate Lock Commitments
The Company enters into commitments to originate mortgage loans whereby the
interest rate on the loan is determined prior to funding (rate lock
commitments). Rate lock commitments on mortgage loans that are intended to be
sold are considered to be derivatives. The period of time between issuance of a
loan commitment and closing and sale of the loan generally ranges from 30 to 60
days. The Company protects itself from changes in interest rates through the use
of best efforts forward delivery commitments, by committing to sell a loan at
the time the borrower commits to an interest rate with the intent that the buyer
has assumed interest rate risk on the loan As a result, the Company is not
exposed to losses nor will it realize significant gains related to its rate lock
commitments due to changes in interest rates. The correlation between the rate
lock commitments and the best efforts contracts is very high due to their
similarity.
The market value of rate lock commitments and best efforts contracts is not
readily ascertainable with precision because rate lock commitments and best
effort contracts are not actively traded in stand-alone markets. The Company
determines the fair value of rate lock commitments and best efforts contracts by
measuring the changes in the value of the underlying assets while taking into
consideration the probability that the rate lock commitments will close. Because
of the high correlation between rate lock commitments and best efforts
contracts, no gain or loss occurs on the rate lock commitments.
Premises and Equipment
Premises and equipment are stated at cost, net of accumulated depreciation.
Depreciation is charged to expense over the estimated useful lives of the assets
on the straight-line basis. Depreciable lives include 40 years for premises,
3-10 years for furniture and equipment, and 5 years for computer software. Costs
of maintenance and repairs are charged to expense as incurred and improvements
are capitalized.
Other Real Estate
Real estate acquired through, or in lieu of, foreclosure is held for sale
and is initially recorded at fair value at the date of foreclosure, establishing
a new cost basis. Subsequent to foreclosure, valuations are periodically
performed by management and the assets are carried at the lower of carrying
amount or fair value less cost to sell. Revenue and expenses from operations and
changes in the valuation allowance are included in other operating expenses.
Intangible Assets
Included in other assets are deposit intangibles of $9,726 and $10,642 at
December 31, 2003 and 2002, respectively, and goodwill of $232 and $270 at
December 31, 2003 and 2002, respectively. Deposit intangibles are being
amortized on a straight-line basis over a ten or fifteen-year period and
goodwill is being amortized on a straight-line basis over a fifteen-year period.
Stock-Based Compensation
At December 31, 2003, the Company had a stock-based employee compensation
plan which is described more fully in Note 9. The company accounts for this plan
under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under the plan had an exercise price equal to the market value
of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of FASB Statement No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation.
35
Years Ended December 31,
------------- ---------------- ---------------
(In thousands, except per share data) 2003 2002 2001
------------- ---------------- ---------------
Net income as reported $ 11,442 $ 10,014 $7,314
Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards (61) (35) (15)
---- ---- ----
Pro forma net income $ 11,381 $ 9,979 $7,299
======== ======= =======
Earnings per share:
Basic-as reported $ 3.26 $ 2.85 $ 2.08
======== ======= =======
Basic-pro forma $ 3.24 $ 2.84 $ 2.08
======== ======= =======
Diluted-as reported $ 3.24 $ 2.85 $ 2.08
======== ======= =======
Diluted-pro forma $ 3.22 $ 2.84 $ 2.08
======== ======= =======
Pension Plan
The Company sponsors a defined benefit pension plan, which covers
substantially all full-time officers and employees. The benefits are based upon
length of service and a percentage of the employee's compensation during the
final years of employment. Pension costs are computed based upon the provisions
of SFAS No. 87. The Company contributes to the pension plan amounts that are
deductible for federal income tax purposes.
Income Taxes
Deferred income tax assets and liabilities are determined using the balance
sheet method. Under this method, the net deferred tax asset or liability is
determined based on the tax effects of the temporary differences between the
book and tax basis of the various balance sheet assets and liabilities and gives
current recognition to changes in tax rates and laws.
Trust Assets and Income
Assets (other than cash deposits) held by the Trust Departments in a
fiduciary or agency capacity for customers are not included in the consolidated
financial statements since such items are not assets of the Company. Trust
income is recognized on the accrual basis.
Earnings Per Share
Basic earnings per share represents income available to common stockholders
divided by the weighted-average number of common shares outstanding during the
period. Diluted earnings per share reflects additional common shares that would
have been outstanding if dilutive potential common shares had been issued, as
well as any adjustment to income that would result from the assumed issuance.
Potential common shares that may be issued by the Company relate solely to
outstanding stock options, and are determined using the treasury stock method.
The following shows the weighted average number of shares used in computing
earnings per share and the effect on the weighted average number of shares of
dilutive potential common stock. Potential dilutive common stock had no effect
on income available to common shareholders.
- ----------------------------------------- ----------- ------------ -----------
2003 2002 2001
- ----------------------------------------- ----------- ------------ -----------
Average number of common shares
outstanding 3,512,896 3,511,377 3,511,380
Effect of dilutive options 20,364 5,712 1,216
--------- --------- ---------
Average number of common shares
outstanding used to calculate diluted
earnings per share 3,533,260 3,517,089 3,512,596
- ----------------------------------------- ========= ========= =========
In 2002 and 2001, stock options representing 9,750 and 4,125 shares,
respectively, were not included in the computation of diluted net income per
share because to do so would have been anti-dilutive. There were no
anti-dilutive stock options excluded during 2003.
Advertising
The Company practices the policy of charging advertising costs to expenses
as incurred.
Use of Estimates
In preparing consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America, management is
36
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities as of the date of the balance sheet and reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates. Material estimates that are particularly
susceptible to significant change in the near term relate to the determination
of the allowance for loan losses and the valuation of foreclosed real estate and
deferred tax assets.
Changing economic conditions, adverse economic prospects for borrowers, as
well as regulatory agency action as a result of examination, could cause NBB and
BTC to recognize additions to the allowance for loan losses and may also affect
the valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans.
Recent Accounting Pronouncements
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure," which amends SFAS No. 123
to provide alternative methods of transition for an entity that voluntarily
changes to the fair value based method of accounting for stock-based employee
compensation. The provisions of the Statement were effective December 31, 2002.
Management currently intends to continue to account for stock-based compensation
under the intrinsic value method set forth in Accounting Principles Board
("APB") Opinion 25 and related interpretations. For this reason, the transition
guidance of SFAS No. 148 does not have an impact on the Company's consolidated
financial position or consolidated results of operations. The Statement does
amend existing guidance with respect to required disclosures, regardless of the
method of accounting used. The revised disclosure requirements are presented
herein.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). The Interpretation elaborates
on the disclosures to be made by a guarantor in its financial statements under
certain guarantees that it has issued. It also clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the fair
value of the obligation undertaken in issuing the guarantee. The recognition
requirements of the Interpretation were effective beginning January 1, 2003. The
initial adoption of the Interpretation did not materially affect the Company,
and management does not anticipate that the recognition requirements of this
Interpretation will have a materially adverse impact on either the Company's
consolidated financial position or consolidated results of operations in the
future.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"). This Interpretation provides guidance
with respect to the identification of variable interest entities and when the
assets, liabilities, noncontrolling interests, and results of operations of a
variable interest entity need to be included in a company's consolidated
financial statements. The Interpretation requires consolidation by business
enterprises of variable interest entities in cases where (a) the equity
investment at risk is not sufficient to permit the entity to finance its
activities without additional subordinated financial support from other parties,
which is provided through other interests that will absorb some or all of the
expected losses of the entity, or (b) in cases where the equity investors lack
one or more of the essential characteristics of a controlling financial
interest, which include the ability to make decisions about the entity's
activities through voting rights, the obligations to absorb the expected losses
of the entity if they occur, or the right to receive the expected residual
returns of the entity if they occur. The implementation of FIN 46 did not have a
significant impact on either the Company's consolidated financial position or
consolidated results of operations. Interpretive guidance relating to FIN 46 is
continuing to evolve and the Company's management will continue to assess
various aspects of consolidations and variable interest entity accounting as
additional guidance becomes available.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." The Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities under SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities." The Statement is effective for contracts entered into
or modified after June 30, 2003, with certain exceptions, and for hedging
relationships designated after June 30, 2003 and is not expected to have an
impact on the Company's consolidated financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). Many of these instruments
were previously classified as equity. This Statement is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003, except for mandatory redeemable financial instruments of nonpublic
entities. Adoption of the Statement did not result in an impact on the Company's
consolidated financial statements.
In November 2003, the FASB's Emerging Issues Task Force (EITF) reached a
consensus on a new disclosure requirement related to unrealized losses on
investment securities. The new disclosure requires a table of securities which
have unrealized losses as of the reporting date. The table must distinguish
between those securities which have been in a continuous unrealized loss
position for twelve months or more and those securities which have been in a
continuous unrealized loss position for less than twelve months. The table is to
include the aggregate unrealized losses of securities whose fair values are
below book values as of the reporting date, and the aggregate fair value of
securities whose fair values are below book values as of the reporting date. In
addition to the quantitative disclosure, FASB requires a narrative discussion
that provides sufficient information to allow financial statement users to
understand the quantitative disclosures and the information that was considered
in determining whether impairment was not other-than-temporary. The new
disclosure requirements apply to fiscal years ending after December 15, 2003.
37
The Company has included the required disclosures in their consolidated
financial statements.
In December 2003, the FASB issued a revised version of SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits an
amendment of FASB Statements No. 87, 88 and 106." This Statement revises
employers' disclosures about pension plans and other postretirement benefits. It
does not change the measurement or recognition of those plans required by FASB
Statements No. 87, No. 88, and No. 106. This Statement retains the disclosure
requirements contained in the original FASB Statement No. 132, which it
replaces. However, it requires additional disclosures to those in the original
Statement 132 about the assets, obligations, cash flows, and net periodic
benefit costs of defined benefit pension plans and other defined benefit
postretirement plans. The required information should be provided separately for
pension plans and for other postretirement benefit plans. The disclosures for
earlier annual periods presented for comparative purposes are required to be
restated for (a) the percentages of each major category of plan assets held, (b)
the accumulated benefit obligation, and (c) the assumptions used in the
accounting for the plans. This Statement is effective for financial statements
with fiscal years ending after December 15, 2003. The interim-period disclosures
required by this Statement are effective for interim periods beginning after
December 15, 2003. The Company has included the required disclosures in its
consolidated financial statements.
Note 2: Restriction on Cash
As members of the Federal Reserve System, the Company's subsidiary banks are
required to maintain certain average reserve balances. For the final weekly
reporting period in the years ended December 31, 2003 and 2002, the aggregate
amounts of daily average required balances approximated $2,463 and $2,092,
respectively.
Note 3: Securities
The amortized cost and fair value of securities available for sale, with
gross unrealized gains and losses, follows:
December 31, 2003
Gross Gross
Available for sale: Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
------------- -------------- ----------- ------------
U.S. Treasury $ 2,249 $ 91 $ --- $ 2,340
U.S. Government agencies and corporations 4,639 12 2 4,649
States and political subdivisions 80,872 2,524 282 83,114
Mortgage-backed securities 10,518 365 3 10,880
Corporate debt securities 24,609 773 319 25,063
------------- ----------
Federal Home Loan Bank stock-restricted 1,646 142 $ 606 1,646
----- ======
Federal Reserve Bank stock-restricted 209 $ 3,907 209
========
Other securities 1,257 1,399
----- -----
Total securities available for sale $125,999 $129,300
======== ========
December 31, 2002
Gross Gross
Amortized Unrealized Unrealized
Available for sale: Cost Gains Losses Fair Value
------------- -------------- ------------- -------------
U.S. Treasury $ 3,748 $ 214 $ --- $ 3,962
U.S. Government agencies and corporations 7,038 94 112 7,132
States and political subdivisions 68,876 1,928 67 70,692
-------------
Mortgage-backed securities 16,244 565 $179 16,809
======
Corporate debt securities 16,993 485 17,411
-------------
Federal Home Loan Bank stock-restricted 1,655 194 1,655
-----
Federal Reserve Bank stock-restricted 209 $3,480 209
========
Other securities 1,670 1,864
------ -----
Total securities available for sale $116,433 $119,734
======== ========
The amortized cost and fair value of single maturity securities available
for sale at December 31, 2003, by contractual maturity, are shown below.
Expected maturities may differ from contractual maturities because borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties. Mortgage-backed securities included in these totals are categorized
by final maturity at December 31, 2003.
38
Amortized Cost Fair Value
----------------- -----------------
Due in one year or less $ 3,531 $ 3,585
Due after one year through five years 11,285 11,722
Due after five years through ten years 75,087 76,690
Due after ten years 33,216 34,278
No maturity 2,880 3,025
----------------- -----------------
$ 125,999 $ 129,300
========= =========
The amortized cost and fair value of securities held to maturity, with gross
unrealized gains and losses, follows:
December 31, 2003
Gross Gross
Held to maturity: Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
------------- ------------ ------------ -----------
U.S. Government agencies and corporations $ 5,993 $ 73 $ 66 $ 6,000
States and political subdivisions 56,361 2,257 104 58,514
------------
Mortgage-backed securities 4,291 207 294 4,498
-----
Corporate debt securities 34,209 2,099 $ 464 36,014
------ ----- === ------
Total securities held to maturity $ 100,854 $4,636 $ 105,026
======= ===== =======
December 31, 2002
Gross Gross
Amortized Unrealized Unrealized
Held to maturity: Cost Gains Losses Fair Value
-------------- ----------- ------------ -------------
U.S. Government agencies and corporations $10,013 $ 193 $ --- $ 10,206
States and political subdivisions 52,610 1,693 48 54,255
------------
Mortgage-backed securities 8,989 399 83 9,388
----
Corporate debt securities 27,948 1,473 $ 131 29,338
------ ----- ====== ------
Total securities held to maturity $99,560 $ 3,758 $103,187
====== ===== ========
The amortized cost and fair value of single maturity securities held to
maturity at December 31, 2003, by contractual maturity, are shown below.
Expected maturities may differ from contractual maturities because borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties. Mortgage-backed securities included in these totals are categorized
by final maturity at December 31, 2003.
Amortized Fair
Cost Value
-------------- -------------
Due in one year or less $ 1,540 $ 1,597
Due after one year through five years 23,448 24,974
Due after five years through ten years 52,114 54,241
Due after ten years 23,752 24,214
------ ------
$ 100,854 $105,026
========= ========
Information regarding investments in an unrealized loss position at December
31, 2003 that are temporarily impaired follows:
Less Than 12 Months 12 Months or More Total
----------------------- -------------------- -------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
---------- ----------- --------- ---------- --------- ---------
US Government agencies
and corporations $ 2,934 68 $ --- --- $ 2,934 68
State and political
subdivisions 14,191 365 1,173 21 15,364 386
Mortgage-backed securities 704 3 --- --- 704 3
Corporate debt securities 14,217 613 --- --- 14,217 613
---------- ----------- --------- ---------- --------- ---------
Total temporarily
impaired securities $ 32,046 1,049 $ 1,173 21 $ 33,219 1,070
========== =========== ========= ========== ========= =========
39
The Company had 54 securities with a fair value of $33,219 which were
temporarily impaired at December 31, 2003. The total unrealized loss on these
securities was $1,070. Losses are attributed to interest rate movements. Credit
quality of the securities portfolio is continuously monitored by management. The
Company has the ability to hold these securities until maturity. Therefore, the
losses associated with these securities are not considered other than temporary
at December 31, 2003.
At December 31, 2003 and 2002, securities with a carrying value of $31,309
and $31,170, respectively, were pledged to secure trust deposits and for other
purposes as required or permitted by law.
As members of the Federal Reserve and the Federal Home Loan Bank (FHLB) of
Atlanta, NBB and BTC are required to maintain certain minimum investments in the
common stock of those entities. Required levels of investment are based upon NBB
and BTC's capital and a percentage of qualifying assets. In addition, NBB and
BTC are eligible to borrow from the FHLB with borrowings collateralized by
qualifying assets, primarily residential mortgage loans totaling approximately
$96,062, and NBB and BTC's capital stock investment in the FHLB.
Note 4: Loans to Officers and Directors
In the ordinary course of business, the Company, through its banking
subsidiaries, has granted loans to executive officers and directors of
Bankshares and its subsidiaries amounting to $5,037 at December 31, 2003 and
$5,505 at December 31, 2002. During the year ended December 31, 2003 total
principal additions were $1,914 and principal payments were $2,382.
Note 5: Allowance for Loan Losses
An analysis of the allowance for loan losses follows:
Years ended December 31,
2003 2002 2001
------------ ------------ -----------
Balance at beginning of year $ 5,092 $4,272 $ 3,886
Provision for loan losses 1,691 2,251 1,408
Loans charged off (1,660) (1,571) (1,128)
Recoveries of loans previously charged off 246 140 106
----- ----- -----
Balance at end of year $ 5,369 $5,092 $ 4,272
======== ======= ========
The following is a summary of information pertaining to impaired loans:
December 31,
2003 2002 2001
---------- ---------- --------
Impaired loans without a valuation allowance $ 365 $ 46 $ 275
Impaired loans with a valuation allowance 506 93 65
------ ------ ------
Total impaired loans $ 871 $ 139 $ 340
====== ====== ======
Valuation allowance related to impaired loans $ 135 $ 33 $ 39
====== ====== ======
Years ended December 31,
2003 2002 2001
--------- --------- --------
Average investment in impaired loans $353 $397 $671
Interest income recognized on impaired loans 66 11 57
Interest income recognized on a cash basis on
impaired loans --- --- ---
--------- --------- --------
No additional funds are committed to be advanced in connection with impaired
loans. Nonaccrual loans excluded from impaired loan disclosure under FASB 114 at
December 31, 2003 and 2002 were $8 and $166, respectively. If interest on these
loans had been accrued, such income would have been $0 and $16 respectively. No
nonaccrual loans were excluded from impaired loans, disclosed under FASB 114, at
December 31, 2002. Loans past due greater than 90 days which continue to accrue
interest totaled $931 and $977 at December 31, 2003 and 2002, respectively.
40
Note 6: Premises and Equipment
A summary of the cost and accumulated depreciation of premises and equipment
follows:
December 31,
2003 2002
-------------- --------------
Premises $ 11,419 $ 11,193
Furniture and equipment 8,835 7,772
Construction-in-progress 10 254
----- --------
$ 20,264 $ 19,219
Accumulated depreciation (10,170) (9,281)
--------- --------
$ 10,094 $9,938
========= ========
Depreciation expense for the years ended December 2003, 2002 and 2001
amounted to $924, $977 and $1,106, respectively.
The Company leases branch facilities under noncancellable operating leases.
The future minimum lease payments under these leases (with initial or remaining
lease terms in excess of one year) as of December 31, 2003 are as follows: $241
in 2004, $94 in 2005, $73 in 2006, $75 in 2007, $68 in 2008, and $143
thereafter.
Note 7: Deposits
The aggregate amounts of time deposits in denominations of $100 or more at
December 31, 2003 and 2002 were $95,216 and $89,261, respectively.
At December 31, 2003 the scheduled maturities of time deposits are as
follows:
-------------------------- ------------------------------
2004 $ 189,445
2005 41,953
2006 17,623
2007 30,784
2008 35,454
Thereafter 994
---------
$ 316,253
At December 31, 2003 and 2002, overdraft demand deposits reclassified to
loans totaled $1,276 and $407, respectively.
Note 8: Employee Benefit Plans
401(k) Plan
The Company has a Retirement Accumulation Plan qualifying under IRS Code
Section 401(k), in which Bankshares, NBB, BTC and NSFS are participating
employers. Eligible participants may contribute up to 100% of their total annual
compensation to the plan. Employee contributions are matched by the employer
based on a percentage of an employee's total annual compensation contributed to
the plan. For the years ended December 31, 2003, 2002 and 2001, NBB and BTC
contributed $231, $227 and $196, respectively, to the plan.
Employee Stock Ownership Plan
Bankshares has a nonleveraged Employee Stock Ownership Plan (ESOP) which
enables employees of Bankshares and its subsidiaries who have one year of
service and who have attained the age of 21 prior to the plan's January 1 and
July 1 enrollment dates to own Bankshares common stock. Contributions to the
ESOP are determined annually by the Board of Directors. Contribution expense
amounted to $389, $227 and $179 in the years ended December 31, 2003, 2002 and
2001, respectively. Dividends on ESOP shares are charged to retained earnings.
As of December 31, 2003, the number of allocated shares held by the ESOP was
97,566 and the number of unallocated shares was 9,179. All shares held by the
ESOP are treated as outstanding in computing the Company's basic net income per
share. Upon reaching age 55 with ten years of plan participation, a vested
participant has the right to diversify 50% of his or her allocated ESOP shares
and Bankshares or the ESOP, with the agreement of the Trustee, is obligated to
purchase those shares. The ESOP contains a put option which allows a withdrawing
participant to require Bankshares or the ESOP, if the plan administrator agrees,
to purchase his or her allocated shares if the shares are not readily tradable
on an established market at the time of its distribution.
Defined Benefit Plan
Effective January 1, 2002, the NBB plan was amended, restated, and renamed
The National Bankshares, Inc. Retirement Income Plan. At the same time, the BTC
plan was merged into it, and National Bankshares, Inc. and National Bankshares
Financial Services, Inc. were added as participating employers in the pension
plan. The merged NBI plan did not alter the eligibility standards of the bank
41
plans, and substantially all employees are covered. The merged NBI plan benefit
formula is still based upon the length of service of retired employees and a
percentage of qualified W-2 compensation during their final years of employment.
Information pertaining to activity in the plans is as follows:
December 31,
2003 2002 2001
----------------- ----------------- ---------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 7,078 $ 6,014 $ 5,668
Service cost 427 353 422
Interest cost 501 429 422
Actuarial (gain) loss 938 593 (53)
(Gain) due to plan amendment ------- ------- -------
Benefits paid (467) (222) (445)
------- ------- -------
Benefit obligation at end of year 8,477 7,078 6,014
------- ------- -------
Change in plan assets:
Fair value of plan assets at beginning of year 4,504 4,650 4,692
Actual return on plan assets 729 (239) 55
Employer contribution 649 315 348
Benefits paid (467) (222) (445)
------- ------- -------
Fair value of plan assets at end of year 5,415 4,504 4,650
------- ------- -------
Funded status (3,062) (2,574) (1,364)
Unrecognized net actuarial loss 2,693 2,177 931
Unrecognized prior service cost 64 73 171
Unrecognized transition asset (88) (100) (114)
------- ------- -------
Net accrued pension cost (includes accrued) $ (393) $ (424) $ (376)
======= ======= =======
The accumulated benefit obligations at December 31, 2003, 2002 and 2001 were
$6,456, 5,618 and $4,053 respectively. The estimated minimum contribution for
2004 is $623.
Amounts recognized in the consolidated balance sheets:
December 31,
2003 2002 2001
----------------- --------------- -------------
Accrued benefit liabilities $ (1,041) $ (1,113) $(376)
Intangible asset 64 73 ---
Deferred tax asset 227 235 ---
Accumulated other comprehensive income 357 381 ---
--------- --------- ---------
Net amount recognized $ (393) $ (424) $(376)
========= ========= =========
The components of net periodic cost are as follows:
Years ended December 31,
2003 2002 2001
--------------- ------------------- -----------------
Service cost $ 427 $ 353 $ 422
Interest cost 501 429 422
Expected return on plan assets (418) (427) (434)
Amortization of prior service cost 9 9 15
Recognized net actuarial loss 111 12 5
Amortization of transition asset (13) (13) (23)
---- ---- ----
Net periodic benefit cost $617 $ 363 $ 407
=== === ===
The weighted average assumptions used to determine benefit obligations are as
follows:
2003 2002 2001
--------------- ----------------- ---------------
Weighted average assumptions as of December 31,
Weighted average discount rate 6.50% 7.00% 7.50%
Rate of compensation increase 4.00% 4.00% 5.00%
42
The weighted average assumptions used to determine net periodic benefit cost are
as follows:
2003 2002 2001
--------------- ----------------- ---------------
Weighted average assumptions as of December 31,
Weighted average discount rate 7.00% 7.50% 7.50%
Expected return on plan assets 8.00% 9.00% 9.00%
Rate of compensation increase 4.00% 5.00% 5.00%
Long Term Rate of Return
The Company, as plan sponsor, selects the expected long-term
rate-of-return-on-assets assumption in consultation with its investment advisors
and actuary. This rate is intended to reflect the average rate of earnings
expected to be earned on the funds invested or to be invested to provide plan
benefits. Historical performance is reviewed - especially with respect to real
rates of return (net of inflation) - for the major asset classes held or
anticipated to be held by the trust, and for the trust itself. Undue weight is
not given to recent experience, - which may not continue over the measurement
period, - but other higher significance is placed on current forecasts of future
long-term economic conditions.
Because assets are held in a qualified trust, anticipated returns are not
reduced for taxes. Further, and solely for this purpose, the plan is assumed to
continue in force and not terminate during the period during which assets are
invested. However, consideration is given to the potential impact of current and
future investment policy, cash flow into and out of the trust, and expenses
(both investment and non-investment) typically paid from plan assets (to the
extent such expenses are not explicitly estimated within periodic cost).
The Company, as plan sponsor, has adopted a Pension Administrative Committee
Policy (the Policy) for monitoring the investment management of its qualified
plans. The Policy includes a statement of general investment principles and a
listing of specific investment guidelines, to which the committee may make
documented exceptions. The guidelines state that, unless otherwise indicated,
all investments that are permitted under the Prudent Investor Rule shall be
permissible investments for the pension plan. All plan assets are to be invested
in marketable securities. Certain investments are prohibited, including
commodities and future contracts, private placements, repurchase agreements,
options and derivatives and stocks and ADR's of non-U.S. companies. The Policy
establishes quality standards for fixed income investments and mutual funds
included in the pension plan trust. The Policy also outlines diversification and
asset allocation standards.
Asset Allocation
2003 2002
- ----------------------------------- ----------------- -------------------
U.S. Government agency 11% 21%
obligations
Mutual funds 40% 24%
Corporate bonds 18% 24%
Equity securities 29% 23%
Cash 2% 8%
----------------- -------------------
100% 100%
Note 9: Stock Option Plan
The Company has adopted the National Bankshares, Inc. 1999 Stock Option Plan
to give key employees of Bankshares and its subsidiaries an opportunity to
acquire shares of National Bankshares, Inc. common stock. The purpose of the
1999 Stock Option Plan is to promote the success of Bankshares and its
subsidiaries by providing an incentive to key employees that enhances the
identification of their personal interest with the long term financial success
of the Company and with growth in stockholder value. Under the 1999 Stock Option
Plan, up to 250,000 shares of Bankshares common stock may be granted. The 1999
Stock Option Plan is administered by the Stock Option Committee, which is the
NBI Board of Directors' Compensation Committee, made up entirely of independent
directors of National Bankshares, Inc. The Stock Option Committee may determine
whether options are incentive stock options or nonqualified stock options and
may determine the other terms of grants, such as number of shares, term, a
vesting schedule, and the exercise price. The 1999 Stock Option Plan limits the
maximum term of any option granted to ten years, states that options may be
granted at not less than fair market value on the date of the grant and contains
certain other limitations on the exercisability of incentive stock options. The
options vest 25% after one year, 50% after two years, 75% after three years and
100% after four years. At the discretion of the Stock Option Committee, options
may be awarded with the provision that they may be accelerated upon a change of
control, merger, consolidation, sale or dissolution of National Bankshares, Inc.
At December 31, 2003, there were 182,000 additional shares available for grant
under the Plan.
43
A summary of the status of the Company's stock option plan is presented below:
2003 2002 2001
------ ------ ------
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Shares Price Shares Price Shares Price
----------- ----------- ------------- ----------- ---------- ------------
Outstanding, beginning of year 51,500 $ 24.06 34,000 $ 21.18 18,000 $ 19.57
Granted 16,500 46.65 17,500 29.65 16,000 23.00
Exercised (4,000) 19.16 --- --- --- ---
------- ------ ------
Outstanding, end of year 64,000 $ 30.20 51,500 $ 24.06 34,000 $ 21.18
====== ====== ======
Options exercisable at year-end 24,125 $ 22.74 14,375 $ 20.76 5,875 $ 20.14
Weighted-average fair value of
options granted during the year $ 10.65 $ 5.97 $ 4.89
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:
Years Ended December 31,
----------------------------------------------------
2003 2002 2001
----------------- ----------------- ----------------
Dividend yield 1.73% 1.88% 1.86%
Expected life 10 years 10 years 10 years
Expected volatility 22.14% 22.14% 22.77%
Risk-free interest rate 4.82% 4.31% 4.48%
Information pertaining to options outstanding at December 31, 2003 is as
follows:
Options Outstanding Options Exercisable
--------------------- ---------------------
Remaining Range of Number Weighted Number Weighted
Contractual Life Exercise Price Outstanding Average Exercisable Average
Exercise Price Exercise Price
------------------- ----------------- ------------------ ----------------- ----------------- ------------------
9.83 years $46.65 16,500 $46.65 --- $ ---
8.83 years 29.65 17,500 29.65 --- 29.65
7.83 years 23.00 16,000 23.00 8,000 23.00
6.83 years 18.50 9,000 18.50 6,750 18.50
5.83 years 22.00 5,000 22.00 5,000 22.00
Note 10: Income Taxes
Allocation of income tax expense between current and deferred portions is as
follows:
Years ended December 31,
--------------------------
2003 2002 2001
----------- ----------- -----------
Current $ 3,436 $ 3,554 $ 2,451
Deferred (200) (551) (166)
-------- -------- --------
Total income tax expense $ 3,003 $ 2,285 $ 3,236
======== ======== ========
The following is a reconciliation of the "expected" income tax expense,
computed by applying the U.S. Federal income tax rate of 35% in 2003 and 34% in
2002 and 2001 to income before income tax expense, with the reported income tax
expense:
Years ended December 31,
--------------------------
2003 2002 2001
------------ ---------- ----------
Computed "expected" income tax expense $ 5,137 $ 4,426 $ 3,264
Tax-exempt interest income (1,977) (1,652) (1,239)
Nondeductible interest expense 169 191 220
Other, net (93) 38 40
-------- -------- --------
Reported income tax expense $ 3,236 $ 3,003 $ 2,285
======== ======== ========
44
The components of the net deferred tax asset, included in other assets, are as
follows:
December 31,
--------------
2003 2002
------------- --------------
Deferred tax assets:
Allowance for loan losses and unearned fee income $ 1,760 $ 1,514
Valuation allowance on other real estate owned 31 14
Deferred compensation and other liabilities 421 349
Deposit intangibles and goodwill 100 87
Community development corporation related tax credit 4 8
Other --- ---
-------- ---------
$ 2,316 $ 1,972
-------- ---------
Deferred tax liabilities:
Net unrealized losses on securities available for sale $(1,154) $(1,122)
Fixed assets (222) (71)
Discount accretion on securities (82) (94)
Other (99) (94)
-------- ---------
Net deferred tax asset $(1,557) $(1,381)
-------- ---------
$ 759 $ 591
======== =========
The Company has determined that a valuation allowance for the gross deferred
tax assets is not necessary at December 31, 2003 and 2002 due to the fact that
the realization of the entire gross deferred tax assets can be supported by the
amount of taxes paid during the carryback period available under current tax
laws.
Note 11: Restrictions on Dividends
Bankshares' principal source of funds for dividend payments is dividends
received from its subsidiary banks. For the years ended December 31, 2003, 2002,
and 2001, dividends received from subsidiary banks were $5,377, $3,406 and
$3,761, respectively.
Substantially all of Bankshares' retained earnings are undistributed
earnings of its banking subsidiaries, which are restricted by various
regulations administered by federal and state bank regulatory agencies. Bank
regulatory agencies restrict, without prior approval, the total dividend
payments of a bank in any calendar year to the bank's retained net income of
that year to date, as defined, combined with its retained net income of the
preceding two years, less any required transfers to surplus. At December 31,
2003, retained net income, which was free of such restriction, amounted to
approximately $16,292.
Note 12: Minimum Regulatory Capital Requirement
The Company (on a consolidated basis) and the subsidiary banks are subject
to various regulatory capital requirements administered by the federal banking
agencies. Failure to meet minimum capital requirements can initiate certain
mandatory and possibly additional discretionary actions by regulators that, if
undertaken, could have a direct material effect on the Company's and the banks'
financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Company and the banks must meet
specific capital guidelines that involve quantitative measures of their assets,
liabilities, and certain off balance sheet items as calculated under regulatory
accounting practices. The capital amounts and classification are also subject to
qualitative judgments by regulators about components, risk weightings, and other
factors. Prompt corrective action provisions are not applicable to bank holding
companies.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the banks to maintain minimum amounts and ratios (set
forth in the following table) of total and Tier 1 capital (as defined in the
regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as
defined) to average assets (as defined). Management believes, as of December 31,
2003 and 2002, that the Company and the banks meet all capital adequacy
requirements to which they are subject.
As of December 31, 2003, the most recent notifications from the appropriate
regulatory authorities categorized the banks as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized, an institution must maintain minimum total risk-based, Tier 1
risk-based, and Tier 1 leverage ratios as set forth in the following tables.
There are no conditions or events since these notifications that management
believes have changed the banks' category. The Company's and the banks' actual
capital amounts and ratios as of December 31, 2003 and 2002 are also presented
in the following tables.
45
To Be Well
Capitalized Under
Minimum Capital Prompt Corrective
Actual Requirement Action Provisions
--------------------- -------------------- -----------------------
Amount Ratio Amount Ratio Amount Ratio
---------- ---------- ---------- --------- ------------ ----------
December 31, 2003
Total capital (to risk weighted assets)
Bankshares consolidated $74,260 15.0% $39,567 8.00% N/A N/A
NBB 41,084 14.1% 23,267 8.00% $ 29,084 10.00%
BTC 28,510 14.3% 15,968 8.00% 19,961 10.00%
Tier 1 capital (to risk weighted assets)
Bankshares consolidated $68,891 13.9% $19,784 4.00% N/A N/A
NBB 37,903 13.0% 11,634 4.00% $ 17,450 6.00%
BTC 26,322 13.2% 7,984 4.00% 11,976 6.00%
Tier 1 capital (to average assets)
Bankshares consolidated $68,891 9.9% $27,687 4.00% N/A N/A
NBB 37,903 9.7% 15,611 4.00% $ 19,514 5.00%
BTC 26,322 8.9% 11,758 4.00% 14,697 5.00%
To Be Well
Capitalized Under
Minimum Capital Prompt Corrective
Actual Requirement Action Provisions
---------------------- --------------------- ----------------------
Amount Ratio Amount Ratio Amount Ratio
----------- ---------- ---------- ---------- ----------- ----------
December 31, 2002
Total capital (to risk weighted assets)
Bankshares consolidated $65,525 13.8% $ 37,980 8.0% N/A N/A
NBB 36,370 13.5% 21,518 8.0% $ 26,897 10.0%
BTC 25,808 12.8% 16,183 8.0% 20,229 10.0%
Tier 1 capital (to risk weighted assets)
$60,433 12.7% $ 18,990 4.0% N/A N/A
Bankshares consolidated 33,398 12.4% 10,759 4.0% $ 16,138 6.0%
NBB 23,688 11.7% 8,092 4.0% 12,138 6.0%
BTC
Tier 1 capital (to average assets)
$60,433 9.0% $ 26,791 4.0% N/A N/A
Bankshares consolidated 33,398 8.9% 14,924 4.0% $ 18,655 5.0%
NBB 23,688 8.1% 11,632 4.0% 14,541 5.0%
BTC
46
Note 13: Condensed Financial Statements of Parent Company
Financial information pertaining only to Bankshares (Parent) is as follows:
Consolidated Balance Sheets
December 31,
2003 2002
------------ -------------
Assets Cash due from subsidiaries $ 621 $ 40
Securities available for sale 3,454 2,913
Investments in subsidiaries, at equity 76,521 70,298
Refundable income taxes due from 111 ---
subsidiaries
Other assets 188 59
------ ------
Total assets $80,784 $73,310
====== ======
Liabilities Other liabilities $143 $209
And Stockholders' equity 80,641 73,101
Stockholders' ------ ------
Equity Total liabilities and
stockholders' equity $80,784 $73,310
====== ======
Condensed Statements of Income
Years Ended December 31,
2003 2002 2001
----------- ------------ ------------
Income Dividends from Subsidiaries $5,377 $3,406 $3,761
- ------ Interest on securities - taxable 13 27 12
Interest on securities - nontaxable 109 86 91
Other income 616 462 ---
Securities gains (losses) (1) 319 (13)
------- ------- ------
6,114 4,300 3,851
Expenses Other expenses 970 798 207
- -------- ------- ------- ------
Income before income tax benefit (expense) and
equity in undistributed net income of subsidiaries 5,144 3,502 3,644
Applicable income tax benefit (expense) 120 (1) 69
------- ------- ------
Income before equity in undistributed net income
of subsidiaries 5,264 3,501 3,713
Equity in undistributed net income of subsidiaries 6,178 6,513 3,601
------- ------- ------
Net income $11,442 $10,014 $7,314
========= ========= ========
Condensed Statements of Cash Flows
Years ended December 31,
2003 2002 2001
------------- -------------- -------------
Cash Flows Net income $ 11,442 $ 10,014 $ 7,314
From Adjustments to reconcile net income to net
Operating cash provided by operating activities:
Expenses Equity in undistributed net income of
subsidiaries (6,178) (6,513) (3,601)
Amortization of premiums and accretion
of discounts, net 4 5 5
Depreciation expense 1 --- ---
Cash Flows Securities (gains) losses 1 (319) 13
from Investing Net change in refundable income taxes
Activities due from subsidiaries (111) --- (18)
Net change in other assets (18) (29) 3
Net change in other liabilities (40) 12 102
--------- -------- ---------
Net cash provided by operating
activities 5,101 3,170 3,818
--------- -------- ---------
Purchases of securities available for sale (1,105) (730) (777)
47
Proceeds from sales of securities available
for sale 406 827 ---
Calls of securities available for sale 73 103 25
--------- -------- ---------
Net cash provided by (used in)
investing activities (626) 200 (752)
--------- -------- ---------
Cash Flows Cash dividends paid (3,971) (3,406) (3,020)
from Common stock repurchase --- --- (8)
Financing Exercise of stock option 77 --- ---
Activities --------- -------- ---------
Net cash used in financing activities (3,894) (3,406) (3,028)
--------- -------- ---------
Net change in cash 581 (36) 38
Cash due from subsidiaries at beginning
of year 40 76 38
--------- -------- ---------
Cash due from subsidiaries at end of year $ 621 $ 40 $ 76
========= ======== =========
Note 14: Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit; standby
letters of credit and interest rate locks. 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 instrument for commitments to extend credit and
standby letters of credit, is represented by the contractual amount of those
instruments. The Company uses the same credit policies in making commitments and
conditional obligations as it does for on-balance sheet instruments. The Company
may require collateral or other security to support the following financial
instruments with credit risk.
At December 31, 2003, and 2002, financial instruments were outstanding whose
contract amounts represent credit risk:
Financial instruments whose contract amounts December 31,
represent credit risk: 2003 2002
- -------------------------------------------- --------------- ---------------
Commitments to extend credit $ 85,903 $ 64,788
Standby letters of credit 6,557 7,153
Mortgage loans sold with potential recourse 37,171 37,214
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation 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 for equity lines of credit may expire
without being drawn upon. Therefore, the total commitment amounts do not
necessarily represent future cash requirements. The amount of collateral
obtained, if it is deemed necessary by the Company, is based on management's
credit evaluation of the customer.
Unfunded commitments under commercial lines of credit, revolving credit
lines, and overdraft protection agreements are commitments for possible future
extensions of credit. Some of these commitments are uncollateralized and do not
contain a specified maturity date and may not be drawn upon to the total extent
to which the Company is committed.
Standby letters of credit are conditional commitments issued by the Company
to guarantee the performance of a customer to a third party. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loans to customers. Collateral held varies but may include accounts
receivable, inventory, property, plant and equipment, and income-producing
commercial properties.
The Company originates mortgage loans for sale to secondary market investors
subject to contractually specified and limited recourse provisions. In 2003, the
Company originated $37,039 and sold $37,171 to investors, compared to $36,915
originated and $37,214 sold in 2002. Every contract with each investor contains
certain recourse language. In general, the Company may be required to repurchase
a previously sold mortgage loan if there is major noncompliance with defined
loan origination or documentation standards, including fraud, negligence or
material misstatement in the loan documents. Repurchase may also be required if
necessary governmental loan guarantees are canceled or never issued, or if an
investor is forced to buy back a loan after it has been resold as a part of a
loan pool. In addition, the Company may have an obligation to repurchase a loan
if the mortgagor has defaulted early in the loan term. This potential default
period is approximately twelve months after sale of a loan to the investor.
At December 31, 2003, the Company had locked-rate commitments to originate
mortgage loans amounting to approximately $633 and loans held for sale of $714.
The Company has entered into commitments, on a best-effort basis, to sell loans
of approximately $1,084. Risks arise from the possible inability of
counterparties to meet the terms of their contracts. The Company does not expect
any counterparty to fail to meet its obligations.
The Company maintains cash accounts in other commercial banks. The amount on
deposit with correspondent institutions at December 31, 2003 that exceeded the
insurance limits of the Federal Deposit Insurance Corporation was $106.
48
Note 15: Concentrations of Credit Risk
The Company does a general banking business, serving the commercial and
personal banking needs of its customers. NBB's market area, commonly referred to
as Virginia's New River Valley and Mountain Empire, consists of Montgomery,
Giles and Pulaski Counties and the cities of Radford and Galax, together with
portions of adjacent counties. BTC's market area adjoins NBB's and includes the
counties of Tazewell, Wythe, Smyth and Washington in Virginia, as well as
contiguous portions of McDowell and Mercer Counties in West Virginia.
Substantially all of NBB's and BTC's loans are made within their market area.
The ultimate collectibility of the banks' loan portfolios and the ability to
realize the value of any underlying collateral, if needed, are influenced by the
economic conditions of the market area. The Company's operating results are
therefore closely correlated with the economic trends within this area.
At December 31, 2003 and 2002, approximately $203,646 and $201,639,
respectively, of the loan portfolio was concentrated in commercial real estate.
This represents approximately 50% and 49% of the loan portfolio at December 31,
2003 and 2002, respectively. Included in commercial loans at December 31, 2003
and 2002 was approximately $169,340 and $96,674, respectively, in loans for
college housing and professional office buildings. This represents approximately
42% and 24% of the loan portfolio at December 31, 2003 and 2002, respectively.
Loans secured by residential real estate were approximately $114,590 and
$116,337 at December 31, 2003 and 2002, respectively. This represents
approximately 28% of the loan portfolio at December 31, 2003 and 2002. Loans
secured by automobiles were approximately $18,219 and $23,526 at December 31,
2003 and 2002, respectively. This represents approximately 4% of the loan
portfolio at December 31, 2003 and 6% at December 31, 2002.
The Company has established operating policies relating to the credit
process and collateral in loan originations. Loans to purchase real and personal
property are generally collateralized by the related property and with loan
amounts established based on certain percentage limitations of the property's
total stated or appraised value. Credit approval is primarily a function of
collateral and the evaluation of the creditworthiness of the individual borrower
or project based on available financial information. Management considers the
concentration of credit risk to be minimal.
Note 16: Fair Value of Financial Instruments and Interest Rate Risk
The fair value of a financial instrument is the current amount that would be
exchanged between willing parties, other than in a forced liquidation. Fair
value is best determined based upon quoted market prices. However, in many
instances, there are no quoted market prices for the Company's various financial
instruments. In cases where quoted market prices are not available, fair values
are based on estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, including the
fair discount rate and estimates of future cash flows. Accordingly, the fair
value estimates may not be realized in an immediate settlement of the
instrument. SFAS No. 107 excludes certain financial instruments and all
nonfinancial instruments from its disclosure requirements. Accordingly, the
aggregate fair value amounts presented may not necessarily represent the
underlying fair value of the Company.
The Company assumes interest rate risk (the risk that general interest rate
levels will change) as a result of its normal operations. As a result, the fair
values of the Company's financial instruments will change when interest rate
levels change and that change may be either favorable or unfavorable to the
Company. Management attempts to match maturities of assets and liabilities to
the extent believed necessary to minimize interest rate risk. However, borrowers
with fixed rate obligations are less likely to prepay in a rising rate
environment. Conversely, depositors who are receiving fixed rates are more
likely to withdraw funds before maturity in a rising rate environment and less
likely to do so in a falling rate environment. Management monitors rates and
maturities of assets and liabilities and attempts to minimize interest rate risk
by adjusting terms of new loans and deposits.
The following methods and assumptions were used by the Company in estimating
fair value disclosures for financial instruments: Cash and Due from Banks,
Interest-Bearing Deposits, and Federal Funds Sold
The carrying amounts approximate fair value.
Securities
The fair values of securities are determined by quoted market prices or
dealer quotes. The fair value of certain state and municipal securities is not
readily available through market sources other than dealer quotations, so fair
value estimates are based on quoted market prices of similar instruments
adjusted for differences between the quoted instruments and the instruments
being valued.
Loans Held for Sale
Fair values of loans held for sale are based on commitments on hand from
investors or prevailing market
prices.
Loans
Fair values are estimated for portfolios of loans with similar financial
characteristics. Loans are segregated by type such as commercial, real estate -
commercial, real estate - construction, real estate - mortgage, credit card and
other consumer loans. Each loan category is further segmented into fixed and
adjustable rate interest terms and by performing and nonperforming categories.
The fair value of performing loans is calculated by discounting scheduled
cash flows through the estimated maturity using estimated market discount rates
that reflect the credit and interest rate risk inherent in the loan, as well as
estimates for prepayments. The estimate of maturity is based on the Company's
historical experience with repayments for loan classification, modified, as
required, by an estimate of the effect of economic conditions on lending.
Fair value for significant nonperforming loans is based on estimated cash
49
flows which are discounted using a rate commensurate with the risk associated
with the estimated cash flows. Assumptions regarding credit risk, cash flows and
discount rates are judgmentally determined using available market information
and specific borrower information.
Deposits
The fair value of demand and savings deposits is the amount payable on
demand. The fair value of fixed maturity term deposits and certificates of
deposit is estimated using the rates currently offered for deposits with similar
remaining maturities.
Accrued Interest
The carrying amounts of accrued interest approximate fair value.
Other Borrowed Funds
Other borrowed funds, represents treasury tax and loan deposits, and
short-term borrowings from the Federal Home Loan Bank. The carrying amount is a
reasonable estimate of fair value because the deposits are generally repaid
within 120 days from the transaction date.
Commitments to Extend Credit and Standby Letters of Credit
The only amounts recorded for commitments to extend credit, standby letters
of credit and financial guarantees written are the deferred fees arising from
these unrecognized financial instruments. These deferred fees are not deemed
significant at December 31, 2003 and 2002, and as such, the related fair values
have not been estimated.
The estimated fair values, and related carrying amounts, of the Company's
financial instruments are as follows:
December 31,
2003 2002
----------------------------- ----------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
-------------- -------------- -------------- -------------
Financial assets:
Cash and due from banks $ 11,733 $ 11,733 $ 12,316 $ 12,316
Interest-bearing deposits 36,220 36,220 18,818 18,818
Federal funds sold --- --- 1,724 1,724
Securities 230,154 234,326 219,294 222,921
Mortgage loans held for sale 714 714 846 846
Loans, net 401,428 405,304 404,247 406,844
Accrued interest receivable 4,610 4,610 4,290 4,290
Financial liabilities:
Deposits $ 625,378 $ 628,415 $ 608,271 $ 611,448
Other borrowed funds 135 135 748 748
Accrued interest payable 489 489 700 700
Note 17: Selected Quarterly Data (Unaudited)
The following is a summary of the unaudited quarterly results of operations
for the years ended December 31, 2003 and 2002:
2003
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------------- --------------- -------------- -------------
Income Statement Data:
Interest income $ 10,476 $ 10,396 $ 10,262 $ 9,947
Interest expense 3,478 3,256 2,840 2,678
--------- --------- --------- ---------
Net interest income 6,998 7,140 7,422 7,269
Provision for loan losses 440 402 435 414
Noninterest income 1,369 1,504 1,522 1,791
Noninterest expense 4,567 4,569 4,704 4,806
Income taxes 728 872 894 742
--------- --------- --------- ---------
Net income $ 2,632 $ 2,801 $ 2,911 $ 3,098
========= ========= ========= =========
Per Share Data:
Basic net income per share $ 0.75 $ 0.80 $ 0.83 $ 0.88
Fully diluted net income per share $ 0.75 $ 0.79 $ 0.82 $ 0.88
Cash dividends per share --- $ 0.54 --- $ 0.59
Book value per share $ 21.57 $ 22.34 $ 22.56 $ 22.94
50
2002
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------------- --------------- -------------- -------------
Income Statement Data:
Interest income $ 10,594 $ 10,645 $ 10,760 $ 10,748
Interest expense 4,266 3,960 3,783 3,755
--------- --------- --------- ---------
Net interest income 6,328 6,685 6,977 6,993
Provision for loan losses 646 546 519 540
Noninterest income 1,369 1,546 1,482 1,315
Noninterest expense 4,389 4,348 4,380 4,310
Income taxes 558 790 848 807
--------- --------- --------- ---------
Net income $ 2,104 $ 2,547 $ 2,712 $ 2,651
========= ========= ========= =========
Per Share Data:
Basic net income per share $ 0.60 $ 0.72 $ 0.78 $ 0.75
Fully diluted net income per share $ 0.60 $ 0.72 $ 0.78 $ 0.75
Cash dividends per share --- $ 0.46 --- $ 0.51
Book value per share $ 19.20 $ 19.79 $ 20.80 $ 20.82
Note 18: Proposed Acquisitions
On December 24, 2003, the Company's BTC subsidiary entered into an agreement
to acquire the loans and assume the deposit liabilities of the Richlands,
Virginia branch office of FNB Southeast of Reidsville, North Carolina. BTC
received approval for this transaction from its primary regulator, the Federal
Reserve Bank, on February 18, 2004. The transaction, which does not include the
purchase of fixed assets, is expected to close in the first half of 2004. When
it is consummated, the purchase and assumption will add approximately $8.0
million in loans and approximately $18.6 million in deposits. The Company has
determined that the transaction does not constitute the acquisition of a
business, and therefore will be accounted for under the provisions of SFAS No.
72, Accounting for Certain Acquisitions of Banking or Thrift Institutions.
The Company's NBB subsidiary entered into an agreement with The South
Financial Group of Greenville, South Carolina on February 2, 2004. The contract
provides that NBB will purchase substantially all of the assets and assume
substantially all of the liabilities of The South Financial Group's wholly-owned
subsidiary, Community National Bank located in Pulaski, Virginia. This
transaction, which is subject to regulatory approval, is planned to close in the
first half of 2004. It is expected to add approximately $53.0 million in
deposits and approximately $67.8 million in total assets. Any goodwill and
intangible assets arising from the transaction will be accounted for under the
provisions of SFAS No. 142, Goodwill and Other Intangible Assets.
51
Independent Auditor's Report
To the Board of Directors and Stockholders
National Bankshares, Inc.
Blacksburg, Virginia
We have audited the accompanying consolidated balance sheets of National
Bankshares, Inc. and subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of income, changes in stockholders' equity and
cash flows for the years ended December 31, 2003, 2002 and 2001. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of National Bankshares,
Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for the years ended December 31, 2003, 2002 and
2001 in conformity with accounting principles generally accepted in the United
States of America.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia
January 21, 2004 (except for Note 18, as to which the date is February 2, 2004)
52
Item 9. Changes In and Disagreements With Accountants on Accounting and
Financial Disclosure
None
Item 9A. Controls and Procedures
Under the supervision and with the participation of management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this annual
report. Based on that evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. There were no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation.
Disclosure controls and procedures are our controls and procedures that are
designed to ensure that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act is accumulated and
communicated to our management, including our principal executive officer and
principal financial officer, as appropriate, to allow timely decisions regarding
required disclosure.
Part III
Item 10. Directors and Executive Officers of the Registrant
Information with respect to the directors of Bankshares is set out under the
caption "Election of Directors" on pages 2 through 3 of Bankshares' Proxy
Statement dated March 15, 2004 which information is incorporated herein by
reference.
The Board of Directors of Bankshares has a standing audit committee
made up entirely of independent directors, as that term is defined in the
Nasdaq Stock Market Rules. Dr. J. R. Stewart chairs the Audit Committee
and its members are Mr. J. A. Deskins, Mr. P. A. Duncan and Dr. J. M. Lewis.
Each member of the Audit Committee has extensive business experience;
however, the Committee has identified Dr. Lewis as its financial expert, since
he has a professional background which involves financial oversight
responsibilities. Dr. Lewis currently oversees the preparation of financial
statements in his role as President of New River Community College. He
previously served as the College's Chief Financial Officer.
The Company and each of its subsidiaries have adopted Codes of Ethics for
directors, officers and employees, specifically including the Chief Executive
Officer and Chief Financial Officer of Bankshares. These Codes of Ethics are
available on the Company's web site at www.nationalbankshares.com.
The following is a list of names and ages of all executive officers of
Bankshares; their terms of office as officers; the positions and offices within
Bankshares held by each officer; and each person's principal occupation or
employment during the past five years.
================================================================================
Year Elected an
Name Age Offices and Positions Held Officer/Director
- --------------------------------------------------------------------------------
James G. Rakes 59 Chairman, President and Chief Executive 1986
Officer, National Bankshares, Inc.;
President and Chief Executive Officer of
The National Bank of Blacksburg since 1983.
President and Treasurer of National
Bankshares Financial Services, Inc. since
2001.
- --------------------------------------------------------------------------------
J. Robert Buchanan 52 Treasurer, National Bankshares, Inc.; 1998
Executive Vice President, Chief Operating
Officer and Secretary of Bank of Tazewell
County since 2003; prior thereto Cashier
and Senior Vice President/Chief Financial
Officer of The National Bank of Blacksburg
since 1998.
- --------------------------------------------------------------------------------
Marilyn B. Buhyoff 55 Secretary & Counsel, National Bankshares, 1989
Inc.; Counsel of the National Bank of
Blacksburg since 1989 and prior thereto
Senior Vice President/ Administration,
since 1992. Secretary of National
Bankshares Financial Services, Inc. since
2001and Executive Vice President since 2004
- --------------------------------------------------------------------------------
F. Brad Denardo 51 Corporate Officer, National Bankshares, 1989
Inc.; Executive Vice President/Chief
Operating Officer of the National Bank of
Blacksburg since 2002; prior thereto
Executive Vice President/Loans of The
National Bank of Blacksburg since 1989.
================================================================================
51
Item 11. Executive Compensation
The information set forth under "Executive Compensation" on pages 5 through
6 of Bankshares' Proxy Statement dated March 15, 2004 is incorporated herein by
reference.
The following table summarizes information concerning National Bankshares
equity compensation plans at December 31, 2003:
Number of Shares
Remaining Available
for Future Issuance
Number of Shares to Weighted Average Under Equity
be Issued upon Exercise Price of Compensation Plans
Exercise of Outstanding (Excluding Shares
Outstanding Options Options and Reflected in First
Plan Category and Warrants Warrants Column)
- --------------------------------------- --------------------- -------------------- ---------------------
Equity compensation plans approved by
shareholders-1999 Stock Incentive Plan 64,000 $ 30.20 182,000
- --------------------------------------- --------------------- -------------------- ---------------------
Equity compensation plans not
approved by shareholders --- --- ---
- --------------------------------------- --------------------- -------------------- ---------------------
Total 64,000 $ 30.20 182,000
- --------------------------------------- ===================== ==================== =====================
Item 12. Security Ownership of Certain Beneficial Owners and Management And
Related Stockholder Matters
Certain responses to this Item will be included under the caption "Stock
Ownership of Directors and Executive Officers" on pages 1 and 2 of Bankshares'
Proxy Statement dated March 15, 2004 for the Annual Meeting of Stockholders to
be held April 13, 2004 which was filed on March 15, 2004.
Item 13. Certain Relationships and Related Transactions
The information contained under "Certain Transactions With Officers and
Directors" on page 14 of Bankshares' Proxy Statement dated March 15, 2004 is
incorporated herein by reference.
Item 14. Principal Accounting Fees and Services
The following fees were paid to Yount, Hyde & Barbour, P.C., Certified
Public Accountants & Management Consultants, for services provided to Bankshares
for the year ended December 31, 2003. The Audit Committee determined that the
provision of non-audit services by Yount, Hyde & Barbour P.C. did not compromise
the firm's ability to maintain its independence.
Principal Accounting Fees and Services
2003 2002
---------------------- ----------------------
Fees Percentage Fees Percentage
---------- ----------- ---------- -----------
Audit fees $53,000 71% $47,395 58%
Audit-related fees 16,800 23% 19,382 24%
Tax fees 4,550 6% 6,385 8%
All other fees --- 0% 8,050 10%
---------- ----------- ---------- -----------
$74,350 100% $81,212 100%
========== =========== ========== ===========
Audit fees: Audit and review services and review of documents filed with
the SEC.
Audit-related fees: Employee benefit plan audits, accounting assistance
with proposed acquisitions, and consultation concerning financial accounting and
reporting standards.
Tax fees: Preparation of federal and state tax returns, review of
quarterly estimated tax payments, and consultation concerning tax compliance
issues.
All other fees: Information systems network vulnerability testing.
54
The Audit Committee of the Board of Directors of Bankshares meets in
advance and specifically approves of the provision of all services of Yount,
Hyde & Barbour, P.C.
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
15 (a) 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)
3(i) Articles of Amendment to Articles of Page 62
Incorporation of National Bankshares, Inc.,
dated April 8, 2003.
4(i) Specimen copy of certificate for National (incorporated
Bankshares, Inc. common stock, $2.50 par herein by reference
value to Exhibit 4(a) of
the Annual Report
on Form 10K for
Fiscal year ended
December 31, 1993)
4(i) Article Four of the Articles of Incorporation (incorporated
of National Bankshares, Inc. included in herein by reference
Exhibit No. 3(a) 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 reference
Technology, Inc. and The National Bank of to Exhibit 10(e)
Blacksburg of the Annual
Report on Form
10K for Fiscal year
ended December 31,
1992)
*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)
*10(iii)(A) Employment Agreement dated January 2002 (incorporated
between National Bankshares, Inc. and herein by reference
James G. Rakes to Exhibit 10(iii)
(A) of Form 10Q for
the period ended
June 30, 2002)
*10(iii)(A) Employee Lease Agreement dated August 14, (incorporated
2002, between National Bankshares, Inc. and herein by reference
The National Bank of Blacksburg to Exhibit 10 (iii)
(A) of Form 10Q for
the period ended
September 30, 2002)
*10(iii)(A) Change in Control Agreement dated January 5, (incorporated
2003, between National Bankshares, Inc. and herein by reference
Marilyn B. Buhyoff to Exhibit 10 (iii)
(A) of Form 10K for
the period ended
December 31, 2002)
*10(iii)(A) Change in Control Agreement dated January 8, (incorporated
2003, between National Bankshares, Inc. and herein by reference
F. Brad Denardo to Exhibit 10 (iii)
(A) of Form 10K for
the period ended
December 31, 2002)
*10(iii)(A) Change in Control Agreement dated June 1, (incorporated
1998, between Bank of Tazewell County and herein by reference
Cameron L.Forester to Exhibit 10 (iii)
(A) of Form 10K for
the period ended
December 31, 2002)
21(i) Subsidiaries of National Bankshares, Inc. Page 63
23 Consent of Yount, Hyde & Barbour, P.C. to Page 64
incorporation by reference of independent
auditor's report included in this Form 10-K,
into registrant's registration statement on
Form S-8.
31(i) Section 906 Certification of Chief Executive Page 57
Officer
31(ii) Section 906 Certification of Chief Financial Page 58
Officer
32(i) 18 U.S.C. Section 1350 Certification of Chief Page 60
Executive Officer
32(ii) 18 U.S.C. Section 1350 Certification of Chief Page 60
Financial Officer
*Indicates a management contract or compensatory plan required to be filed
herein.
55
15 (b) Reports on Form 8-K filed during the last quarter of the
period covered by this report:
On October 17, 2003, the Company filed a report on Form 8-K reporting
the issuance of a press release announcing earnings for the third
quarter of 2003.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, National Bankshares, Inc. has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
NATIONAL BANKSHARES, INC.
/s/ JAMES G. RAKES
-------------------------
James G. Rakes
Chairman, President & Chief Executive Office
(Principal Executive Officer)
/s/ J. ROBERT BUCHANAN
J. Robert Buchanan
Treasurer
(Principal Financial Officer)
56
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Registrant and
in the capacities and on the date indicated.
Name Date Title
- ---- ---- -----
/s/ L. A. BOWMAN 03/11/2004 Director
- ---------------------- ----------
L. A. Bowman
/s/ J. A. DESKINS, SR. 03/11/2004 Director
- ----------------------------- ----------
J. A. Deskins, Sr.
/s/ P. A. DUNCAN 03/11/2004 Director
- ---------------------- ----------
P. A. Duncan
/s/ J. M. LEWIS 03/11/2004 Director
- ----------------------------- ----------
J. M. Lewis
/s/ M. G. MILLER 03/11/2004 Director
- ---------------------- ----------
M. G. Miller
/s/ W. T. PEERY 03/11/2004 Director
- ----------------------------- ----------
W. T. Peery
03/11/2004 Chairman of the Board
/s/ J. G. RAKES President and Chief Executive
- ----------------------------- Officer - National
J. G. Rakes Bankshares, Inc.
/s/ J. M. SHULER 03/11/2004 Director
- ----------------------------- ----------
J. M. Shuler
/s/ J. R. STEWART 03/11/2004 Director
- ---------------------- ----------
J. R. Stewart
59
Index of 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)
3(i) Articles of Amendment to Articles of Page 62
Incorporation of National Bankshares, Inc.,
dated April 8, 2003.
4(i) Specimen copy of certificate for National (incorporated
Bankshares, Inc. common stock, $2.50 par herein by reference
value by 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 by National Bankshares, Inc. herein by reference
included in Exhibit No. 3(a) 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 reference
Technology, Inc. and The National Bank of to Exhibit 10(e) of
Blacksburg the Annual Report
on Form 10K for
fiscal year ended
December 31, 1992)
*10(iii)(A) National Bankshares, Inc. 1999 Stock (incorporated
Option 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)
*10(iii)(A) Employment Agreement dated January 2002 (incorporated
between National Bankshares, Inc. and herein by reference
James G. Rakes to Exhibit
10(iii)(A) of Form
10Q for the period
ended June 30,
2002)
*10(iii)(A) Employment Lease Agreement dated August 14, (incorporated
2002, between National Bankshares, Inc. and herein by reference
The National Bank of Blacksburg to Exhibit
10(iii)(A) for the
period ended
September 30, 2002)
*10(iii)(A) Change in Control Agreement dated January 5, (incorporated
2003, between National Bankshares, Inc. and herein by reference
Marilyn B. Buhyoff to Exhibit
10 iii (A) of Form
10K for the period
ended December 31,
2002)
*10(iii)(A) Change in Control Agreement dated January 8, (incorporated
2003, between National Bankshares, Inc. and herein by reference
F. Brad Denardo to Exhibit 10 iii
(A) of Form 10K for
the period ended
December 31, 2002)
*10(iii)(A) Change in Control Agreement dated June 1, (incorporated
1998, between Bank of Tazewell County and herein by reference
Cameron L. Forester to Exhibit 10 iii
(A) of Form 10K for
the period ended
December 31, 2002)
21(i) Subsidiaries of National Bankshares, Inc. Page 63
23 Consent of Yount, Hyde & Barbour, P.C. to Page 64
incorporation by reference of independent
auditor's report included in this Form 10-K,
into registrant's registration statement on
Form S-8.
31(i) Section 906 Certification of Chief Page 57
Executive Officer
31(ii) Section 906 Certification of Chief Page 58
Financial Officer
32(i) 18 U.S.C. Section 1350 Certification of Page 60
Chief Executive Officer
32(ii) 18 U.S.C. Section 1350 Certification of Page 60
Chief Financial Officer
* Indicates a management contract or compensatory plan required to be filed
herein.
61