United States Securities and Exchange Commission Washington, D. C. 20549 Form 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarterly Period Ended Commission File Number: June 30, 1999 0-15204 National Bankshares, Inc. - ------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Virginia 54-1375874 - ------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 South Main Street P.O. Box 90002 Blacksburg, Virginia 24062-9002 - ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (Registrant's telephone number, including area code) (540)552-2011 ------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at July 30, 1999 - ------------------------------- --------------------------------- Common Stock, $2.50 Par Value 3,516,977 (This report contains 31 pages) National Bankshares, Inc. and Subsidiaries Form 10-Q Index Page ---- Part I Financial Information - -------------------------------- Item 1 - Financial Statements Consolidated Balance Sheets, June 30, 1999 and December 31, 1998 4-5 Consolidated Statements of Income and Comprehensive Income, Three Months Ended June 30, 1999 and 1998 6-7 Consolidated Statements of Income and Comprehensive Income, Six Months Ended June 30, 1999 and 1998 8-9 Consolidated Statements of Changes in Stockholders' Equity, Six Months Ended June 30, 1999 and 1998 10 Consolidated Statements of Cash Flows, Six Months Ended June 30, 1999 and 1998 11-12 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 13-27 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 28-29 Part II Other Information - ---------------------------- Items 1 - 3 - Legal Proceedings; Changes in Securities; Defaults Upon Senior Securities 30 Item 4 - Submission of Matters to a Vote of Security Holders 30 Item 5 - Other Information 30 Item 6 - Exhibits and Reports on Form 8 - K 30 Signatures 31 - ---------- -2- National Bankshares, Inc. and Subsidiaries Part I Financial Information Item 1. Financial Statements The consolidated financial statements of National Bankshares, Inc. (Bankshares) and its wholly-owned subsidiaries, The National Bank of Blacksburg (NBB) and Bank of Tazewell County (BTC), (the Company), conform to generally accepted accounting principles and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments which are necessary for a fair presentation of the consolidated financial statements have been included. The results of operations for the six months ended June 30, 1999 are not necessarily indicative of results of operations for the full year or any other interim period. The interim period consolidated financial statements and financial information included herein should be read in conjunction with the notes to consolidated financial statements included in the Company's 1998 Annual Report to Stockholders and additional information supplied in the 1998 Form 10-K. -3- National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets June 30, 1999 and December 31, 1998 (Unaudited) June 30, December 31, ($000's, except share and per share data) 1999 1998 ========= ============ Assets Cash and due from banks $ 12,232 14,421 Interest-bearing deposits --- 7,027 Federal funds sold 1 5,090 Securities available for sale 120,734 136,078 Securities held to maturity (fair value $25,919 in 1999 and $31,151 in 1998) 25,790 30,676 Mortgage loans held for sale 305 2,180 Loans: Real estate construction loans 16,461 12,827 Real estate mortgage loans 51,982 48,724 Commercial and industrial loans 136,698 110,509 Loans to individuals 70,176 69,493 -------- ------- Total loans 275,317 241,553 Less unearned income and deferred fees (2,047) (2,296) -------- ------- Loans, net of unearned income and deferred fees 273,270 239,257 Less allowance for loan losses (2,884) (2,679) -------- ------- Loans, net 270,386 236,578 -------- ------- Bank premises and equipment, net 7,629 6,657 Accrued interest receivable 3,866 3,777 Other real estate owned, net 645 628 Other assets 3,774 2,054 -------- ------- Total assets $445,362 445,166 ======== ======= Liabilities and Stockholders' Equity Noninterest-bearing demand deposits $ 53,669 55,479 Interest-bearing demand deposits 86,900 84,319 Savings deposits 47,229 46,387 Time deposits 195,195 196,511 -------- ------- Total deposits 382,993 382,696 -------- ------- Other borrowed funds 8,598 214 Accrued interest payable 649 647 Other liabilities 1,060 926 -------- ------- Total liabilities 393,300 384,483 -------- ------- Common stock subject to ESOP put option 2,182 2,180 -------- ------- -4- (Continued) Stockholders' equity: Preferred stock of no par value. Authorized 5,000,000 shares; none issued and outstanding --- --- Common stock of $2.50 par value. Authorized 5,000,000 shares; issued and outstanding 3,516,977 shares in 1999 and 3,792,833 in 1998 8,792 9,482 Retained earnings 45,218 50,182 Accumulated other comprehensive income (1,948) 1,019 Common stock subject to ESOP put option (2,182) (2,180) -------- ------- Total stockholders' equity 49,880 58,503 Commitments and contingent liabilities -------- ------- Total liabilities and stockholders' equity $445,362 445,166 ======== ======= -5- National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income and Comprehensive Income Three Months Ended June 30, 1999 and 1998 (Unaudited) June 30, June 30, ($000's, except per share data) 1999 1998 ========= ========= Interest Income Interest and fees on loans $ 5,840 5,443 Interest on interest-bearing deposits 54 163 Interest on federal funds sold 26 109 Interest on securities - taxable 1,729 1,765 Interest on securities - nontaxable 521 443 -------- -------- Total interest income 8,170 7,923 -------- -------- Interest Expense Interest on time deposits of $100,000 or more 580 592 Interest on other deposits 2,810 2,863 Interest on borrowed funds 2 3 -------- -------- Total interest expense 3,392 3,458 -------- -------- Net interest income 4,778 4,465 Provision for loan losses 237 73 -------- -------- Net interest income after provision for loan losses 4,541 4,392 -------- -------- Noninterest Income Service charges on deposit accounts 347 308 Other service charges and fees 65 46 Credit card fees 214 180 Trust income 210 177 Other income 16 43 Realized securities gains, net 4 72 -------- -------- Total noninterest income 856 826 -------- -------- Noninterest Expense Salaries and employee benefits 1,507 1,459 Occupancy and furniture and fixtures 270 245 Data processing and ATM 216 210 FDIC assessment 8 6 Credit card processing 186 163 Goodwill amortization 10 10 Net costs of other real estate owned 3 --- Other operating expense 746 757 -------- -------- Total noninterest expense 2,946 2,850 -------- -------- Income before income tax expense 2,451 2,368 Income tax expense 651 666 -------- -------- Net income 1,800 1,702 -6- (Continued) Other comprehensive income, net of taxes: Unrealized gains (losses) on securities available for sale (1,067) (10) -------- -------- Comprehensive Income $ 733 1,692 ======== -------- Net income per share $ 0.50 0.45 ======== ======== -7- National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income and Comprehensive Income Six Months Ended June 30, 1999 and 1998 (Unaudited) June 30, June 30, ($000's, except per share data) 1999 1998 ========= ========= Interest Income Interest and fees on loans $ 11,375 10,597 Interest on interest-bearing deposits 55 337 Interest on federal funds sold 107 178 Interest on securities - taxable 3,606 3,514 Interest on securities - nontaxable 1,116 868 -------- -------- Total interest income 16,259 15,494 -------- -------- Interest Expense Interest on time deposits of $100,000 or more 1,246 1,188 Interest on other deposits 5,578 5,560 Interest on borrowed funds 4 6 -------- -------- Total interest expense 6,828 6,754 -------- -------- Net interest income 9,431 8,740 Provision for loan losses 469 94 -------- -------- Net interest income after provision for loan losses 8,962 8,646 -------- -------- Noninterest Income Service charges on deposit accounts 608 583 Other service charges and fees 113 99 Credit card fees 377 318 Trust income 441 353 Other income 59 54 Realized securities gains, net 24 85 -------- -------- Total noninterest income 1,622 1,492 -------- -------- Noninterest Expense Salaries and employee benefits 3,066 2,858 Occupancy and furniture and fixtures 527 491 Data processing and ATM 415 406 FDIC assessment 24 15 Credit card processing 342 291 Goodwill amortization 19 17 Net costs of other real estate owned 6 26 Other operating expense 1,473 1,442 -------- -------- Total noninterest expense 5,872 5,546 -------- -------- Income before income tax expense 4,712 4,592 Income tax expense 1,233 1,282 -------- -------- Net income 3,479 3,310 -8- (Continued) Other comprehensive income, net of taxes: Unrealized gains (losses) on securities available for sale (2,967) 77 -------- -------- Comprehensive Income $ 512 3,387 ======== -------- Net income per share $ 0.94 0.87 ======== ======== -9- National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Six Months Ended June 30, 1999 and 1998 (Unaudited) Common Stock Accumulated Subject Other To ESOP ($000's, except for per Common Retained Comprehensive Put share data) Stock Earnings Income Option Total ====== ========= ============= ====== ===== Balances, December 31, 1997 $9,482 46,191 194 (1,838) 54,029 Net income --- 3,310 --- --- 3,310 Unrealized gains (losses) on securities available for sale, net of tax --- --- 77 --- 77 Dividend ($.36 per share) --- (1,365) --- --- (1,365) Change in common stock subject to ESOP put option --- --- --- (357) (357) ------ ------ ----- ------ ------ Balances, June 30, 1998 $9,482 48,136 271 (2,195) 55,694 ====== ====== ===== ====== ====== Balances, December 31, 1998 $9,482 50,182 1,019 (2,180) 58,503 Net income --- 3,479 --- --- 3,479 Unrealized gains (losses) on securities available for sale, net of tax (1) --- --- (2,967) --- (2,967) Dividend ($.39 per share) --- (1,372) --- --- (1,372) Stock tender offer (2) (690) (7,071) --- --- (7,761) Change in common stock subject to ESOP put option --- --- --- (2) (2) ------ ------ ----- ------ ------ Balances, June 30, 1999 $8,792 45,218 (1,948) (2,182) 49,880 ====== ====== ===== ====== ====== (1) Net unrealized holding loss for year $(4,448) plus reclassification adjustment of $(47) unrealized gain for quarter and less income tax benefit of $1,528. (2) Represents the repurchase of 275,856 shares at $28.00 per share and related expenses. -10- National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows Six Months Ended June 30, 1999 and 1998 (Unaudited) June 30, June 30, ($000's) 1999 1998 ========= ========= Cash Flows from Operating Activities Net Income $ 3,479 3,310 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 469 94 Depreciation of bank premises and equipment 431 383 Amortization of intangibles 76 68 Amortization of premiums and accretion of discounts, net 241 28 Gains on sales and calls of securities available for sale, net (24) --- Gains on calls of securities held to maturity, net (2) (85) Gains on other real estate owned --- (19) (Increase) decrease in: Mortgage loans held for sale 1,875 (459) Accrued interest receivable (89) (177) Other assets (268) (477) Increase in: Accrued interest payable 2 32 Other liabilities 134 325 ------- ------- Net cash provided by operating activities 6,324 3,023 ------- ------- Cash Flows from Investing Activities Net (increase) decrease in federal funds sold 5,089 (3,120) Net (increase) decrease in interest-bearing deposits 7,027 (6,180) Proceeds from calls and maturities of securities available for sale 21,376 14,936 Proceeds from sales of securities available for sale 1,218 --- Proceeds from calls and maturities of securities held to maturity 4,870 23,775 Purchases of securities available for sale (11,944) (37,747) Purchases of loan participations (4,688) (2,910) Collections of loan participations 7,209 3,853 Net increase in loans made to customers (36,855) (15,159) Proceeds from disposal of other real estate owned --- 194 Recoveries on loans charged off 40 205 Bank premises and equipment expenditures (1,408) (553) Proceeds from disposal of fixed assets 5 --- ------- ------- Net cash used in investing activities (8,061) (22,706) ------- ------- -11- (Continued) Cash Flows from Financing Activities Deposits assumed, net of premium paid --- 7,025 Net increase (decrease) in time deposits (1,316) 5,541 Net increase in other deposits 1,613 7,401 Net increase (decrease) in other borrowed funds 8,384 (7) Dividend paid (1,372) (1,365) Repurchase of common stock (7,761) --- ------- ------- Net cash provided by (used in) financing activities (452) 18,595 ------- ------- Net decrease in cash and due from banks (2,189) (1,088) Cash and due from banks at beginning of period 14,421 12,435 ------- ------- Cash and due from banks at end of period $12,232 11,347 ======= ======= Supplemental Disclosure of Cash Flow Information Cash paid for interest $ 6,826 6,722 ======= ======= Cash paid for income taxes $ 1,410 1,233 ======= ======= Loans charged to the allowance for loan losses $ 304 193 ======= ======= Loans transferred to other real estate owned $ 17 40 ======= ======= -12- National Bankshares, Inc. and Subsidiaries Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The purpose of this discussion is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly-owned subsidiaries (the Company), which are not otherwise apparent from the consolidated financial statements and other information included in this report. Reference should be made to the financial statements and other information included in this report as well as the 1998 Annual Report and Form 10-K for an understanding of the following discussion and analysis. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements. Results of Operations - for the six months ended June 30, 1999 - ---------------------------------------------------------------- Net income for the six months ended June 30, 1999 was $3,479,000 which represents an increase of $169,000 or 5.11% over the first six months of 1998. The return on average assets for the six months ended June 30, 1999 was 1.58% and 1.63% as of June 30, 1998. The return on average equity was 11.84% for the period ended June 30, 1999 and 11.75% as of June 30, 1998. Earnings per share for the period ending June 30, 1999 was $0.94 per share, an increase of $0.07 per share over the same period in 1998. The following table provides selected consolidated data. June 30, December 31, ($000's, except per share and 1999 1998 1998 1997 percent data) ====== ====== ============ ============ Interest income $16,259 15,494 31,828 29,797 Interest expense 6,828 6,754 13,928 13,106 Net interest income 9,431 8,740 17,900 16,691 Provision for loan losses 469 94 624 435 Noninterest income 1,622 1,492 3,174 2,834 Noninterest expense 5,872 5,546 11,061 10,031 Income taxes 1,233 1,282 2,591 2,499 Net income $ 3,479 3,310 6,798 6,560 Return on average assets 1.58% 1.63% 1.61% 1.66% Return on average equity (1) 11.84% 11.75% 11.66% 12.21% Basic net income per share $ .94 .87 1.79 1.73 Book value per share (1) $ 14.80 15.26 16.00 14.73 (1) Includes amount related to common stock subject to ESOP put option excluded from stockholders' equity on the Consolidated Balance Sheets. -13- Net Interest Income - ------------------- Net interest income at the end of the first six months of 1999 was $9,431,000, an increase of $691,000 or 7.91% over the same period in 1998. The net interest margin is one of the primary ratios used by banks to measure net interest income. The net interest margin is composed of the yield on earning assets on a fully tax equivalent basis less the cost to fund earning assets. The funding cost factors in interest bearing deposits as well as capital and demand deposits. The following table sets forth the Company's net interest margin for the period specified. June 30, December 31, 1999 1998 1998 1997 --------- --------- ------------ ------------ Yield on earning assets 8.10% 8.35% 8.25% 8.24% Cost to fund earning assets 3.26% 3.52% 3.50% 3.50% -------- ------- ------- ------- Net interest margin 4.84% 4.83% 4.75% 4.74% ======== ======= ======= ======= A second measure of net interest income is the net interest spread. The ratio consists of the yield on earning assets on a fully tax equivalent basis less the cost of interest bearing liabilities. It does not reflect the benefit received from "free funds" provided by demand deposits and capital. The following table sets forth the company's net interest spread for the periods shown. June 30, December 31, 1999 1998 1998 1997 --------- --------- ------------ ------------ Yield on earning assets 8.10% 8.35% 8.25% 8.24% Cost of interest-bearing liabilities 4.18% 4.50% 4.48% 4.43% -------- ------- ------- ------- Net interest spread 3.92% 3.85% 3.77% 3.81% ======== ======= ======= ======= As can be seen by the table shown above, the yield on earning assets for the six months ended June 30, 1999 has declined by fifteen basis points from the year-ended 1998. The cost to fund earning assets declined by twenty-four basis points. These elements combined to produce a nine basis point improvement in the net interest margin. Provision and Allowance for Loan Losses - --------------------------------------- The adequacy of the allowance for loan losses is based on management's judgement 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. Changing trends in the loan -14- mix are also evaluated in determining the adequacy of the allowance for loan losses. Loan loss and other industry indications related to asset quality are presented in the following table. For the periods ended June 30, December 31, 1999 1998 1998 1997 ($000's, except for % data) ========= ========== ========== ========== Balance at beginning of period $ 2,679 2,438 2,438 2,575 Provision for loan losses 469 94 624 435 Loans charged off (304) (193) (638) (679) Recoveries 40 205 255 107 -------- -------- --------- --------- Balance at the end of period $ 2,884 2,544 2,679 2,438 ======== ======== ========= ========= Ratio of allowance for loan losses to end of period loans, net of unearned income and deferred fees 1.06% 1.10% 1.12% 1.12% ======== ======== ========= ========= Ratio of net charge-offs (recoveries) to average loans, net of unearned income and deferred fees(1) .21% (.01)% .17% .23% ======== ======== ========= ========= Ratio of allowance for loan losses to nonperforming loans(2) 1,802.50% 6,204.88% 9,567.86% 2,802.30% ======== ======== ========= ========= (1) Net charge-offs are on an annualized basis. (2) The Company defines nonperforming loans as total nonaccrual and restructured loans. Loans 90 days past due and still accruing are excluded. June 30, December 31, ($000's, except for % data) 1999 1998 1998 1997 ======== ======== ======== ======== Nonperforming Assets Nonaccrual loans $ 160 42 28 87 Restructured loans --- --- --- --- ------ ------ ------ ------ Total nonperforming loans 160 42 28 87 Foreclosed property 645 286 628 421 ------ ------ ------ ------ Total nonperforming assets $ 805 328 656 508 ====== ====== ====== ====== Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned .29% .14% .27% .23% ====== ====== ====== ====== -15- Accruing Loans Past Due 90 Days or More --------------------------------------- Past due 90 days or more and still accruing $2,484 962 550 672 ====== ====== ====== ====== Ratio of loans past due 90 days or more to loans, net of unearned income and deferred fees .91% .42% .23% .31% ====== ====== ====== ====== Impaired Loans -------------- Total impaired loans $ 265 572 373 177 ====== ====== ====== ====== Impaired loans with a valuation allowance 145 284 145 53 Valuation allowance (145) (52) (145) (53) ------ ------ ------ ------ Impaired loans net of allowance $ --- 232 --- --- ====== ====== ====== ====== Impaired loans with no valuation allowance $ 120 288 228 124 ====== ====== ====== ====== Average recorded investment in impaired loans $ 302 279 387 458 ====== ====== ====== ====== Income recognized on impaired loans $ 7 26 32 23 ====== ====== ====== ====== Amount of income recognized on a cash basis $ --- --- --- 12 ====== ====== ====== ====== As can be seen by the preceding table, the provision for loan losses was $469,000 for the period ending June 30, 1999, up $375,000 over the same period the prior year. The ratio of the allowance for loan losses to loans net of unearned income declined by four basis points. The net charge-offs ratio at period-end was .21%. It should be noted that loans past due 90 days or more have increased when compared to prior period data. As mentioned in the Company's 1998 Form 10-K, the Company has two additional credits totaling approximately $1.7 million which are experiencing collection problems. These loans are 90 days or more past due at June 30, 1999. Management believes, at present, that these credits can be recovered without loss. At June 30, 1999 both loans were on an accrual basis. Overall, it is expected that provisions for loan loss expense will be higher in 1999. Such expense will be required by strong loan growth and the need to maintain an adequate overall reserve. Further additions could be made necessary by unforeseen losses and/or a change in the circumstances surrounding the two credits mentioned above. -16- Noninterest Income - ------------------ Noninterest income is an important source of the company's income. This category is comprised of service charges on deposit accounts, other service charges and fees, credit card fees, trust income and other income. Net securities gains and losses are also included in this category. Noninterest income for the period ended June 30, 1999 was $1,622,000, an increase of $130,000 or 8.71% over the same period in 1998. Service charges on deposit accounts were $608,000 at June 30, 1999, an increase of $25,000 or 4.29% from the same period in 1998. This was primarily due to an increase in the volume of return checks and overdraft fees and enhanced collection efforts. Other service charges increased by $14,000 when June 30, 1999 and 1998 are compared. Credit card fees increased by $59,000 or 18.55% when the first six months of 1999 and 1998 are compared. Continued growth in volume was the primary cause of this increase. Trust income increased by 24.93% when compared to the first six months of 1998. Trust income is dependent on market conditions as well as the types of accounts being handled at any given point in time. The level of estate business, for example, cannot be predicted with any degree of preciseness. Other income, which is comprised of various miscellaneous types of income, increased by $5,000 for the first six months of 1999. Included in other income in 1999 was approximately $12,000 which represented a recovery of principal for a bond charged-off in prior year. Net securities gains and losses decreased $61,000 when 1999 and 1998 are compared. The income in this category reflects gains and losses on securities called prior to maturity. Noninterest Expense - ------------------- Noninterest expenses for the first six months of 1999 were $5,872,000, an increase of $326,000 or 5.88% over the first six months of 1998. Salaries and fringe benefits were $3,066,000 at the end of the first six months of 1999. This represents an increase of $208,000 or 7.28% over the first six months of 1998. A portion of this increase was due to the acquisition of the Galax branch. This facility was acquired in the second quarter of 1998. Accordingly, 1998 data contains only a small amount of salaries expense associated with the acquisition. The remainder of the increase was due to normal merit increases and other personnel related costs. Occupancy expenses increased by $36,000 or 7.33% when the first six months of 1999 and 1998 are compared. Acquisition of the previously mentioned Galax Branch contributed to this increase. Data processing expense increased by $9,000 or 2.22%. -17- Credit card expense increased by $51,000 or 17.53% in the first six months of 1999. Increases in overall volume also contributed to this increase. Included in the category was approximately $4,000 in expense related to the reissuance of debit cards. The next scheduled reissuance will be in four years. Other expenses at June 30, 1999 were $1,473,000, which represents an increase of $31,000 or 2.15% over the same period in 1998. Other expenses include various types of costs. Examples of expense accounts included are telephone, franchise taxes, stationary and supplies, market expense, correspondent charges and numerous others. Some expenses included in this area represent accrued expense for anticipated expenditures, while others are on a cash or pay as incurred basis. Some categories are within management's ability to control while others can only be controlled to a degree. Balance Sheet - ------------- The following table sets forth selected consolidated balance sheet data. June 30, December 31, 1999 1998 1998 1997 ========= ========= ============ ============ ($000's) Selected Period-End Data - ------------------------ Loans, net $270,386 228,429 236,578 214,552 Total Securities 146,524 149,188 166,754 149,974 Total Assets 445,362 425,480 445,166 402,907 Total Deposits 382,993 365,068 382,696 344,867 Stockholders' Equity 49,880 55,694 58,503 54,029 Selected Daily Averages Data - ---------------------------- Loans, net $250,981 220,437 225,613 204,540 Total securities 160,418 146,456 152,432 157,179 Interest-earning assets 421,317 386,664 398,340 374,478 Total assets 444,256 408,837 420,988 395,932 Total deposits 382,576 349,106 359,970 339,439 Interest-bearing liabilities 328,696 302,392 310,634 295,565 Stockholders' equity 57,093 54,821 58,282 53,712 Total average assets at June 30, 1999 were $444,256,000, an increase of $35,419,000 or 8.66% from June 30, 1998. A portion of this increase was due to the acquisition of the Galax branch in the second quarter of 1998. The Company also continues to experience satisfactory growth in deposits from nonacquisition related sources. -18- A comparison of the loan portfolio at June 30, 1999 and 1998 indicates that construction and commercial loans have experienced the greatest increase followed by real estate and loans to individuals which have grown only slightly as part of total loans. The following table sets forth selected balance sheet caption as a percentage of total assets at the dates shown. June 30, December 31, 1999 1998 1998 1997 ========= ========= ============ ============ Assets - ------ Interest bearing-deposits --- 3.74% 1.58% 2.41% Federal funds sold --- 1.74% 1.14% 1.07% Securities available for sale 27.11% 20.80% 30.57% 16.28% Securities held to maturity 5.79% 14.26% 6.89% 20.95% Mortgage loans held for sale .07% .20% .49% .10% Real estate construction loans 3.70% 2.73% 2.88% 2.11% Real estate mortgage loans 11.67% 10.89% 10.95% 10.66% Commercial and industrial loans 30.69% 24.91% 24.82% 25.16% Loans to individuals 15.76% 16.35% 15.61% 16.54% Liabilities - ----------- Noninterest-bearing demand deposits 12.05% 11.84% 12.46% 11.19% Interest-bearing demand deposits 19.51% 19.11% 18.94% 19.33% Savings deposits 10.60% 11.26% 10.42% 11.61% Time deposit 43.83% 43.59% 44.14% 43.47% Other borrowed funds 1.93% .11% .05% .12% At present the Company is relying on short-term borrowings for liquidity. It is anticipated that this condition will be resolved through securities portfolio maturities and/or calls. While the procurement of additional deposits remains an option, increased interest expense would likely result, as interest rates would have to increase to attract new deposits. -19- As shown by the above table, management has shifted a substantial portion of its investment portfolio to the available for sale category. A portion of this shift was accomplished through calls, maturities of bonds and their subsequent reinvestment. In the fourth quarter of 1998, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and hedging Activities". The statement allowed, upon adoption, the transfer of securities from the held to maturity classification to the available for sale without calling into question management's intent to hold its remaining securities until maturity. The Company used this opportunity to transfer approximately $20,516,000 in securities to held for sale category. The overall mix of loan and deposits has remained roughly the same. Liquidity - --------- Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. Net cash provided by operating activities was $6,324,000 for the six months ended June 30, 1999. Net cash used in investing activities was $8,061,000 with the majority of that cash invested in securities and loans. Net cash used in financing activities was $452,000. Net cash decreased $2,189,000 from December 31, 1998. During the first half of 1999 the Company repurchased 275,856 of its common shares at $28.00 per share. Cash used for the purchase and related expenses was $7,761,000. The Company actively manages its liquidity position through its investing activities. In addition, securities with a remaining maturity of less than one year totaled $28,573,000. Liquidity is also managed through the management of deposit liabilities, in particular, volatile funds such as time deposits over $100,000. The amount of such deposits is largely dependent on the rate of interest offered. The Company had approximately $35,758,000 in such deposits due within twelve months. Other types of deposits such as interest-bearing demand, savings and time deposits less than $100,000 are less volatile and less rate dependent historically. Short-term liquidity needs can also be satisfied by way of credit facilities established with correspondent banks, the Federal Home Loan Bank and Federal Reserve. Longer term borrowings, if necessary, can be obtained through the Federal Home Loan Bank. NBB is in process of constructing a new building which is expected to be completed in the third quarter. This facility will provide additional office space to replace existing leased properties and also add a branch facility. This project is not expected to have a material impact on the Company's liquidity. The Year 2000 also has liquidity implications. Management is fully aware of customer apprehension associated with the Year 2000 date change. Accordingly, it is management's plan to provide for additional liquidity as part of its contingency planning processes. Please refer to the above information related to the establishment of credit facilities and the Year 2000 discussion which follows for the steps the Company is taking to allay unwarranted customer concerns. -20- Management is not aware of any other trend, commitment or events that will result in or that are reasonably likely to result in a decrease in liquidity that would be adverse and to a degree that operations would be materially impaired. Capital Resources - ----------------- Total stockholders' equity decreased $8,623,000 or 14.74% from December 31, 1998. During the first six months of 1999, retained earnings decreased by $4,964,000. Retained earnings experienced this net decrease due to the payment of a dividend ($1,372,000), the repurchase of 275,856 shares of common stock ($7,071,000) offset by earnings of $3,479,000. Accumulated comprehensive income decreased stockholders' equity by $2,967,000. This category is comprised solely of changes in the net unrealized gains (losses) on securities available for sale. Common stock subject to put option increased by $2,000. The common stock subject to put option is affected by the current market price of the Company's common stock as well as the number of shares outstanding. The following table sets forth the various ratios by which bank capital is measured. The Company and its subsidiaries continue to be well capitalized. June 30, December 31, 1999 1998 1998 1997 ========= ========= ========== ============ Consolidated Capital Ratios --------------------------- Total capital (to risk weighted assets) 18.7% 22.6% 22.4% 23.3% Tier 1 Capital (to risk weighted assets) 17.8% 21.6% 21.5% 22.3% Tier 1 capital (to average assets, leverage ratio) 11.9% 13.6% 13.4% 13.7% Tender Offer - ------------ On March 15, 1999, the Company announced a stock tender offer. The Company sought to repurchase 200,000 shares, but reserved the right to purchase an additional two percent of its outstanding shares of common stock. The tender off closed on April 30, 1999. The offer resulted in the repurchase of 275,856 shares. The Company's Form 13E-4 filed March 15, 1999, amended 13E-4 filed March 31, 1999 and the Final Amendment filed May 24, 1999 are incorporated herein. Selected Affiliate Bank Data - ---------------------------- The following table sets forth selected data for NBB and BTC: -21- June 30, 1999 -------------- (000's, except for % data) NBB BTC --- --- Assets $269,957 172,946 Deposits 237,901 145,130 Shareholders Equity 25,670 23,918 Net Income 2,351 1,099 Return on Average Assets 1.78% 1.26% Return on Average Equity 15.96% 8.20% Tier 1 Capital Rates 12.90% 25.10% Total Risk Based Capital Rates 13.80% 26.00% Tier 1 Leverage Ratio 9.50% 14.20% Year 2000 - --------- The Company recognizes the risks and challenges presented by the impact of the century date change on information processing and other microchip controlled systems. The Year 2000 ("Y2K") involves several issues for financial institutions. The Company's own internal information processing and microchip controlled systems, as well as those of its major service vendors, must be Y2K compliant. Banks face credit, earnings and liquidity risk should commercial loan customers or large depositors suffer significant business disruptions as a result of the impact of computer failures in their own operations or in those of their suppliers or customers. Banks could encounter temporary funding shortages if customers withdraw unusually large sums of cash because they are unduly concerned about the effects of Y2K. And, although management believes the level of counterpart trading risk is low, there could be a temporary or permanent effect on the investment portfolio resulting from the negative impact of Y2K on the underlying entities. Both of the Company's bank subsidiaries have established Y2K project management teams that have developed Y2K plans with assessment, testing, and remediation phases. The internal audit department is conducting Y2K audits, and both banks are subject to the guidelines promulgated by the Federal Financial Institutions Examination Counsel (FFIEC) and to regular Year 2000 compliance examinations by their respective federal regulators. The assessment phase outlined in both NBB's and BTC's Y2K plans has been completed. The banks have identified all internal mission critical information technology and microchip controlled systems. Outside vendors that provide mission critical service to the institutions have also been identified. Because of their importance to daily business operations, substantial attention has been focused on the banks' customer information processing hardware and software. In 1997, in the normal course of business, NBB purchased a new Unisys host computer and peripherals and installed the latest version of its Information Technology, Inc. (ITI) software. In the last quarter of 1998, BTC converted from its previous in-house information processing system. BTC is now processed using NBB's hardware and software. The NBB system has been tested, including century date rollover and other critical dates, and validation of the ITI application is complete. -22- Each bank has identified as mission critical independent information technology systems in their Trust Departments. NBB has successfully completed proxy testing of its external service provider, and BTC has successfully tested its internal system. Microchip controlled bank security systems are also mission critical. Testing of these systems at both banks determined that minor renovations were necessary at three offices. Those renovations are now complete. The Federal Reserve Bank of Richmond has provided comprehensive procedures and instructions for interface testing. During the first quarter of 1999, NBB and BTC successfully tested all utilized services, including wire transfer, automated clearing house and savings bonds. Both NBB and BTC deal with outside vendors that provide mission critical support for bank card processing and ATM servicing. The banks are monitoring these vendors' progress to assure their Y2K readiness. The vendors regularly provide status reports and testing criteria. In the first quarter of 1999, both BTC and NBB converted to a new ATM servicer. Testing of that application was successfully concluded. Each bank has developed and implemented programs to assess the level of Y2K risk among large loan customers. NBB's Credit Review department performs a precredit analysis of all new large loans made by both banks. An assessment of the potential effects of the Year 2000 on the credit-worthiness of borrowers is a part of this analysis. BTC is asking new commercial borrowers to sign an agreement to insure compliance with minimum standards with regard to Y2K issues. That bank is also following up with these borrowers to insure that promised deadlines are met. Both NBB and BTC have also completed assessments of Year 2000 preparedness among existing large commercial loan customers. The banks have ongoing initiatives designed to educate customers about Y2K issues and to allay any unwarranted concerns about the safety and soundness of the institutions. Leaflets discussing the topic were sent to all customers, and the banks have posted information on their Web sites. NBB held a public forum directed at small businesses and has established a toll free information hotline. Employee training and awareness campaigns have been completed. Additional employee training and public education efforts are planned throughout the rest of 1999. Contingency plans have been drafted by NBB and BTC to 1) identify alternatives if mission critical applications do not meet the banks' readiness plan, and 2) develop a course of action to assure business continuity in the event there are system failures on critical dates. Both institutions are providing their Boards of Directors with regular reports on Y2K initiatives and preparedness, and both Boards have approved bank contingency plans. At this time, National Bankshares, Inc. believes that in the most likely worst-case scenarios, Y2K will not have a material effect on the Company's operations, liquidity or financial condition. Although contingency plans address multiple alternative scenarios, the Company believes it is impossible for any business to address the potentially unlimited number of possible circumstances relating to Y2K issues. Even though it is highly unlikely, National Bankshares recognizes that if its Y2K assessment, remediation or contingency plans prove to be inadequate, this could have a material impact on its operations and therefore result in a material adverse effect on the Company's results of operations and financial condition. -23- The Company's recently completed upgrade of internal processing systems does enhance Y2K preparedness. However, the major goals of the upgrade were to provide a shared information processing system for affiliates and to provide additional processing capacity and the ability to use the most advanced version of software available. The costs of the upgrade were substantial, but the total of costs of the upgrade directly related to the Y2K component was not material. Results of Operations for the Three Months Ended June 30, 1999 - -------------------------------------------------------------- Net Income for the second quarter of 1999 was $1,800,000 which represents an increase of $98,000 or 5.76% over the second quarter of 1998. The return on average assets for the quarter-ended June 30, 1999 and June 30, 1998 was 1.61% and 1.64%, respectively. The return on average equity for the second quarter of 1999 was 12.62% and 11.94% for the second quarter of 1998. Earnings per share for the second quarter of 1999 was $0.50 an increase of $0.05 over the second quarter in 1998. The following table sets forth selected quarterly consolidated data. For the Quarter-Ended --------------------- ($000's, except per share of percent and per June 30, June 30, Percent % share data) 1999 1998 $ Difference Difference -------- -------- ------------ ---------- Interest income $ 8,170 7,923 247 3.12% Interest expense 3,392 3,458 (66) (1.91%) Net interest income 4,778 4,465 313 7.01% Provision for loan loss 237 73 164 224.66% Noninterest income 856 826 30 3.63% Noninterest expense 2,946 2,850 96 3.37% Income taxes 651 666 15 2.25% Net income 1,800 1,702 98 5.76% Return on average assets $ 1.61 1.64% --- --- Return on average equity 12.62% 11.94% --- --- Basic net income per share $ .50 .45 --- --- Net Interest Income - ------------------- Net interest income for the second quarter of 1999 was $4,778,000 an increase of $313,000 over the second quarter of 1998. The principal cause of this net increase was loan volume. Provision for Loan Losses - ------------------------- The provision for loan losses for the second quarter was $237,000 compared to $73,000 in 1999. As previously mentioned, it is expected that bad debts expense will continue to increase in 1999 due to loan growth and losses. -24- Noninterest Income - ------------------ Noninterest income for the second quarter of 1999 was $856,000, an increase of $30,000 or 3.63% over the same period last year. While most categories experienced increases, securities gains and losses declined substantially. Such gains and losses are dependent primarily on securities with call features. The security of these calls are dependent on the rate environment at the time. Noninterest Expense - ------------------- Noninterest expense for the quarter ended June 30, 1999 were $2,946,000, an increase of $96,000 or 3.37% over the same period in 1998. The largest increase was in the salaries and employee benefits area. Balance Sheet - ------------- The following table sets forth selected consolidated quarterly averages. Quarterly Averages for the Second Quarter of -------------------------- (In 000's) 1999 1998 ---- ---- Loans, net $260,743 225,666 Total securities 153,227 148,596 Total assets 447,683 416,415 Total deposits 385,610 356,440 Stockholders' equity 57,361 57,107 Total average quarterly assets for the three months ended June 30, 1999 were $447,683,000 an increase of $31,268,000 or 7.51% over the second quarter of 1998. Total deposits increased $29,170,000 or 8.18% when the two periods are compared. As can be seen by the table above the majority of the growth was in lending activities. The securities portfolio increased slightly. -25- Banking Terms Basis Point - a deposits in other Net Interest Margin - measure-ment unit banks. net taxable-equivalent defined as one interest income divided hundredth of one Earnings Per Share- by average earning percent; it usually Basic - net income, assets. refers to an interest reduced by dividends on rate. preferred stock, Nonperforming Assets - divided by the weighted the sum of loans on Book Value Per Share - average number of which interest income the value of a share of common shares is not being accrued, common stock determined outstanding in the restructured loans on b y d i v i d i n g period. which the interest shareholders' equity at rates or terms of the end of a period, Equity Capital/Share- repayment have been excluding preferred holders' Equity - a materially revised and stock, by the number of balance sheet amount real estate that has common shares that represents the been acquired through outstanding at the end total investment in the foreclosure. of the same period. corporation by holders of common and preferred Rate-Sensitive Assets/ Core Deposits - demand stock; it includes Liabilities - earning deposits, savings amounts added through assets and interest- accounts, interest the retention of bearing liabilities checking accounts, earnings. that can be repriced or insured money market replaced at a different a c c o u n t s a n d Interest-Bearing interest rate, within a certificates of deposit Liabil-ities - deposits specific period, due to under $100,000. This and borrowed funds on rate changes or is a more stable source which the corporation maturity. of funds than funds pays interest; includes purchased on the basis interest checking Return on Average of rate only. accounts, money market Assets (ROA) - net accounts, certificates income as a percentage Cost of Funds - of deposit, short-term of average total interest on deposits borrowings and long- assets. It is a key and borrowed funds term debt. profitability ratio divided by the average that indicates how balance of such funds. Leverage Capital effectively a bank has Ratio - the total of used its total Comprehensive Income - Tier 1 capital less resources. net income plus the certain intangible change in unrealized assets such as Return on Average gains and losses, net goodwill, divided by Equity (ROE) - net of tax, plus certain quarterly average income as a percentage reclassification assets. A key of total average adjustments on regulatory capital shareholders' equity. securities available requirement with the Provides a measure of for sale for the minimum amount allowed how productively a period. of 4%. bank's equity has been employed. Earning Assets - loans Net Interest Income - (net of unearned the difference between Risk-Based Assets - a income), investment income from earning regulatory method of securities, money assets and interest classifying assets market investments and paid on deposits and based on their interest-bearing borrowed funds. potential risk of loss, -26- used in calculating mixes of taxable and various capital ratios. tax-exempt assets. Assets are classified in one of four Tier 1 Risk-Based Capi- categories based tal Ratio - common primarily on credit shareholders' equity risk and are adjusted less certain intangible to reflect the relative assets, such as riskiness of that goodwill, divided by category. risk-based assets. Current regulatory Securities Available minimum requires that for Sale - securities at least a 4% ratio be that will be held for maintained. indefinite periods of time and that may be Total Risk-Based sold as part of the Capital Ratio - total bank's asset/liability capital divided by strategy. These risk-based assets. securities are recorded Total capital consists at their current market of common shareholders' value rather than at equity, the allowance their historical for loan losses, amortized cost. certain components of nonpermanent preferred Securities Held to stock and subordinated Maturity - securities debt less certain that the bank has the intangible assets, such ability and the intent as goodwill. Current to hold to maturity. regulatory minimum These securities are requires that at least recorded at their an 8% ratio be original cost, adjusted maintained. for amortization of premium or discount Yield on Earning Assets accretion. - total taxable- equivalent interest Spread or Interest-Rate income dividend by the Differential - the average balance of difference between the earnings assets. average interest rates received on earning assets and the average interest rates paid for interest-bearing liabilities. Taxable-Equivalent In- come - income that has been adjusted by increasing tax-exempt interest income to an equivalent pretax amount of taxable income. This adjustment allows corporations to compare the effective pretax yields on different -27- Item 3. Quantitative and Qualitative Disclosures About Market Risk Derivatives The Company is not a party to derivative financial instruments with off- balance sheet risks such as futures, forwards, swaps and options. The Company is a party to financial instruments with off-balance sheet risks such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business to meet the financing needs of its customers. Management does not plan any future involvement in high risk derivative products. The Company has investments in mortgage-backed securities, collateralized mortgage obligations, structured notes and other similar instruments which are included in securities available for sale and securities held to maturity. The fair value of these investments at June 30, 1999 approximated $6,592,000. Interest Rate Sensitivity The Company's securities and loans and its deposits are subject to interest rate risk. The Company's profitability in the near term may temporarily be affected, either positively by a falling interest rate scenario or negatively by a period of rising rates. The table below sets forth, as of June 30, 1999, the distribution of repricing opportunities of the Company's interest-earning assets and interest-bearing liabilities, the interest rate sensitivity gap (i.e., interest rate sensitive assets less interest rate sensitive liabilities), and the cumulative interest rate sensitivity gap. The table sets forth the time periods during which interest-earning assets and interest-bearing liabilities will mature or may reprice in accordance with their contracted terms. The method of analysis presented in the following table has certain inherent shortcomings. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees and at different times to changes in market interest rates. In addition, loan prepayments and early withdrawals of certificates of deposit could cause the interest sensitivities to vary from those which appear on the table. The classification of securities as held to maturity or available for sale also effects rate sensitivity. Available for sale securities which may be sold can be used to adjust the Company's interest rate sensitivity position. Finally, call features in the investment portfolio can have a considerable effect. Since the call decision is dependent on interest rate levels at a future point in time, the ultimate effect on interest rate sensitivity cannot be precisely determined. A substantial number of bonds in the investment portfolio contain these features. (In $000's, except for ratios) <3 Months 6 Months 12 Months 1-5 Years >5 Years ========= ======== ========= ========= ======== Interest-earning assets $ 62,525 23,710 41,558 150,939 141,368 Interest-bearing liabilities 189,224 33,109 74,394 41,195 --- --------- -------- -------- -------- -------- Gap (126,699) (9,399) (32,836) 109,744 141,368 ========= ======== ======== ======== ======== Cumulative gap $(126,699) (136,098) (168,934) (59,190) 82,178 ========= ======== ======== ======== ======== Cumulative gap ratio .33 .39 .43 .82 1.24 ========= ======== ======== ======== ======== -28- The Company also uses simulation analysis to forecast its balance sheet and monitor interest rate sensitivity. One test used by the Company is shock analysis, which measures the effect of a hypothetical, immediate and parallel shift in interest rates. The following table shows the results of a rate shock of 100, 200, and 300 basis points and the effects on net income and return on average assets and return on average equity at June 30, 1999. ($000's, except for percent data) Return on Return on Rate Shift Net Income Average Equity Average Assets ========== ========== ============== ============== 300 $5,067 8.81% 1.06% 200 5,939 10.48% 1.27% 100 6,805 12.10% 1.48% (-)100 8,986 16.07% 2.02% (-)200 9,842 17.52% 2.23% (-)300 9,963 17.73% 2.25% Simulation analysis allows the Company to test asset and liability management strategies under rising and falling rate conditions. As a part of simulation process, certain estimates and assumptions must be made dealing with, but 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 to a degree by the periodic re-forecasting 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. -29- National Bankshares, Inc. and Subsidiaries Part II Other Information Items 1-3. Legal Proceedings; Changes in Securities; Defaults Upon Senior Securities None for the three months ended June 30, 1999. Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 27 - Financial Data Schedule (b) Reports on Form 8-K filed during the three months ended June 30, 1999: -- Tender offer results as of May 3, 1999 -- Tender offer results as of May 24, 1999 The aforementioned Form 8-K's are incorporated by reference. -30- National Bankshares, Inc. and Subsidiaries Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. National Bankshares, Inc. (Registrant) Date: August 3, 1999 /s/James G. Rakes -------------- ------------------------------------- James G. Rakes, Chairman President and Chief Executive Officer Date: August 2, 1999 /s/J. Robert Buchanan -------------- ------------------------------------- J. Robert Buchanan, Treasurer (principal financial officer) -31-