UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended Commission File No. 0-16761 June 30, 2002 HIGHLANDS BANKSHARES, INC. West Virginia 55-0650793 - ---------------------------------- ------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) P.O. Box 929 Petersburg, West Virginia 26847 (304) 257-4111 -------------------------- (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days. Yes ..X. No .... State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. Class Outstanding at June 30, 2002 - ------------------------------------------ ---------------------------- Common Stock, par value - $5 478,958 shares 1 HIGHLANDS BANKSHARES, INC. INDEX Page PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Income - Six Months Ended June 30, 2002 and 2001 2 Consolidated Statements of Income - Three Months Ended June 30, 2002 and 2001 3 Consolidated Balance Sheets - June 30, 2002 and December 31, 2001 4 Consolidated Statements of Changes in Stockholders' Equity - Six Months Ended June 30, 2002 and 2001 5 Consolidated Statements of Cash Flows - Six Months Ended June 30, 2002 and 2001 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 PART II OTHER INFORMATION Item 1. Legal Proceedings 19 Item 2. Changes in Securities 19 Item 3. Defaults upon Senior Securities 19 Item 4. Submission of Matters to a Vote of Security Holders 19 Item 5. Other Information 19 Item 6. Exhibits and Reports on Form 8K 19 SIGNATURES 20 2 Part I Financial Information Item 1 Financial Statements HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands of Dollars Except Per Share Amounts) Six Months Ended June 30, 2002 2001 ---------- ---------- Interest Income Interest and fees on loans $ 8,556 $ 8,923 Interest on federal funds sold 96 248 Interest on time deposits 65 132 Interest and dividends on investment securities Taxable 623 735 Nontaxable 103 79 ------- ------ Total Interest Income 9,443 10,117 ------- ------ Interest Expense Interest on time deposits over $100,000 1,121 1,276 Interest on other deposits 2,863 3,655 Interest on borrowed money 103 105 ------- ------ Total Interest Expense 4,087 5,036 ------- ------ , Net Interest Income 5,356 5,081 Provision for Loan Losses 260 255 ------- ------ Net Interest Income After Provision for Loan Losses 5,096 4,826 ------- ------ Noninterest Income Service charges 273 290 Other 291 253 ------- ------ Total Noninterest Income 564 543 ------- ------ Noninterest Expense Salaries and employee benefits 2,066 1,888 Equipment and Occupancy expense 517 470 Data processing 286 262 Other 948 868 ------- ------ Total Noninterest Expense 3,817 3,488 ------- ------ Income Before Income Taxes 1,843 1,881 Provision for Income Taxes 581 640 ------- ------ Net Income $ 1,262 $ 1,241 ======= ====== Per Share Data Net Income $ 2.57 $ 2.47 ======= ====== Cash Dividends $ .74 $ .68 ======= ====== Weighted Average Common Shares Outstanding 491,359 501,898 ======= ======= The accompanying notes are an integral part of these statements. 3 HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands of Dollars Except Per Share Amounts) Three Months Ended June 30, 2002 2001 ---------- ---------- Interest Income Interest and fees on loans $ 4,277 $ 4,550 Interest on federal funds sold 42 116 Interest on time deposits 32 73 Interest and dividends on investment securities Taxable 304 380 Nontaxable 51 42 ------- ------ Total Interest Income 4,706 5,161 ------- ------ Interest Expense Interest on time deposits over $100,000 541 697 Interest on other deposits 1,340 1,792 Interest on borrowed money 50 48 ------- ------ Total Interest Expense 1,931 2,537 ------- ------ Net Interest Income 2,775 2,624 Provision for Loan Losses 140 135 ------- ------ Net Interest Income After Provision for Loan Losses 2,635 2,489 ------- ------ Noninterest Income Service charges 144 149 Other income 141 120 ------- ------ Total Noninterest Income 285 269 ------- ------ Noninterest Expense Salaries and employee benefits 1,017 954 Equipment and Occupancy expense 265 241 Data processing expense 141 122 Other 514 451 ------- ------ Total Noninterest Expense 1,937 1,768 ------- ------ Income Before Income Taxes 983 990 Provision for Income Taxes 321 343 ------- ------ Net Income $ 662 $ 647 ======= ====== Per Share Data Net Income $ 1.38 $ 1.29 ======= ====== Cash Dividends $ .37 $ .34 ======= ====== Weighted Average Common Shares Outstanding 480,936 501,898 ======= ======= The accompanying notes are an integral part of these statements. 4 HIGHLANDS BANKSHARES, INC. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars) June 30, December 31, 2002 2001 ------------ ------------ ASSETS Cash and due from banks - noninterest bearing $ 6,545 $ 6,492 Time deposits in other banks 5,785 6,334 Federal funds sold 5,789 13,284 Securities held to maturity (note 2) 1,571 1,603 Securities available for sale (note 3) 28,262 29,460 Other investments 858 792 Loans, net of unearned interest (note 5) 215,989 205,469 Less allowance for loan losses (note 6) (1,723) (1,603) Bank premises and equipment 6,933 7,056 Interest receivable 1,926 1,818 Investment in insurance contracts (note 7) 5,188 5,100 Other assets 1,568 973 ------- ------- Total Assets $278,691 $276,778 ======= ======= LIABILITIES Deposits: Noninterest bearing Demand deposits $ 32,686 $ 29,279 Interest bearing Money market and checking 20,156 17,936 Money market savings 13,533 11,407 Savings 29,820 26,782 Time deposits over $100,000 42,467 45,182 All other time deposits 105,402 111,456 ------- ------- Total Deposits 244,064 242,042 Borrowed money 4,276 4,523 Accrued expenses and other liabilities 2,326 1,903 ------- ------- Total Liabilities 250,666 248,468 ------- ------- STOCKHOLDERS' EQUITY Common stock ($5 par value, 1,000,000 shares authorized, 546,764 shares issued) 2,734 2,734 Surplus 1,662 1,662 Retained earnings 25,522 24,624 Accumulated other comprehensive loss 317 283 Treasury stock (at cost, 67,806 shares in 2002 and 44,866 in 2001) (2,210) (993) -------- -------- Total Stockholders' Equity 28,025 28,310 ------- ------- Total Liabilities and Stockholders' Equity $278,691 $276,778 ======= ======= The accompanying notes are an integral part of these statements. 5 HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (In Thousands of Dollars) Accumulated Other Common Treasury Retained Comprehensive Stock Surplus Stock Earnings Income Total Balance, December 31, 2001 $2,734 $ 1,662 $ (993) $ 24,624 $ 283 $ 28,310 Comprehensive Income Net Income 1,262 1,262 Net change in unrealized appreciation on investment securities available for sale, net of taxes 34 34 ----- ------ ------ ------ ------ ------ Total Comprehensive Income 1,296 Treasury stock purchased (1,217) (1,217) Dividends paid (364) (364) ----- ------ ------ ------- ------ ------- Balances, June 30, 2002 $2,734 $ 1,662 $(2,210) $ 25,522 $ 317 $28,025 ===== ======= ======= ======= ===== ======= Accumulated Other Common Treasury Retained Comprehensive Stock Surplus Stock Earnings Income Total Balance, December 31, 2000 $2,734 $ 1,662 $ (993) $ 22,826 $ 39 $26,268 Comprehensive Income Net Income 1,241 1,241 Net change in unrealized appreciation on investment securities available for sale, net of taxes 140 140 ----- ------ ------ ------ ------ ------ Total Comprehensive Income 1,381 Dividends paid (342) (342) ----- ------ ------ ------ ------ ------ Balances, June 30, 2001 $2,734 $ 1,662 $ (993) $ 23,725 $ 179 $27,307 ======== ====== ======= ======= ====== ======= The accompanying notes are an integral part of these statements. 6 HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) Six Months Ended June 30, 2002 2001 ---------- ---------- Cash Flows from Operating Activities: Net income $ 1,262 $ 1,241 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 264 254 Net securities amortization 148 33 Provision for loan losses 260 255 Income from insurance investments (88) (96) Increase in interest receivable (108) (235) (Increase) decrease in other assets (616) 131 Increase in accrued expenses 423 263 ------- ------ Net Cash Provided by Operating Activities 1,545 1,846 ------- ------ Cash Flows from Investing Activities: Net change in time deposits in other banks 548 441 Net change in federal funds sold 7,495 (605) Proceeds from maturities of securities available for sale 4,481 9,792 Proceeds from maturities of securities held to maturity 31 395 Purchase of securities available for sale (3,376) (15,934) Purchase of other investments (67) (29) Net change in loans (10,659) (10,165) Purchase of property and equipment (140) (615) -------- ------ Net Cash Consumed by Investing Activities (1,687) (16,720) -------- ------- Cash Flows from Financing Activities: Net change in time deposits (8,769) 13,564 Net change in other deposits 10,791 808 Dividends paid in cash (364) (342) Purchase of treasury stock (1,217) Repayment of borrowed money (247) (422) Advances of borrowed money 600 ------- ------ Net Cash Provided by Financing Activities 194 14,208 ------- ------ Net Increase (Decrease) in Cash and Cash Equivalents 52 (666) Cash and Cash Equivalents, Beginning of Period 6,492 7,062 ------- ------ Cash and Cash Equivalents, End of Period $ 6,544 $ 6,396 ======= ====== Supplemental Disclosures: Cash Paid For: Income taxes $ 430 $ 1,002 Interest 4,052 4,970 The accompanying notes are an integral part of these statements. 7 HIGHLANDS BANKSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ACCOUNTING PRINCIPLES: The consolidated financial statements conform to generally accepted accounting principles and to general industry practices. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of June 30, 2002, and the results of operations for the three and six month periods ended June 30, 2001 and 2002. The notes included herein should be read in conjunction with the notes to financial statements included in the 2001 annual report to stockholders of Highlands Bankshares, Inc. The Company does not expect the anticipated adoption of any newly issued accounting standards to have a material impact on future operations or financial position. NOTE 2 SECURITIES HELD TO MATURITY: The amortized cost and fair value of securities held to maturity as of June 30, 2002 and December 31, 2001, are as follows: 2002 2001 ----------------- ----------------- Amortized Fair Amortized Fair Cost Value Cost Value Obligations of states and political subdivisions $ 1,566 $ 1,628 $1,597 $ 1,633 Mortgage-backed securities 5 5 6 6 ------- ------ ------ ------ Total $ 1,571 $ 1,633 $1,603 $ 1,639 ====== ====== ===== ====== NOTE 3 SECURITIES AVAILABLE FOR SALE: The amortized cost and fair value of securities available for sale as of June 30, 2002 and December 31, 2001, are as follows: 2002 2001 --------------- ------------------- Amortized Fair Amortized Fair Cost Value Cost Value US Treasury securities and obligations of US Government corporations and agencies $16,579 $16,836 $16,123 $16,432 Obligations of states and political subdivisions 5,818 5,924 6,319 6,380 Mortgage-backed securities 5,322 5,471 6,527 6,609 Other investments 34 31 42 39 ------ ------ ----- ------ Total $27,753 $28,262 $29,011 $29,460 ====== ====== ====== ====== 8 HIGHLANDS BANKSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 OTHER INVESTMENTS Other investments totaling $ 858,550 include investments in the Federal Home Loan Bank and other governmental entities whose transferability is restricted NOTE 5 LOANS OUTSTANDING: A summary of loans outstanding as of June 30, 2002 and December 31, 2001, is as follows: 2002 2001 ---- ---- Commercial $ 44,706 $ 42,204 Real estate - construction 5,013 3,868 - mortgages 118,587 111,668 Consumer installment 47,789 47,927 ------- ------- Total 216,095 205,667 Unearned interest (106) (198) -------- -------- Net loans outstanding $215,989 $205,469 ======= ======= NOTE 6 ALLOWANCE FOR LOAN LOSSES: A summary of transactions in the allowance for loan losses for the six months ended June 30, 2002 and 2001, follows: 2002 2001 ---- ---- Balance, beginning of period $ 1,603 $ 1,493 Provisions charged to operating expenses 260 255 Loan recoveries 96 139 Loan charge-offs (236) (187) -------- ------- Balance, end of period $ 1,723 $ 1,700 ======= ======= NOTE 7 INVESTMENT IN INSURANCE CONTRACTS: Investment in insurance contracts consist of single premium insurance contracts which have the dual purposes of providing a rate of return to the Company which approximately equals the Company's average cost of funds and providing life insurance and retirement benefits to employees. The carrying value of these investments was $5,188,000 at June 30, 2002 and $5,100,000 at December 31, 2001. 9 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations Overview Year to Date Operations The Company's year to date net income was $1,261,616, an increase of 1.69% compared to 2001. Earnings per share were $2.57 for 2002 compared to $2.47 per share for 2001. The Company's annualized return on average equity was 9.03% in 2002 compared to 9.17% for 2001. Return on average assets was .92% for 2002 and ..94% for 2001, respectively. The increase in earnings per share was due primarily to a 5.41% increase in net interest income. Growth in average earning assets (8.92%) and interest bearing liabilities (5.57%) within the last twelve months offset a declining net interest margin between 2002 and 2001. The increase in the tax equivalent net interest income was 5.63% for the period. The provision for loan losses of $260,000 was up slightly ($5,000) over the same period in 2001 and is reflective of moderate net charge offs in 2002. Noninterest income increased 3.87% due to a higher volume of insurance activity partially offset by decline in account service charges. Noninterest expenses increased 9.43%, mainly the result of operating expenses at the new branch in Gore, Virginia which opened in June 2001 and salary/benefit increases. Quarter Ending June 30 Operations Overall net income for the quarter ending June 30, 2002 increased 2.32% to $662,000 when compared to 2001 income of $647,000. Earnings per share for the second quarter of 2002 were $1.38 versus $1.29 in 2001 (a 6.98% increase). Increases in the net interest income of 5.75% were offset by increases in operating expenses of 9.56% during the period. Net Interest Income Year to Date Operations The Company's net yield on interest earning assets on a tax equivalent basis was 4.23% through the second quarter of 2002 compared to 4.36% for the second quarter of 2001. The volume of all lending increased substantially in the last twelve months due to a strong economy and additional branch locations. Commercial rates decreased from 9.04% in 2001 to 8.04% in 2002 due to the Federal Reserve Bank actions over the last year. Rates on real estate loans declined 148 basis points. Rates on consumer loans actually increased 38 basis points, largely due to a shift in demand for used vehicles and short term personal loans. The overall decrease of 101 basis points in returns on average loans was more than offset by decreases in the rates paid on deposits and borrowed money (see "Deposits" below). Through the second quarter of 2002, the Company saw an overall decrease of 160 basis points in the yields on investment securities compared to 2001 results. The decrease is reflective of recent reinvestments at lower rates. Average investments in securities have increased over the last twelve months as deposit growth has outpaced loan demand creating excess cash to invest. Interest rates earned on fed funds sold and interest bearing deposits declined 285 basis points as rates were cut eleven times in 2001 by the Federal Reserve Bank ("The Fed") by one-quarter to one-half point each time. The increase in federal funds is intended to serve as a source of funding should maturing, high rate certificates leave the Banks. The Company experienced a $8.8 million decline in the balance of certificates in the first half of 2002 due to repricing of maturing certificates at much lower rates, but, this outflow has been offset by increased levels of demand and savings deposits. 10 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Net Interest Income (Continued) Year to Date Operations (Continued) Customers appear reluctant to commit to long-term, fixed rates on certificates when rates are at historical lows and are instead placing their deposits in accounts that are highly liquid and will allow them to respond quickly when rates increase. Interest rates paid on transaction and savings accounts declined a combined 94 basis points due to lower rates resulting from the Fed actions. The average balance in time deposits grew 3.20% in 2002 since this same time in 2001 and has been a source of funding for the loan growth discussed earlier. A 118 basis point decrease in rates paid on time deposits between 2001 and 2002 reflects the declining rate environment throughout 2002, especially after the tragedies of September 11. Beginning in 1999, the Company has borrowed amounts from the FHLB at fixed rates of interest and loaned these monies to customers on a fixed rate basis. The Company anticipates continuing to use this approach as a mechanism to provide long-term financing to customers and limit market rate risk. In addition, monies were borrowed on a short-term, variable rate basis to fund the renovation and expansion at the Capon Valley Bank. The Bank anticipates refinancing this variable rate debt when long-term interest rates are favorable. The cost of all FHLB borrowings decreased 44 basis points from 2001 to 2002 due to rate changes in market. Quarter Ending June 30 Operations The Company's net interest income on a tax equivalent basis of $2,805,000 was 4.33% of average earning assets for the quarter ending June 30, 2002 compared to net interest income of $2,648,000 (4.39% of average earning assets) for the same period in 2001. A 6.00% decrease in income from loans was the result of an increase in volume which was outpaced by a 118 basis point decline in average yields. Yields on investment securities also declined significantly over the previous year in response to prevailing market conditions. Outpacing the decline in asset yields was a decrease in average rates paid on interest bearing liabilities from 4.91% in 2001 to 3.63% in 2002. The decrease was primarily the result of a 137 basis point decline in the cost of time deposits as high rate deposits are maturing and are being replaced by lower rate deposits. The Company expects future deposit rates to remain stable or decrease slightly in the second half of 2002 as rates on higher costing certificates continue to mature and are replaced with rates in line with current market rates. A complete yield analysis is shown as Table I on page 17. Noninterest Income Year to Date Operations Noninterest income for 2002 rose slightly from 2001 levels. Service charge income declined by 5.86% and other operating income increased by 15.02%. Service charge income declined as the result of a single customer being sold to new investors who infused funds in the business and eliminated overdrafts and their related fees. The net increase in other income is primarily due to a corresponding increase in underwriting revenue of HBI Life Insurance Company. Quarter Ending June 30 Operations Noninterest interest income for the quarter ending June 30, 2002 increased 5.94% as the result of the increase in other income discussed in the preceding paragraph. 11 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Noninterest Expenses Year to Date Operations Overall noninterest expense increased 9.43% in 2002 as the result of operating expense increases at Capon Valley Bank's new Gore Branch which opened in June 2001, a marketing campaign with additional advertising expenses and an increase in expenses relative to employee benefit plan administration. Personnel expense increases of 9.43% were the result of an 8.00% increase in full time equivalent employees due to growth and reorganization and an increase in average wages. Expenses for occupancy, equipment and data processing expenses increased 10.00% due to costs of upgrading data processing equipment, equipping an additional branch facility and increasing data processing services for stockholder services. Other noninterest expenses increased 9.22% due to asset growth and additional advertising. The overall increase in noninterest expense of 9.43% is in line with management estimates through the second quarter of the year and the increase in average earning assets of 8.92%. Quarter Ending June 30 Operations Overall, noninterest expenses increased 9.56% for the quarter ending June 30, 2002 compared to the quarter ending June 30, 2001. The reasons for the quarterly increase are the same as for the year-to-date increases and the percentage increases for the quarters are relatively the same as the year-to-date increases. Loan Portfolio The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area. The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Randolph, Mineral, Hampshire, northern Pendleton counties in West Virginia and Frederick County in Virginia. Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area. The principal economic risk associated with each of the categories of loans in the Company's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased depending on prevailing economic conditions. The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness. The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company's market areas. The risk associated with real estate construction loans varies based upon the supply of and demand for the type of real estate under construction. Loans outstanding increased $10,520,000 or 5.12% in the first half of 2002 compared to levels at December 31, 2001. The first quarter of any year is traditionally slow as farming and logging operations are hampered by weather conditions and retail borrowing in the first quarter is put on hold until the spring. Thus, the first quarter increase of 2.01% in the loan portfolio was not anticipated but certainly welcomed. A 6.98% rise in real estate construction and mortgage loans since the beginning of this year was primarily responsible for the increase through the second quarter with consumer and commercial lending remaining stable. The loan to deposit ratio was 88.50% at June 30, 2002 compared to 84.89% at December 31, 2001. Loan demand is expected to remain satisfactory in the near future barring any significant declines in the local or national economies. 12 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Asset Quality and Risk Elements Nonperforming loans include nonaccrual loans, loans 90 days or more past due and restructured loans. Nonaccrual loans are loans on which interest accruals have been suspended or discontinued permanently. Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower. Nonaccrual loans totaled $668,000 at June 30, 2002 compared to $885,000 in nonaccrual loans at December 31, 2001. The decrease was the result of foreclosures, which resulted in increases in other real estate owned. Real estate acquired through foreclosure was $596,500 at June 30, 2002 and $77,000 at December 31, 2001. All foreclosed property held was in the Company's primary service area. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance. The Company is actively marketing all foreclosed real estate and does not anticipate material write-downs in value before disposition. An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed periodically for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), timber and related industries. Management recognizes these concentrations and considers them when structuring its loan portfolio. As of June 30, 2002, management is not aware of any significant potential problem loans in which the debtor is currently meeting their obligations as stated in the loan agreement but which may change in future periods. Allowance for Loan Losses Management evaluates the loan portfolio in light of national and local economic changes, changes in the nature and value of the portfolio and industry standards. The Company's loan classification system, which rates existing loans, provides the basis for adjusting the allowance for loan losses. Management reviews these classification totals, along with internally generated loan review reports, past due reports, historical loan loss experience and individual borrower's financial health to determine the necessary amount to be provided in the allowance for loan losses. Management evaluates nonperforming loans relative to their collateral value and makes the appropriate adjustments to the allowance when needed. 13 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses (Continued) The provision for credit losses and changes in the allowance for credit losses are shown below (in thousands of dollars). Quarter Ended Six Months Ended June 30, June 30, ------------------ -------------------- Allowance for credit losses 2002 2001 2002 2001 --------------------------- ---- ---- ---- ---- Balance, beginning of period $ 1,623 $ 1,595 $ 1,603 $ 1,493 Net charge-offs (recoveries) Charge-offs (114) (83) (236) (187) Recoveries 74 53 96 139 ------ ------ ------ ------ Total net charge-offs * (40) (30) (140) (48) Provision for credit losses 140 135 260 255 ------ ------ ------ ------ Balance, End of Period $ 1,723 $ 1,700 $ 1,723 $ 1,700 ====== ====== ====== ====== Quarter Ended Six Months Ended June 30, June 30, ------------------ -------------------- 2002 2001 2002 2001 ---- ---- ---- ---- * Components of net charge-offs: Real estate $ 22 $ $ 13 $ Commercial (2) (18) (8) Installment (60) (30) (135) (40) ------- ------ ------- ------ Total $ (40) $ (30) $ (140) $ (48) ======= ====== ======= ====== The allowance for credit losses of $1,723,000 at June 30, 2002, was up $100,000 from its level at March 31, 2002. The increase was due to limited net charge offs during the second quarter of 2002 compared to the provision charged to operations. The allowance was equal to .80% and .78% of total loans at June 30, 2002 and December 31, 2001, respectively. The Company believes that its allowance must be viewed in its entirety and, therefore, is available for potential credit losses in it entire portfolio, including, loans, credit-related commitments and other financial instruments. In the opinion of management, the allowance, when taken as a whole, is adequate to absorb reasonably estimated credit losses inherent in the Company's portfolio. 14 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses (Continued) The following table shows the allocation of loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan types as of June 30, 2002 and December 31, 2001: June 30, 2002 December 31, 2001 ------------- ----------------- Loan Allowance Percentage Percentage of Allowance Percentage Percentage of Type Allocation of Allowance Total Loans Allocation of Allowance Total Loans Commercial $ 569 33% 21% $ 487 30% 21% Mortgage 554 32% 57% 576 36% 56% Consumer 525 31% 22% 450 28% 23% Unallocated 75 4% 0% 90 6% % ----- --- --- ----- --- --- Totals $ 1,723 100% 100% $ 1,603 100% 100% ======= ==== ==== ====== ==== ==== Until recently, the allowance allocation weighted toward commercial loans due to its sensitivity to economic conditions. During 2001, the adoption of FFIEC guidelines SAB 102 placed more weight of the allowance toward the actual composition of the portfolio in combination with specific allocations toward impaired loans. As a result, a shift of weighted allowance has moved to consumer loans which now carries 22% of the balances and 31% of the allocation, with mortgage at 32% and commercial at 33% of the allocation. Securities The Company's securities portfolio serves numerous purposes. Portions of the portfolio may secure certain public and trust deposits. The remaining portions are held as investments or used to assist the Company in liquidity and asset/liability management. Total securities at June 30, 2002 were $29,833,000 compared to $31,063,000 at December 31, 2001. Securities as a percentage of total assets were 10.70% at June 30, 2002 compared to 11.22% at December 31, 2001. The level of securities relative to total assets has dropped slightly throughout 2002 as the demand for loans has been partially funded by investment maturities. The securities portfolio consists of three components, specifically, securities held to maturity, securities available for sale and other investments. Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Other investments include restricted securities whose ownership is required to participate in certain governmental programs. The Company's recent purchases of all securities have generally been limited to securities of high credit quality with short to medium term maturities. Changes in the market values of securities available for sale are reflected as changes in stockholders' equity, net of the deferred tax effect. As of June 30, 2002, the fair value of the securities available for sale exceeded their cost by $509,000 ($317,000 after tax considerations). 15 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Deposits The Company's main source of funds remains deposits received from individuals, governmental entities and businesses located within the Company's service area. Deposit accounts include demand deposits, savings, money market and certificates of deposit. Total deposits increased 0.84% between December 31, 2001 and June 30, 2002, in all deposit areas except time deposits. The cost of funds for the first six months of 2002 was 3.84% compared to 5.00% for the same period in 2001. The costs on all deposit types decreased during the period. The majority of the Company's deposits are time deposits that are attractive to persons seeking high yields on their deposits but without the need for liquidity. The Company has recently seen a substantial decrease in all time deposits as a result of maturing high-rate certificates of deposits. Total deposits have grown slightly as noted due to the shift from time deposits as they matured to savings and money market accounts. Customers are keeping their investments in transaction accounts waiting for market forces to increase rates. Capital The Company seeks to maintain a strong capital base to expand facilities, promote public confidence, support current operations and grow at a manageable level. As of June 30, 2002, the Company's total risk based capital ratio was 14.41% which is far above the regulatory minimum of 8.0%. The leverage ratio of total capital to total assets was 10.16% at June 30, 2002, which is comparable to the Company's peer group. In the second quarter of 2002, the Company repurchased stock from unrelated parties in two separate transactions. Total shares repurchased were 22,940 at a cost of $1,217.000. In June 2002, the Company approved a three for one stock split effective September 3, 2002 to shareholders of record on August 1, 2002. Liquidity Liquidity is the ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, investments and loans maturing within one year. The Company's ability to obtain deposits and purchase funds at favorable rates determines its liquidity exposure. As a result of the Company's management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors' requirements and meet its customers' credit needs. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds. To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions and the Federal Reserve Bank of Richmond. Both subsidiary banks have lines of credit with the Federal Home Loan Bank of Pittsburgh although utilization has been insignificant. In the past, growth in deposits has been sufficient to fund the net increase in loans and investment securities 16 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Interest Rate Sensitivity In conjunction with maintaining a satisfactory level of liquidity, management must also control the degree of interest rate risk assumed on the balance sheet. Managing this risk involves regular monitoring of the interest sensitive assets relative to interest sensitive liabilities over specific time intervals. At June 30, 2002 the Company had a negative gap position through the first three months, shifting to a positive gap by the end of one year. With the largest amount of interest sensitive assets and liabilities repricing within one year, the Company believes it is in an excellent position to respond to rapid market rate changes quickly. Early withdrawal of deposits, prepayments of loans and loan delinquencies are some of the factors that could affect actual versus expected cash flows. In addition, changes in rates on interest sensitive assets and liabilities may not be equal, which could result in a change in net interest margin. While the Company does not match each of its interest sensitive assets against specific interest sensitive liabilities, it does review its positions regularly and takes actions to reposition it when necessary. Securities and Exchange Commission Web Site The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including Highlands Bankshares, Inc., and the address is (http://www.sec.gov). 17 Table I HIGHLANDS BANKSHARES, INC. NET INTEREST MARGIN ANALYSIS (Dollar Amounts in Thousands) Six Months Ended Six Months Ended June 30, 2002 June 30, 2001 -------------------- ----------------- Average Income/ Average Income/ Balance Expense Rates Balance Expense Rates Interest Income Loans 1, 4 Commercial $11,568 $ 461 8.04% $11,291 $ 506 9.04% Consumer 54,207 3,147 11.71% 52,645 2,959 11.33% Real estate 144,180 4,948 6.92% 131,075 5,458 8.40% ------- ----- ------ ------- ----- --------- Total 209,955 8,556 8.22% 195,011 8,923 9.23% Federal funds sold 11,562 96 1.69% 10,223 248 4.89% Interest bearing deposits 5,324 65 2.20% 5,830 132 4.57% Investments Taxable 3 25,756 623 4.88% 22,795 735 6.50% Tax exempt 2,3 5,695 163 5.77% 3,290 125 7.66% ----- ----- ---- ----- ----- ----- Total Earning Assets 258,292 9,503 7.53% 237,149 10,163 8.64% ------- ----- ------- -------- ------ ------- Interest Expense Money markets 31,842 205 1.30% 29,096 310 2.15% Savings 28,132 206 1.48% 24,498 307 2.53% Time deposits 150,276 3,573 4.79% 145,614 4,314 5.97% Other borrowed money 4,344 103 4.78% 4,059 105 5.22% ----- ----- ---- ----- ----- ----- Total Interest Bearing Liabilities 214,594 4,087 3.84% 203,267 5,036 5.00% ------- -------- ------ ------- ----- ------- Net Interest Income 5,416 $5,127 ===== ===== Net Yield on Interest Earning Assets 4.23% 4.36% ==== ===== 1 Interest income on loans includes loan fees. 2 On a taxable equivalent basis based on a tax rate of 37%. 3 Average balance information is reflective of historical cost and has not been adjusted for changes in market value. 4 Average balances include non-accrual loans. 17 Table I (Continued) HIGHLANDS BANKSHARES, INC. NET INTEREST MARGIN ANALYSIS (Dollar Amounts in Thousands) Three Months Ended Three Months Ended June 30, 2002 June 30, 2001 ------------------- ------------------- Average Income/ Average Income/ Balance Expense Rates Balance Expense Rates Interest Income Loans 1, 4 Commercial $11,708 $ 226 7.74% $10,337 $ 273 10.59% Consumer 53,837 1,578 11.76% 53,362 1,276 9.59% Real estate 148,558 2,473 6.68% 134,975 3,001 8.92% ------- ------- ------ ------- ----- ------- Total 214,103 4,277 8.01% 198,674 4,550 9.19% Federal funds sold 9,777 42 1.76% 10,124 116 4.60% Interest bearing deposits 5,300 32 1.89% 6,282 73 4.66% Investments Taxable 3 25,104 304 4.86% 23,653 380 6.44% Tax exempt 2,3 5,828 81 5.57% 3,464 66 7.64% ----- ----- ---- ----- ----- ----- Total Earning Assets 260,112 4,736 7.38% 242,197 5,185 8.59% ------- ------ ------ ------- ----- ------ Interest Expense Money markets 34,287 108 1.26% 28,697 135 1.89% Savings 28,567 108 1.52% 25,161 144 2.30% Time deposits 146,032 1,665 4.57% 149,122 2,210 5.94% Other borrowed money 4,221 50 4.75% 4,171 48 4.62% ----- ----- ---- ----- ----- ----- Total Interest Bearing Liabilities 213,107 1,931 3.63% 207,151 2,537 4.91% ------- ------ ------ -------- ----- ------ Net Interest Income 2,805 $2,648 ===== ===== Net Yield on Interest Earning Assets 4.33% 4.39% ==== ===== 1 Interest income on loans includes loan fees. 2 On a taxable equivalent basis based on a tax rate of 37%. 3 Average balance information is reflective of historical cost and has not been adjusted for changes in market value. 4 Average balances include non-accrual loans. 18 TABLE II HIGHLANDS BANKSHARES, INC. INTEREST RATE SENSITIVITY ANALYSIS JUNE 30, 2002 (In Thousands of Dollars) More than 5 Years 1 - 90 91 - 365 1 to 3 3 to 5 or no Days Days Years Years Maturity Total EARNINGS ASSETS Loans $42,768 $105,640 $49,105 $ 8,700 $9,776 $215,989 Fed funds sold 5,789 5,789 Securities 4,206 8,212 11,364 1,766 5,143 30,691 Time deposits in other banks 5,585 200 5,785 ------ ------ ------ ------ ----- ------ Total 58,348 114,052 60,469 10,466 14,919 258,254 ------ ------- ------ ------ ------ ------- INTEREST BEARING LIABILITIES Transaction accounts 20,156 20,156 Money market savings 13,533 13,533 Savings accounts 29,820 29,820 Time deposits more than $100,000 6,797 21,697 8,862 5,111 42,467 Time deposits less than $100,000 16,885 53,162 27,531 7,441 383 105,402 Other borrowed money 1,267 31 2,978 4,276 ------ ------ ------ ------ ----- ------ Total 88,458 74,859 36,424 12,552 3,361 215,654 ------ ------ ------ ------ ----- ------- Rate sensitivity GAP (30,110) 39,193 24,045 (2,086) 11,558 Cumulative GAP (30,110) 9,083 33,128 31,042 42,600 Ratio of cumulative interest sensitive assets to cumulative interest sensitive liabilities 65.96% 105.56% 116.59% 114.62% 119.75% Assumes all transaction, money market and savings deposit accounts reprice within 90 days. 19 Part II Other Information Item 1. Legal Proceedings - Not Applicable Item 2. Changes in Securities - Not Applicable Item 3. Defaults Upon Senior Securities - Not Applicable Item 4. Submission of Matters to a Vote of Security Holders - On April 9, 2002, the stockholders held their annual meeting. The following items were approved by the shareholders by the required majority: 1) Election of the Board of Directors as proposed in the proxy material without any additions or exceptions. 2) Ratification of S. B. Hoover & Company, L.L.P. as auditors for the year ending December 31, 2002. Item 5. Other Information - Not Applicable Item 6. Exhibits and Reports on 8-K - (a)Exhibits 3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are incorporated by reference to Appendix C to Highlands Bankshares, Inc.'s Form S-4 filed October 20, 1986. 3 (ii)Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Appendix D to Highland Bankshares, Inc.'s Form S-4 filed October 20, 1986. (b)Reports on Form 8-K filed during the three months ended June 30, 2002. None 20 Signature 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. HIGHLANDS BANKSHARES, INC. /s/ LESLIE A. BARR ------------------------------------- Leslie A. Barr President /s/ ALAN L. BRILL ------------------------------------- Alan L. Brill Secretary Date: