UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
[X ] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended June 30, 2005
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission File No. 0-16761
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HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
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
(Address of Principal Executive Offices, Including Zip Code)
(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
----- -------
Indicate by check mark whether the issuer is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes No X
----- -----
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
As of August 1, 2005, 1,436,874 shares of Common Stock, $5 Par Value
1
HIGHLANDS BANKSHARES, INC.
INDEX
Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Consolidated Statements of Income - Six Months
Ended June 30, 2005 and 2004 2
Unaudited Consolidated Statements of Income - Three Months
Ended June 30, 2005 and 2004 3
Unaudited Consolidated Balance Sheet - June 30, 2005 and
Audited Consolidated Balance Sheet--December 31, 2004 4
Unaudited Consolidated Statements of Changes in Stockholders'
Equity - Six Months Ended June 30, 2005 and 2004 5
Unaudited Consolidated Statements of Cash Flows - Six Months
Ended June 30, 2005 and 2004 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures about Market Risk 25
Item 4. Controls and Procedures 27
PART II OTHER INFORMATION
Item 1. Legal Proceedings 28
Item 2. Changes in Securities 28
Item 3. Defaults upon Senior Securities 28
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information 28
Item 6. Exhibits and Reports on Form 8K 28
SIGNATURES 29
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,
2005 2004
(Unaudited) (Unaudited)
Interest Income
Interest and fees on loans $ 8,915 $ 8,228
Interest on federal funds sold 101 83
Interest on time deposits 11 8
Interest and dividends on investment securities 371 411
------- ------
Total Interest Income 9,398 8,730
------- ------
Interest Expense
Interest on deposits 2,347 2,281
Interest on borrowed money 309 128
------- ------
Total Interest Expense 2,656 2,409
------- ------
Net Interest Income 6,742 6,321
Provision for Loan Losses 435 405
------- ------
Net Interest Income After Provision for Loan Losses 6,307 5,916
------- ------
Noninterest Income
Service charges 391 382
Investment in insurance contracts 121 100
Insurance related income 125 126
Other 184 136
------- ------
Total Noninterest Income 821 744
------- ------
Noninterest Expense
Salaries and employee benefits 2,453 2,342
Equipment and occupancy expense 606 591
Data processing 305 344
Legal and professional fees 168 180
Directors fees 174 179
Other 745 754
------- ------
Total Noninterest Expense 4,451 4,390
------- ------
Income Before Income Taxes 2,677 2,270
Provision for Income Taxes 910 761
------- ------
Net Income $ 1,767 $ 1,509
======= ======
Per Share Data
Net Income $ 1.23 $ 1.05
Cash Dividends $ .40 $ .30
Weighted Average Common Shares Outstanding 1,436,874 1,436,874
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,
2005 2004
(Unaudited) (Unaudited)
Interest Income
Interest and fees on loans $ 4,526 $ 4,157
Interest on federal funds sold 72 41
Interest on time deposits 6 4
Interest and dividends on investment securities 179 197
------- ------
Total Interest Income 4,783 4,399
------- ------
Interest Expense
Interest on deposits 1,232 1,094
Interest on borrowed money 160 66
------- ------
Total Interest Expense 1,392 1,160
------- ------
Net Interest Income 3,391 3,239
Provision for Loan Losses 210 210
------- ------
Net Interest Income After Provision for Loan Losses 3,181 3,029
------- ------
Noninterest Income
Service charges 217 214
Investment in insurance contracts 54 49
Insurance related income 88 79
Other income 92 68
------- ------
Total Noninterest Income 451 410
------- ------
Noninterest Expense
Salaries and employee benefits 1,233 1,187
Equipment and occupancy expense 306 304
Data processing expense 152 167
Legal and professional fees 86 108
Directors Fees 88 92
Other 370 368
------- ------
Total Noninterest Expense 2,235 2,226
------- ------
Income Before Income Taxes 1,397 1,213
Provision for Income Taxes 479 416
------- ------
Net Income $ 918 $ 797
======= ======
Per Share Data
Net Income $ .64 $ .55
Cash Dividends $ .20 $ .15
Weighted Average Common Shares Outstanding 1,436,874 1,436,874
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,
2005 2004
(unaudited) (audited)
ASSETS
Cash and due from banks - noninterest bearing $ 7,379 $ 6,187
Time deposits in other banks 1,363 651
Federal funds sold 10,631 4,006
Securities held to maturity (note 2) 690 1,162
Securities available for sale (note 2) 22,945 24,702
Other investments (note 3) 1,283 1,165
Loans, net of unearned interest (note 4) 253,938 248,517
Allowance for loan losses (note 5) (2,780) (2,530)
Bank premises and equipment 6,544 6,809
Interest receivable 1,516 1,436
Investments in insurance contracts (note 6) 5,930 5,809
Other assets 1,897 2,078
------- -------
Total Assets $311,336 $299,992
======= =======
LIABILITIES
Deposits:
Noninterest bearing demand deposits $ 40,374 $ 37,522
Interest bearing
Savings and interest bearing demand deposits 73,932 75,342
Time deposits (note 7) 144,269 141,527
------- -------
Total Deposits 258,575 254,391
Short term debt 2,000
Long term debt 15,839 8,377
Accrued expenses and other liabilities 4,098 3,569
------- -------
Total Liabilities 278,512 268,337
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STOCKHOLDERS' EQUITY
Common stock ($5 par value, 3,000,000 shares
authorized) 7,184 7,184
Surplus 1,662 1,662
Retained earnings 24,220 23,028
Accumulated other comprehensive loss (242) (219)
-------- --------
Total Stockholders' Equity 32,824 31,655
------- -------
Total Liabilities and Stockholders' Equity $311,336 $299,992
======= =======
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 Retained Comprehensive
Stock Surplus Earnings Loss Total
Balances, December 31, 2004 $ 7,184 $ 1,662 $ 23,028 $ (219) $31,655
Comprehensive Income
Net income 1,767 1,767
Net change in unrealized
depreciation on
investment
securities available
for sale,
net of taxes (23) (23)
------
Total Comprehensive Income 1,744
Dividends paid (575) (575)
----- ------ ------- ------ ------
Balances, June 30, 2005 $ 7,184 $ 1,662 $ 24,220 $ (242) $32,824
===== ====== ======= ====== ======
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Loss Total
Balances, December 31, 2003 $ 7,184 $ 1,662 $ 20,727 $ (24) $29,549
Comprehensive Income
Net income 1,509 1,509
Net change in unrealized
depreciation on
investment
securities available
for sale,
net of taxes (173) (173)
------
Total Comprehensive Income 1,336
Dividends paid (431) (431)
------ ------ ------- ------ ------
Balances, June 30, 2004 $ 7,184 $ 1,662 $ 21,805 $ (197) $30,454
====== ====== ======= ====== ======
The accompanying notes are an integral part of these statements.
6
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
(Unaudited)
Six Months Ended
June 30,
2005 2004
---------- ---------
Cash Flows from Operating Activities:
Net income $ 1,767 $ 1,509
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 330 335
Net securities amortization 41 267
Provision for loan losses 435 405
Income from insurance investments (121) (100)
(Increase) decrease in interest receivable (80) 167
Decrease in other assets 206 289
Increase (decrease) in accrued expenses 529 (255)
------- -------
Net Cash Provided by Operating Activities 3,107 2,617
------- ------
Cash Flows from Investing Activities:
Net change in time deposits in other banks (712) (129)
Net change in federal funds sold (6,625) 1,065
Proceeds from maturities of securities
available for sale 5,029 9,432
Proceeds from maturities of securities
held to maturity 471 1
Purchase of securities available for sale (3,359) (5,172)
Purchase of other investments (118) (30)
Net change in loans (5,606) (7,326)
Purchase of property and equipment (65) (144)
-------- ------
Net Cash Consumed by Investing Activities (10,985) (2,303)
-------- ------
Cash Flows from Financing Activities:
Increase (decrease) in deposits 4,184 (1,072)
Dividends paid in cash (575) (431)
Additional short term borrowings 1,500
Repayment of short term borrowings (3,500)
Additional long term debt 7,700 1,000
Repayment of long term debt (238) (204)
--------- --------
Net Cash Provided by (Used in) Financing Activities 9,071 (707)
------- -------
Net Increase (Decrease) in Cash and Cash Equivalents 1,193 (393)
Cash and Cash Equivalents, Beginning of Period 6,186 7,214
------- ------
Cash and Cash Equivalents, End of Period $ 7,379 $ 6,821
======= ======
Supplemental Disclosures:
Cash Paid For:
Income taxes $ 911 $ 519
Interest 2,556 2,492
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 U. S. generally
accepted accounting principles and to general industry practices. In
the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments necessary to present
fairly the financial position as of June 30, 2005 and the results of
operations for the three month and six month periods ended June 30,
2005 and 2004.
The notes included herein should be read in conjunction with the notes
to financial statements included in the 2004 annual report on Form
10-K.
NOTE 2 SECURITIES:
The Company's securities portfolio serves several purposes. Portions
of the portfolio secure certain public and trust deposits while the
remaining portions are held as investments or used to assist the
Company in liquidity and asset liability management.
The amortized cost and market value of securities held to maturity as
of June 30, 2005 and December 31, 2004, are as follows (in thousands):
2005 2004
Amortized Market Amortized Market
Cost Value Cost Value
Obligations of states and
political subdivisions $ 690 $ 699 $ 1,162 $ 1,187
------ ------ ----- ------
Total $ 690 $ 699 $ 1,162 $ 1,187
====== ====== ===== ======
The amortized cost and fair value of securities available for sale
as of June 30, 2005 and December 31, 2004 are as follows (in
thousands):
2005 2004
Amortized Market Amortized Market
Cost Value Cost Value
US Treasury securities and
obligations of US
Government corporations
and agencies $16,925 $16,806 $18,248 $18,164
Mortgage-backed securities 3,446 3,457 4,669 4,693
Obligations of states and
political subdivisions 2,647 2,652 1,811 1,817
Other investments 28 30 28 28
------ ------ ----- ------
Total $23,046 $22,945 $24,756 $24,702
====== ====== ====== ======
8
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 SECURITIES (continued):
Taxable and non-taxable interest and dividends on investment
securities for the three month periods ended June 30, 2005 and 2004
and for the six month periods ended June 30, 2005 and 2004 are as
follows (in thousands):
Six Months Ended June 30, Three Months Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Taxable $ 317 $ 345 $ 151 $ 165
Non-taxable 54 66 28 32
----- ----- ----- -----
Total $ 371 $ 411 $ 179 $ 197
===== ===== ===== =====
NOTE 3 OTHER INVESTMENTS:
Other investments totaling $ 1,283,000 include investments in the
Federal Home Loan Bank and other governmental entities whose
transferability is restricted.
NOTE 4 LOANS:
A summary of loans outstanding as of June 30, 2005 and December 31,
2004 is as follows (in thousands):
2005 2004
---- ----
Commercial $ 53,861 $ 52,814
Real estate - construction 10,160 8,850
- mortgages 146,009 140,761
Consumer 43,908 46,092
------- -------
Loans outstanding $253,938 $248,517
======= =======
NOTE 5 ALLOWANCE FOR LOAN LOSSES:
A summary of transactions in the allowance for loan losses for the six
months ended June 30, 2005 and 2004, follows:
2005 2004
Balance, beginning of period $ 2,530 $ 2,463
Provisions charged to operating expenses 435 405
Loan recoveries 85 189
Loan charge-off (270) (719)
------ -------
Balance, end of period $ 2,780 $ 2,338
======= =======
9
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 INVESTMENT IN INSURANCE CONTRACTS:
Investment in insurance contracts consists 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
certain employees. The carrying value of these investments was
$5,930,000 at June 30, 2005 and $5,809,000 at December 31, 2004.
NOTE 7 DEPOSITS:
Balances of time deposits over $100,000 and time deposits less than
$100,000 at June 30, 2005 and December 31, 2004 are set forth below
(in thousands):
2005 2004
Time deposits over $100,000 $ 41,350 $ 39,402
All other time deposits 102,919 102,125
------- -------
Total time deposits $144,269 $141,527
Interest expense for time deposits over $100,000 for the six month and
three month periods ended June 30, 2005 and June 30, 2004 are set
forth below (in thousands):
Six Months Three Months
Ended June 30 Ended June 30
2005 2004 2005 2004
---- ---- ---- ----
$ 637 $ 639 $ 333 $ 289
The following is a summary of the maturity distribution of all time
deposits of $100,000 or more as of June 30, 2005 (in thousands):
Amount
0-90 Days $ 4,859
91-365 Days 16,427
1-3 Years 15,255
3-5 Years 4,809
------
Total $41,350
======
10
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8 EMPLOYEE BENEFITS:
The Company's two subsidiary banks each have separate retirement and
profit sharing plans which cover substantially all full time employees
at each bank.
The Capon Valley Bank has a defined contribution pension plan with
401(k) features that is funded with discretionary contributions by the
Bank. The bank matches on a limited basis the contributions of the
employees. Investment of employee balances is done through the
direction of each employee. Employer contributions are vested over a
six year period.
The Grant County Bank is a member of the West Virginia Bankers'
Association Retirement Plan. Benefits under the plan are based on
compensation and years of service with 100% vesting after seven years
of service. Prior to 2002, the Plan's assets were in excess of the
projected benefit obligations and thus the Bank was not required to
make contributions to the Plan in 2003, 2002 or 2001. The bank was
required to make a contribution in 2004 and will be required to make a
contribution in 2005 due to the inability of the investment portfolio
to meet its expected return in recent years. The Bank has recognized
liabilities of $539,000 at June 30, 2005 as a result of this
shortfall. The following table provides the components of the net
periodic benefit cost for the plan for the six month periods ended
June 30, 2005 and 2004 (in thousands of dollars):
2005 2004
---- ----
Service Cost $ 61 $ 57
Interest Cost 90 81
Expected return on plan assets (89) (87)
Amortization of unrecognized
prior service cost 5 5
Recognized net actuarial loss 13 7
----- ------
Net periodic benefit cost $ 80 $ 63
===== =====
NOTE 9 LONG TERM DEBT:
The Company has continued to borrow money from the Federal Home Loan
Bank of Pittsburgh (FHLB) to meet specific long term funding needs.
Within the year, the Company borrowed an additional $7,700,000 and
repaid $3,738,000 to the Bank. The interest rates of the notes payable
as of June 30, 2005 range from 2.51% to 6.12%. The weighted average
interest rate was 4.25% at June 30, 2005 The debt is secured by the
general assets of the Banks.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction
The following discussion focuses on significant results of the Company's
operations and significant changes in our financial condition or results of
operations for the periods indicated in the discussion. This discussion should
be read in conjunction with our audited financial statements and Report on Form
10-K for the period ended December 31, 2004.
Critical Accounting Policies
The Company's financial statements are prepared in accordance with accounting
principles generally accepted in the United States ("GAAP"). The financial
statements contained within these statements are, to a significant extent,
financial information that is based on measures of the financial effects of
transactions and events that have already occurred. A variety of factors could
affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could change.
The allowance for loan losses is an estimate of the losses that may be sustained
in the loan portfolio. The allowance is based on two basic principles of
accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires
that losses be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance.
The Company has invested in and owns life insurance polices on certain officers.
The policies are designed so that the company recovers the interest expenses
associated with carrying the polices and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits which will be received by the executives at the time of
their retirement is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions."
SFAS No. 106 requires that an employers' obligation under a deferred
compensation agreement be accrued over the expected service life of the employee
through their normal retirement date. Assumptions are used in estimating the
present value of amounts due officers after their normal retirement date. These
assumptions include the estimated income to be derived from the investments and
an estimate of the Company's cost of funds in these future periods. In addition,
the discount rate used in the present value calculation will change in future
years based on market conditions.
Recent Accounting Pronouncements
No recent accounting pronouncements had a material impact on the Company's
consolidated financial statements.
12
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Forward Looking Statements
Certain statements in this report may constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are statements that include projections, predictions,
expectations or beliefs about future events or results or otherwise are not
statements of historical fact. Such statements are often characterized by the
use of qualified words (and their derivatives) such as "expect," "believe,"
"estimate," "plan," "project," "anticipate" or other similar words. Although the
Company believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, new products and delivery
systems, inflation, changes in the stock and bond markets, technology, downturns
in the trucking and timber industries, effects of mergers and/or downsizing in
the poultry industry in Hardy County, and consumer spending and savings habits.
Additionally, actual future results and trends may differ from historical or
anticipated results to the extent: (1) any significant downturn in certain
industries, particularly the trucking and timber industries are experienced; (2)
loan demand decreases from prior periods; (3) the Company may make additional
loan loss provisions due to negative credit quality trends in the future that
may lead to a deterioration of asset quality; (4) the Company may not continue
to experience significant recoveries of previously charged-off loans or loans
resulting in foreclosure; and (5) the Company is unable to control costs and
expenses as anticipated. The Company does not update any forward-looking
statements that may be made from time to time by or on behalf of the Company.
Overview
Net income for the first six months of 2005 increased 17.10% compared to the
same period a year ago, and for the quarter ended June 30, 2005, income was
15.18% higher than the same quarter ended June 30, 2004. Annualized return on
average assets (ROAA) for the six months ended June 30, 2005 was 1.16% and
annualized return on average equity (ROAE) was 11.01% compared to an ROAA of
1.01% and an ROAE of 9.93% for the same period in 2004. Annualized return on
average assets for the quarter ended June 30, 2005 was 1.18% and annualized
return on average equity was 11.27%.
Net interest income before provision for loan losses increased 6.67% for the
first six months of 2005 as compared to the first six months of 2004. Average
balances of earning assets and interest bearing liabilities during the first six
months of 2005 as compared to the same period a year ago were nearly unchanged
as average balances of interest bearing assets increased .86% and average
balances of interest bearing liabilities increased .49%. However, changes in the
mix of earning assets was the largest contributing factor to an increase of 43
basis points in the average rates earned by earning assets. This offset a 21
basis point increase in rates paid on interest bearing liabilities. During the
second quarter of 2005, as competitive rates continued to increase, the Company
saw average rates paid on all deposits begin to increase for the first time in
several quarters. This increase was mirrored in earning assets, with the
exception of loans, as changes in the relative mix of loan types contributed to
a slight decline in average rates earned on loans.
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Overview (continued)
After several years of increasing non interest expense as the result of
operational growth, Highlands noninterest expense year to date in 2005 was
nearly flat as compared to 2004, increasing just 1.39%. An increase in employee
costs was offset by declines in data processing expense and other types of
operating expense. The Company's non interest income year to date was also
relatively strong as increases in earnings on insurance contract investments and
account service charges offset a slight decline in insurance earnings.
The Company's provision for loan losses during the first six months of 2005 was
$30,000 greater as compared to the same period in 2004,. Although balances of
gross loans have grown 2.18% since December 31, 2004, the company has been able
to maintain the consistent provision for loan losses year over year due to a
decline in net charge-offs. Even with the moderate increase in provision and the
relatively strong loan growth, Highlands ratio of allowance for loan losses to
gross loans was 1.09% at June 30, 2005 compared to 1.02% at December 31, 2004
and 1.00% at June 30, 2004.
Highlands' results of operations are discussed in greater detail following.
Unless otherwise specifically noted, the underlying causes for changes in
results for the quarter ended June 30, 2005 as compared to the same quarter in
2004 are substantially the same as the causes discussed for the six months ended
June 30, 2005 as compared to the six months ended June 30, 2004.
Net Interest Income
Year To Date
Net interest income, on a tax equivalent basis, increased 6.51% year to date in
2005 as compared to the same period in 2004. Although average balances of
earning assets increased a modest .86% in 2005 as compared to 2004 and average
balances of interest bearing liabilities increased .49%, net interest income
increased as balances within these overall categories shifted due to the
Company's effort at managing its balance sheet toward increased profitability.
As the Federal Reserve Bank has increased its target rate for federal funds
several times over the past year, the Company has generally seen its average
rates earned on assets and average rates paid on interest bearing liabilities
begin to increase. Although average balances of all earning assets were
relatively unchanged, average balances of loans for the six months ended June
30, 2005 increased 9.46% compared to the same period in 2004, with balances of
all other earning assets decreasing 37.38%. This shift in assets from
comparatively lower earning balances of Fed Funds sold and securities into loans
was the largest contributing factor in the $661,000 increase in interest income
from 2004 to 2005 and the 43 basis point increase in average rates on earning
assets. The average loan to deposit ratio for the first six months of 2005 was
97.74% compared to 87.75% a year ago.
As compared to the first six months of 2004, the Company's average balances of
interest bearing deposits decreased 3.29%, partly offsetting an increase in
average rates paid on deposits. Due to rising rates on deposits as a result of
increased competition for deposit balances and a comparatively slower rate of
increase on the rates available on borrowed funds, the Company has chosen in
recent periods to fund loan growth through acquisition of long term debt versus
competing heavily via rate incentives for deposit balances. The Company's
balances of borrowed money has increased 52.64% since December 31, 2004 and
160.05% since June 30, 2004. Average rates paid on borrowed money year to date
in 2005 have decline 20 basis points as compared to the same period in 2004.
The table at page 15 summarizes the changes in net interest income from changes
in average balances and average rates earned or paid for the six months ended
June 30, 2005 as compared to the six months ended June 30, 2004.
14
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
Year To Date (continued)
EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
(On a fully taxable equivalent basis)
(In thousands of dollars)
Due to change in,
Average Average Total
Volume Rate Change
Interest Income
Loans $ 773 $ (85) $ 688
Fed funds sold (98) 116 18
Interest bearing deposits (2) 5 3
Securities (81) 33 (48)
Interest Expense
Interest bearing
transaction deposits (4) 101 97
Time deposits (93) 61 (32)
Borrowed funds 198 (17) 181
The table on page 15 summarizes the Company's net interest margin for six month
period ended June 30, 2005 as compared to 2004.
Quarter Ending June 30
Net interest income, on a fully taxable equivalent basis, for the second quarter
of 2005 increased 4.67% over the same period a year ago and net interest margin
increased eight basis points. Average balances of earning assets have increased
and loans, a higher yielding asset, have increased as a percentage of earning
assets as compared to the second quarter of 2004. The Company has experienced
average rate increases in interest bearing liabilities to a degree significant
enough to begin to offset the increases in earning assets: therefore the
increase in net interest margin of eight basis points from the second quarter of
2004 was less than the increase experienced of 27 basis points year to date.
A significant contributing factor to the deceleration of growth in net interest
margin has been the slow pace of average loan rates to increase as compared to
both interest bearing liabilities and other types of earning assets. High levels
of competition for loans have been a contributing factor in keeping average loan
rates flat or even declining. In addition, the Company's loan portfolio, over
the past several years, has shifted from higher earning installment loans to
larger real estate backed loans, which typically earn a lower rate of interest
than installment loans.
A third contributing factor to the flat loan rates has been timing of repricing
of adjustable rate mortgages compared to increases of the target rates of Fed
Funds sold set by the Federal Reserve Board. ("The Fed"). Management expects
this factor to be less of an issue in the coming quarters. At March 31, 2005,
approximately 14% of the Company's loan portfolio matured or repriced within 90
days and 51% within a year. At June 30, 2005, these ratios had increased to 17%
and 59%. This change will allow the Company to better offset any increases in
rates paid on liabilities (which occur as a result of increases by the Fed) with
increased rates on new loans or increases due to repricing of existing loans.
The table on page 16 summarizes the Company's net interest margin for the three
month period ended June 30, 2005 as compared to 2004.
15
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
HIGHLANDS BANKSHARES, INC.
NET INTEREST MARGIN ANALYSIS FOR THE SIX MONTH PERIODS ENDED JUNE 30, 2005 AND 2004
(Dollar Amounts in Thousands)
June 30, 2005 June 30, 2004
----------------------------- ------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Income
Loans 1,3 $ 250,869 $8,915 7.17% $ 229,198 $ 8,228 7.22%
Federal funds sold 6,991 101 2.91% 18,241 83 .92%
Interest bearing deposits 1,197 11 1.85% 1,525 8 1.05%
Investments
Taxable 4 22,752 317 2.81% 26,988 345 2.57%
Tax exempt 2,4 2,950 86 5.81% 3,803 105 5.55%
------- ----- ---- ------- ----- -----
Total Earning Assets 284,759 9,430 6.68% 279,755 8,769 6.30%
------- ----- ---- ------- ----- -----
Cash equivalents 6,774 6,787
Allowance for loan losses (2,637) (2,405)
Insurance contracts 5,866 5,607
Other non-earning assets 13,715 11,340
------- -------
Total Assets 308,477 301,084
======= =======
Interest Expense
Money markets 25,352 86 .68% 23,259 40 .35%
Savings 49,012 192 .79% 52,179 141 .54%
Time deposits 142,889 2,069 2.92% 149,210 2,101 2.83%
Short term debt 58 1 2.40%
Long term debt 13,941 308 4.46% 5,479 127 4.66%
------- ----- ---- ------- ----- -----
Total Interest Bearing
Liabilities 231,252 2,656 2.32% 230,127 2,409 2.11%
------- ----- ----- ------- ----- -----
Demand deposits 39,413 36,248
Other liabilities 5,442 4,163
Shareholders' equity 32,370 30,546
------- -------
Total liabilities and
shareholder's equity $ 308,477 $ 301,084
======== ========
Net Interest Income 6,774 6,360
===== =====
Net Yield on Interest Earning
Assets 4.80% 4.53%
===== =====
1 Interest income on loans includes loan fees.
2 On a taxable equivalent basis based on a tax rate of 37%.
3 Average Balances include non-accrual loans
4 Average balance information is reflective of historical cost and has not been
adjusted for changes in market value.
16
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
HIGHLANDS BANKSHARES, INC.
NET INTEREST MARGIN ANALYSIS FOR THE THREE MONTH PERIODS ENDED JUNE 30, 2005 AND 2004
(Dollar Amounts in Thousands)
June 30, 2005 June 30, 2004
---------------------------- --------------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Income
Loans 1,3 $ 253,413 $4,526 7.16% $ 232,022 $4,157 7.21%
Federal funds sold 10,429 72 2.77% 17,210 41 .96%
Interest bearing deposits 1,524 6 1.58% 1,658 4 .97%
Investments
Taxable 4 21,816 151 2.78% 25,938 170 2.64%
Tax exempt 2,4 2,950 44 5.98% 3,646 43 4.74%
------- ----- ----- ------- ----- ----
Total Earning Assets 290,132 4,799 6.63% 280,474 4,415 6.33%
----- ----- ----- ----
Cash equivalents 7,023 6,853
Allowance for loan losses (2,684) (2,300)
Insurance contracts 5,893 5,629
Other non-earning assets 11,010 11,490
------- -------
Total Assets 311,374 302,146
======= =======
Interest Expense
Money markets 25,366 46 .73% 23,617 21 .36%
Savings 49,102 108 .88% 54,648 74 .54%
Time deposits 142,458 1,078 3.04% 145,420 999 2.76%
Other borrowed money 14,098 160 4.55% 5,714 66 4.65%
------- ----- ----- ------- ----- ----
Total Interest Bearing
Liabilities 231,024 1,392 2.42% 229,399 1,160 2.03%
----- ----- ----- ----
Demand deposits 40,472 37,432
Other liabilities 7,212 4,230
Shareholders' equity 32,666 31,085
------- -------
Total liabilities and
shareholder's equity $ 311,374 $ 302,146
======== =======
Net Interest Income 3,407 3,255
===== =====
Net Yield on Interest Earning
Assets 4.71% 4.63%
===== ====
1 Interest income on loans includes loan fees.
2 On a taxable equivalent basis based on a tax rate of 37%.
3 Average Balances include non-accrual loans
4 Average balance information is reflective of historical cost and has not been
adjusted for changes in market value.
17
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Non Interest Expense
Total non-interest expense increased 1.39% for the six months ended June 30,
2005 as compared to the same period a year ago. An increase of 4.74% in salaries
and employee benefits and an increase in occupancy and equipment expense were
offset by declines in data processing expense, legal and professional fees.
A slight decrease in the number of full time equivalent employees was offset by
increases in salary expense due to normal and customary pay increases and an
8.46% increase in the costs of employee post retirement benefits to cause an
increase of $111,000 in salary and benefit expense.
Occupancy and equipment expense increased only slightly as compared to 2004.
System and physical plant upgrades undertaken during recent years are now
largely in place, and costs associated with these upgrades have now stabilized.
Data processing expense decreased 11.34% due mainly to a decrease in the
contractual rate charged to the subsidiary banks by a supplier of account
processing functions.
Legal and professional fees decreased slightly as compared to 2004. Costs
associated with Sarbanes-Oxley Rule 404 compliance caused an increase in legal
and professional fees but were offset by on-site engagements by auditing firms
during the second quarter of 2005 being less than experienced during the same
period in 2004. Although on-site engagements for the second quarter were
decreased as compared to last year, the Company anticipates that third and
fourth quarter engagements in 2005 will exceed 2004, causing a slight increase
in professional fees for the remainder of 2005 as compared to the same period in
2004.
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, Hampshire, Mineral, Randolph,
and northern Pendleton counties in West Virginia and Frederick County, 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.
Historically, loans secured by real estate have lower loss rates if foreclosure
is required than other types of loans. The company continues to strengthen its
position in this regard as the percentage of gross loans secured by real estate
has risen in recent periods. In addition to traditional mortgages, significant
portions of the Company's commercial loan portfolio is secured by real estate.
As of June 30, 2005, 75.36% of the Company's gross loans were secured by real
estate.
18
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Loan Portfolio (continued)
Because of its large impact on the local economy, Management continuously
monitors the economic health of the poultry industry. The Company has direct
loans to poultry growers and the industry is a large employer in the Company's
trade area. In recent periods, the Company's loan portfolio has also begun to
reflect a concentration in loans collateralized by heavy equipment, particularly
in the trucking, timber and coal extraction industries. In part because of
rising fuel costs, and because of continued slow economic growth, the trucking
sector experienced a recent downturn, and profitability growth within this
sector still appears to be sluggish. However, the Company has experienced no
material losses related to foreclosures of loans collateralized by heavy
equipment. While close monitoring of this sector is necessary, management
expects no significant losses in the foreseeable future.
Credit Quality
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.
The following table summarizes the company's non-performing loans as of June 30,
2005, December 31, 2004 and June 30, 2004:
June 30, December 31, June 30
2005 2004 2004
---- ---- ----
(in thousands)
Non-accrual loans $ 235 $ 530 $ 757
Loans past due 90 days or more
and still accruing interest 602 535 426
----- ----- -----
Total $ 837 $1,065 $1,183
===== ===== =====
Loans are typically placed on non-accrual status once they have reached certain
levels of delinquency, depending on loan type, and it is no longer reasonable to
expect collection of principal and interest because collateral is insufficient
to cover both the principal and interest due. After loans are placed on
non-accrual status, they are returned to accrual status if the obligation is
brought current by the borrower or they are charged off if payment is not made
and management believes that collection of the amounts due is doubtful.
Charged-off loans are charged against the allowance for loan losses. Any
subsequent collection or sale of repossessed collateral is added to the
allowance as a recovery.
Real estate acquired through foreclosure was $200,000 at June 30, 2005 compared
to $328,000 at December 31, 2004. All foreclosed property held as of June 30,
2005 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.
As of June 30, 2005, the Company had three potential problem loan as defined in
SEC Industry Guide III that would require disclosure.
19
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Credit Quality (continued)
In July 2004, the Company received notice that a large commercial loan customer
had filed for Chapter 11 bankruptcy protection. Depending upon the final outcome
of the bankruptcy proceedings, the Company may be forced to reclassify the loans
made to this customer, which total approximately $1.4 million, to non-accrual
status. If these loans are reclassified to non-accrual, this will have a
negative impact on interest revenue and net income to the extent that any
interest accruing to the loans of this customer would not be recognized as
income. At present, the interest earned on the loans to this customer total
approximately $100,000 per annum. The loans to this customer are deemed by
Management to be well secured, and if a foreclosure is required, the Company
expects there to be no loss on the sale of the collateral. Since the bankruptcy
filing, this customer has continued to make payments of both principal and
interest, and though remaining moderately delinquent, these payments have been
sufficient to consistently keep the customer less than 60 days past due.
During the fourth quarter of 2004, the Company was informed by another large
commercial loan customer that a Chapter 11 bankruptcy may be forthcoming. As of
the date of this filing, the Company has received no formal notice from this
customer that a bankruptcy filing has occurred. Loans to this commercial
customer total approximately $450,000. This customer continues to make payments
of both principal and interest, and though remaining moderately delinquent,
these payments have been sufficient to consistently keep the customer less than
60 days past due. Management deems the loans to this customer to be adequately
secured and, if foreclosure becomes necessary, expects no material loss.
During the second quarter of 2005, a third commercial loan customer filed for
Chapter 11 bankruptcy protection. Loans to this customer total approximately
$800,000. Through June 30, 2005, this customer, while moderately delinquent, had
continued to make payments; however, as of the date of this filing, loans to
this customer have been moved to non-accrual status. Management has evaluated
the collateral on these loans, and has estimated that a potential loss of
$65,000 is present in the event of foreclosure and has specifically allowed for
this potential loss in the allowance for loan losses.
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.
20
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Allowance For Loan Losses
Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County
Bank, determines the adequacy of its allowance for loan losses independently.
Although the loan portfolios of the two banks are similar to each other, some
differences exist which result in divergent risk patterns and different
charge-off rates amongst the functional areas of the banks' portfolio. Each bank
pays particular attention to individual loan performance, collateral values,
borrower financial condition and economic conditions. The determination of an
adequate allowance at each bank is done in a three step process. The first step
is to identify impaired loans. Impaired loans are problem loans above a certain
threshold which have estimated losses calculated based on collateral values and
projected cash flows. The second step is to identify loans above a certain
threshold which are problem loans due to the borrowers' payment history or
deteriorating financial condition. Losses in this category are determined based
on historical loss rates adjusted for current economic conditions. The final
step is to calculate a loss for the remainder of the portfolio using historical
loss information for each type of loan classification. The determination of
specific allowances and weighting is somewhat subjective and actual losses may
be greater or less than the amount of the allowance. However, Management
believes that the allowance represents a fair assessment of the losses that
exist in the current loan portfolio.
The required level of the allowance for loan losses is computed quarterly and
the allowance adjusted prior to the issuance of the quarterly financial
statements. All loan losses charged to the allowance are approved by the boards
of directors of each bank at their regular meetings. The allowance is reviewed
for adequacy after considering historical loss rates, current economic
conditions (both locally and nationally) and any known credit problems that have
not been considered under the above formula.
Management has analyzed the potential risk of loss on the Company's loan
portfolio given the loan balances and the value of the underlying collateral and
has recognized losses where appropriate. Nonperforming loans are closely
monitored on an ongoing basis as part of the Company's loan review process.
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, 2005 and December 31, 2004:
June 30, 2005 December 31, 2004
-------------- ----------------
Loan Allowance Percentage Allowance Percentage
Type Allocation of Loans Allocation of Loans
---- ----------- --------- ---------- ---------
Commercial $ 1,043 21% $ 697 21%
Mortgage 805 62% 853 60%
Consumer 829 17% 970 19%
Unallocated 103 10
------ ----- ------ ----
Totals $ 2,780 100% $ 2,530 100%
====== ===== ====== ====
As certain loans identified as impaired are paid current, collateral values
increase or loans are removed from watch lists for other reasons, and as other
loans become identified as impaired, and because delinquency levels within each
of the portfolios change, the allocation of the allowance among the loan types
may change. Management feels that the allowance is a fair representation of the
losses present in the portfolio given historical loss trends, economic
conditions and any known credit problems as of a given date. Management believes
that the allowance is to be taken as a whole, and allocation between loan types
is an estimation of potential losses within each type given information known at
the time.
21
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Allowance for Loan Losses (continued)
An analysis of the components of net charge-offs for the six month periods ended
June 30, 2005 and June 30, 2004 and for the quarters ended June 30, 2005 and
June 30, 2004 is set forth in the following table (in thousands):
Quarter Ended Six Months Ended
June 30, June 30,
------------------ --------------
2005 2004 2005 2004
---- ---- ---- ----
Charge-Offs $ (96) $ (500) $ (270) $ (719)
Recoveries 42 95 85 189
------ ----- ----- -----
Total net charge-offs (54) (405) (185) (530)
Components of net charge-offs:
Real estate -- (242) -- (265)
Commercial (28) (53) (39) (65)
Installment (26) (110) (146) (200)
------ ------ ----- -----
Total $ (54) $ (405) $ (185) $ (530)
======= ====== ====== ======
Discontinuation of Trust Operations
As of May 31, 2004, Highlands Bankshares Trust Company, a wholly owned
subsidiary of Highlands Bankshares, Inc. ceased operation. For the first six
months of 2004, on a fully consolidated basis, the Trust Company contributed a
$71,000 loss to Highlands Bankshares, Inc.
The following table summarizes the change in net income for the first six months
of 2005 as compared to 2004 attributable to the discontinuation of the trust
subsidiary:
Change in
net income
Non interest income $ (3)
Salary and benefit expense 43
Occupancy and equipment expense 4
Legal and professional fees 2
Other noninterest expense 40
Income tax expense (15)
----
Total change in net income for
the six month
Ended June 30, 2005 as compared
to 2004 and
Attributable to discontinuation
of trust subsidiary $ 71
22
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Non Interest Income
Total noninterest income increased 10.35% during the first six months of 2005 as
compared to the same period in 2004.
After a decline in non-sufficient funds charges in the first quarter of 2005 as
compared to the first quarter of 2004, these charges have returned to
approximately the same levels as experienced in 2004. Year to date, charges for
non-sufficient funds have increased just under 3% as compared to 2004.
In keeping with recent trends, earnings from sales and reinsurance of credit
life and accident insurance was relatively flat for the first six months of 2005
as compared to last year. As demand for new installment loans, the primary
source for these insurance sales, continues to decline, overall insurance has
fallen.
Also during the first six months of 2005, the company experienced a total of
approximately $30,000 in non-recurring income from gain on the sale of real
estate acquired through foreclosure and from a payment related to a cooperative
POS/ATM network for which one of the subsidiaries was part owner.
Borrowed Money
Long Term Borrowings
The Company borrows funds from the Federal Home Loan Bank ("FHLB") to
reduce market rate risks, provide liquidity, and to fund capital additions.
These borrowings may have fixed or variable interest rates and are amortized
over a period of one to twenty years, or may be comprised of single payment
borrowings with periodic interest payments and principal amounts due at
maturity. In an attempt to manage interest expense and interest rate risk and as
competition for deposits has increased, the Company has, during recent quarters,
used these available debt vehicles to fund loan growth more frequently than was
utilized in the past.. During the six months of 2005, the Company acquired an
additional $7,700,000 in long-term borrowings from the FHLB.
Short Term Borrowings
Although the Company has traditionally not experienced the need for
overnight or other short-term borrowings, loan growth during the fourth quarter
of 2004 and the first quarter of 2005 necessitated occasional overnight
borrowings. During the first quarter of 2005, the Company initiated $1,500,000
in new short-term debt and made repayments of $3,500,000. The Company initiated
no short term borrowings during the second quarter of 2005. Management prefers
to fund growth through longer term vehicles and expects future instances of
overnight borrowings to be minimal.
Parent Company Line of Credit
During the fourth quarter of 2003, the Company obtained a $2,500,000 open
line of credit with another commercial bank. This line of credit was secured by
equity securities in Capon Valley Bank, a subsidiary company. This debt
instrument was obtained as both a precautionary and opportunistic device for
funding should a need arise in the future. There were no advances in 2003, 2004
or year to date in 2005 from this line and it is not anticipated that any
borrowings from this debt facility will be used to fund operating or liquidity
needs.
23
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Liquidity
Operating liquidity is the ability to meet present and future financial
obligations. Short term liquidity is provided primarily through cash balances,
deposits with other financial institutions, federal funds sold, non-pledged
securities and loans maturing within one year. 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, the
Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.
Historically, the Company's primary need for additional levels of operational
liquidity has been to fund increases in loan balances. The Company has normally
funded increases in loans by increasing deposits and decreases in secondary
liquidity sources such as balances of Fed Funds sold and balances of securities.
Although total deposit balances have decreased slightly in recent periods, the
Company has substantially maintained or increased levels of these secondary
liquidity resources and does not anticipate that an unexpectedly high level of
loan demand in coming periods would impact liquidity to the extent that the
Company would be required to pay above market rates to obtain deposits.
The parent Company's operating funds, funds with which to pay shareholder
dividends and funds for the exploration of new business ventures have been
supplied primarily through dividends paid by the Company's subsidiary banks
Capon Valley Bank (CVB) and The Grant County Bank (GCB). The various regulatory
authorities impose restrictions on dividends paid by a state bank. A state bank
cannot pay dividends without the consent of the relevant banking authorities in
excess of the total net profits of the current year and the combined retained
profits of the previous two years. As of July 1, 2005, the subsidiary banks
could pay dividends to Highlands Bankshares, Inc. of approximately $5,026,000
without permission of the regulatory authorities.
Effects of Inflation
Inflation primarily affects industries having high levels of property, plant and
equipment or inventories. Although the Company is not significantly affected in
these areas, inflation does have an impact on the growth of assets. As assets
grow rapidly, it becomes necessary to increase equity capital at proportionate
levels to maintain the appropriate equity to asset ratios. Traditionally, the
Company's earnings and high capital retention levels have enabled the Company to
meet these needs. The Company's reported earnings results have been minimally
affected by inflation. The different types of income and expense are affected in
various ways. Interest rates are affected by inflation, but the timing and
magnitude of the changes may not coincide with changes in the consumer price
index. Management actively monitors interest rate sensitivity, as illustrated by
the gap analysis shown under the section titled Interest Rate Sensitivity in
order to minimize the effects of inflationary trends on interest rates. Other
areas of noninterest expenses may be more directly affected by inflation.
24
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
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, 2005, the Company was above the regulatory minimum levels
of capital. The table below summarizes the capital ratios for the Company and
its subsidiary banks as of June 30, 2005 and December 31, 2004:
June 30, 2005 December 31, 2004
Actual Regulatory Actual Regulatory
Ratio Minimum Ratio Minimum
----- -------- ------ ---------
Total Risk Based Capital
Ratio
Highlands Bankshares 15.10% 8.00% 14.71% 8.00%
Capon Valley Bank 12.94% 8.00% 12.82% 8.00%
The Grant County Bank 15.94% 8.00% 15.68% 8.00%
Tier 1 Leverage Ratio
Highlands Bankshares 10.25% 3.00% 10.14% 3.00%
Capon Valley Bank 8.64% 3.00% 8.57% 3.00%
The Grant County Bank 10.93% 3.00% 11.01% 3.00%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares 13.89% 4.00% 13.58% 4.00%
Capon Valley Bank 11.69% 4.00% 11.57% 4.00%
The Grant County Bank 14.78% 4.00% 14.64% 4.00%
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The greatest portion of the Company's net income is derived from net
interest income. As such, the greatest component of market risk is interest rate
volatility. 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. Early withdrawal of deposits, greater than expected balances of new
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 itself when necessary. 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 quickly to rapid market rate changes.
Interest rate market conditions may also affect portfolio composition of
both assets and liabilities. Traditionally, the Company's subsidiary banks have
primarily offered one year adjustable rate mortgages (ARMs) to its mortgage loan
customers. However, the low interest rate environment has created intense
competition, especially from larger banking institutions and finance companies
offering long term fixed rate mortgages. As a result, the Company in recent
periods has begun to write more mortgage loans with adjustable rates and
maturities greater than one year. The increase in new ARM and balloon loans with
two, three and five year adjustable rates has caused a shift in the maturity
composition of the loan portfolio. This shift to longer term rates is partially
responsible for the average rates earned on the loan portfolio to lag behind
increases in rates paid on deposits and rates earned on other earning assets.
25
Item 3. Quantitative and Qualitative Disclosures About Market Risk (continued)
Also as a result of the low interest rate environment, depositors have seemed,
in recent periods, reluctant to commit to longer term time deposits and in many
instances appeared to be holding monies temporarily in interest bearing
transaction accounts in anticipation of rising rates in the coming periods. This
trend has begun to reverse slightly as time deposit balances began to rise
slightly during 2005. At December 31, 2004 balances of interest bearing
transaction accounts were $75,342,000 but by June 30, 2005 balances in these
accounts had fallen to $73,932,000. Were interest rates to rise sharply in the
coming periods, some of the monies now in interest bearing transaction and
savings accounts may shift to time deposits, causing a rise in the Company's
cost of funds. Alternatively, these balances may be transferred by customers to
other financial institutions offering higher deposit rates, and requiring the
Company to match such rates.
Increases in loan demand have created the need in recent quarters for increased
borrowings from the FHLB. Should loan demand continue to grow, increases in
borrowing from the FHLB may be required. Recent rate trends have, in certain
instances, made borrowing from the FHLB more attractive than increasing deposit
balances by the utilization of rate or other incentives, which could have the
effect of increasing interest expense at a rate greater than the increase in
interest revenues. As such, the Company has chosen to fund its 2005 growth
through greater borrowings than in the past. However, increased deposit
incentives in the form of higher rate features may be required in coming periods
if loan demand grows at a rate whereby current sources of funds will not be
sufficient to support loan funding or if FHLB loan rates become less favorable.
This would have the effect of increasing the Company's cost of funds. The
subsidiary banks of the Company maintain sufficient ability to borrow funds from
the Federal Home Loan Bank (FHLB) for use in loan funding and there has been no
recent indication which would lead Management to believe that FHLB borrowing
rates would rise to levels which would adversely affect interest margin spreads.
While Management does not foresee being forced in future periods to pay above
market rates on its funding, extreme loan growth may cause this scenario to
occur, thereby reducing net interest margin spread
26
Item 3. Quantitative and Qualitative Disclosures About Market Risk (continued)
The following table illustrates the Company's sensitivity to interest rate
changes as of June 30, 2005 (in thousands):
More than
5 Years
1 - 90 91 - 365 1 to 3 3 to 5 or Without
Days Days Years Years Maturity Total
EARNING ASSETS
Loans $42,317 $106,605 $82,358 $11,754 $10,904 $253,938
Fed funds sold 10,631 10,631
Securities 5,873 11,399 6,035 911 700 24,918
Time deposits in
other
banks 1,263 100 1,363
------ ------- ------ ------ ------ -------
Total 60,084 118,104 88,393 12,665 11,604 290,850
------ ------- ------ ------ ------ -------
INTEREST BEARING LIABILITIES
Money market
savings 24,902 24,902
Savings accounts 49,030 49,030
Time deposits 18,188 60,587 51,654 13,840 144,269
Borrowed money 448 1,198 3,310 3,476 7,407 15,839
------ ------- ------ ------ ------ -------
Total 92,568 61,785 54,964 17,316 7,407 234,040
------ ------- ------ ------ ------ -------
Rate sensitivity GAP (32,484) 56,319 33,429 (4,651) 4,197 56,810
Cumulative GAP (32,484) 23,835 57,264 52,613 56,810
Ratio of cumulative
interest sensitive
assets
to cumulative
interest
sensitive
liabilities 64.91% 115.44% 127.36% 123.22% 124.27%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
27
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers
such as Highlands Bankshares, Inc. that file periodic reports under the
Securities Exchange Act of 1934 (the "Act") are now required to include in
those reports certain information concerning the issuer's controls and
procedures for complying with the disclosure requirements of the federal
securities laws. These disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information
required to be disclosed by an issuer in the reports it files or submits
under the Act, is communicated to the issuer's management, including its
principal executive officer or officers and principal financial officer or
officers, or persons performing similar functions, as appropriate to allow
timely decisions regarding required disclosure.
We have established our disclosure controls and procedures to ensure that
material information related to Highlands Bankshares, Inc. is made known to
our principal executive officers and principal finance officer on a regular
basis, in particular during the periods in which our quarterly and annual
reports are being prepared. These disclosure controls and procedures
consist principally of communications between and among the Chief Executive
Officer and Chief Financial Officer, and the other executive officers of
Highlands Bankshares, Inc. and its subsidiaries to identify any new
transactions, events, trends, contingencies or other matters that may be
material to the Company's operations. As required, we will evaluate the
effectiveness of these disclosure controls and procedures on a quarterly
basis, and most recently did so as of the end of the period covered by this
report.
The Company's chief executive officer and chief financial officer, based
on their evaluation as of the end of the period covered by this Annual
Report of the Company's disclosure controls and procedures (as defined in
Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have concluded
that the Company's disclosure controls and procedures are adequate and
effective for purposes of Rule 13(a)-14(c) and timely, alerting them to
financial information relating to the Company required to be included in
the Company's filings with the Securities and Exchange Commission under the
Securities Exchange Act of 1934.
Changes in Internal Controls
During the period reported upon, there were no significant changes in
the internal controls of Highlands Bankshares, Inc. pertaining to its
financial reporting and control of its assets or in other factors that
could significantly affect these controls.
Due to the nature of the Company's business as stewards of assets of
customers, internal controls are of the utmost importance. The company has
established procedures undertaken during the normal course of business to
reasonably ensure that fraudulent activity of either an amount material to
these results or in any amount is not occurring. In addition to these
controls and review by executive officers, the Company retains the services
of Yount, Hyde & Barbour, P.C., a public accounting firm, to complete
regular internal audits to examine the processes and procedures of the
Company and its subsidiary banks to ensure that these processes are both
reasonably effective to prevent fraud, both internal and external, and that
these processes comply with relevant regulatory guidelines of all relevant
banking authorities. The findings of Yount, Hyde & Barbour are presented
both to Management of the subsidiary banks and to the Audit Committee.
28
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 May 10, 2005, the stockholders held their annual meeting. The
following items were approved by the shareholders by the required
majority or plurality:
1) Election of the Board of Directors as proposed in the proxy material
without any additions or exceptions.
Alan L. Brill 895,375 For; 19,344 Withhold Authority
Kathy Kimble 895,625 For; 19,094 Withhold Authority
Courtney Tusing 912,195 For; 2,524 Withhold Authority
John G. VanMeter 898,792 For; 5,274 Withhold Authority
2) Ratification of S. B. Hoover & Company, L.L.P. as auditors for the
year ending December 31, 2005; 887,795 For; 19,808 Against; 7,116
Abstain
Item 5. Other Information - Not Applicable
Item 6. 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
Exhibit 3(ii) to Highland Bankshares, Inc.'s Form 10-Q filed May 15,
2003.
31.1 Certification of Chief Executive Officer Pursuant to section 302 of the
Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and
(B).
31.2 Certification of Chief Financial Officer Pursuant to section 302 of the
Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and
(B).
32.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C. ss. 1350.
32.2 Statement of Chief Financial Officer Pursuant to 18 U.S.C. ss. 1350.
29
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/ C. E. PORTER
---------------------------
C.E. Porter
President
/s/ R. ALAN MILLER
---------------------------
R. Alan Miller
Finance Officer
August 11 , 2005