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 September 30, 2005
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission File No. 0-16761
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
----- ------
Indicate by check mark whether the issuer is a shell company (as
defined in Rule 12b-2 of the Exchange 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 October 31, 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 - Nine Months
Ended September 30, 2005 and 2004 2
Unaudited Consolidated Statements of Income - Three Months
Ended September 30, 2005 and 2004 3
Unaudited Consolidated Balance Sheet - September 30, 2005 and
Audited Consolidated Balance Sheet--December 31, 2004 4
Unaudited Consolidated Statements of Changes in Stockholders'
Equity - Nine Months Ended September 30, 2005 and 2004 5
Unaudited Consolidated Statements of Cash Flows - Nine Months
Ended September 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 27
Item 4. Controls and Procedures 29
PART II OTHER INFORMATION
Item 1. Legal Proceedings 30
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 30
Item 3. Defaults upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits 30
SIGNATURES 31
2
Part I Financial Information
Item 1 Financial Statements
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars Except Per Share Amounts)
(Unaudited)
Nine Months Ended
September 30
2005 2004
Interest Income
Interest and fees on loans $ 13,620 $12,417
Interest on federal funds sold 202 128
Interest on time deposits 26 13
Interest and dividends on investment
securities (note 2) 558 607
------- ------
Total Interest Income 14,406 13,165
------- ------
Interest Expense
Interest on deposits (note 7) 3,674 3,354
Interest on borrowed money 476 197
------- ------
Total Interest Expense 4,150 3,551
------- ------
Net Interest Income 10,256 9,614
Provision for Loan Losses 690 600
------- ------
Net Interest Income After Provision for Loan Losses 9,566 9,014
------- ------
Noninterest Income
Service charges 625 597
Insurance related income 153 194
Investment in insurance contracts 200 189
Other 295 215
------- ------
Total Noninterest Income 1,273 1,195
------- ------
Noninterest Expense
Salaries and employee benefits 3,692 3,553
Equipment and occupancy expense 922 905
Data processing 460 508
Legal and professional fees 338 268
Directors fees 256 267
Other 1,088 1,135
------- ------
Total Noninterest Expense 6,756 6,636
------- ------
Income Before Income Taxes 4,083 3,573
Provision for Income Taxes 1,372 1,189
------- ------
Net Income $ 2,711 $ 2,384
======= ======
Per Share Data
Net Income $ 1.89 $ 1.66
======= ======
Cash Dividends $ .60 $ .45
======= ======
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)
(Unaudited)
Three Months Ended
September 30
2005 2004
Interest Income
Interest and fees on loans $ 4,704 $ 4,189
Interest on federal funds sold 101 45
Interest on time deposits 15 6
Interest and dividends on investment
securities (note 2) 188 195
------- ------
Total Interest Income 5,008 4,435
------- ------
Interest Expense
Interest on deposits (note 7) 1,326 1,073
Interest on borrowed money 167 69
------- ------
Total Interest Expense 1,493 1,142
------- ------
Net Interest Income 3,515 3,293
Provision for Loan Losses 255 195
------- ------
Net Interest Income After Provision for Loan Losses 3,260 3,098
------- ------
Noninterest Income
Service charges 234 214
Insurance related income 29 68
Investment in insurance contracts 79 88
Other income 109 81
------- ------
Total Noninterest Income 451 451
------- ------
Noninterest Expense
Salaries and employee benefits (note 8) 1,227 1,210
Equipment and occupancy expense 316 314
Data processing expense 155 164
Legal and professional fees 170 89
Directors fees 82 88
Other 355 377
------- ------
Total Noninterest Expense 2,305 2,242
------- ------
Income Before Income Taxes 1,406 1,307
Provision for Income Taxes 463 432
------- ------
Net Income $ 943 $ 875
======= ======
Per Share Data
Net Income $ .66 $ .61
======= ======
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)
September 30, December 31,
2005 2004
(unaudited) (audited)
ASSETS
Cash and due from banks - noninterest bearing $ 7,698 $ 6,187
Time deposits in other banks 1,448 651
Federal funds sold 10,982 4,006
Securities held to maturity (note 2) 491 1,162
Securities available for sale (note 2) 23,408 24,702
Other investments (note 3) 1,336 1,165
Loans, net of unearned interest (note 4) 255,874 248,517
Allowance for loan losses (note 5) (2,919) (2,530)
Bank premises and equipment 6,468 6,809
Interest receivable 1,638 1,436
Investments in insurance contracts (note 6) 5,991 5,809
Other assets 1,709 2,078
------- -------
Total Assets $314,124 $299,992
======= =======
LIABILITIES
Deposits:
Noninterest bearing demand deposits $ 41,938 $ 37,522
Interest bearing
Savings and interest bearing demand deposits 72,809 75,342
Time deposits (note 7) 146,472 141,527
------- -------
Total Deposits 261,219 254,391
Short term debt (note 9) 2,000
Long term debt (note 9) 15,702 8,377
Accrued expenses and other liabilities 3,725 3,569
------- -------
Total Liabilities 280,646 268,337
------- -------
STOCKHOLDERS' EQUITY
Common stock ($5 par value, 3,000,000 shares
authorized, 1,436,874 shares outstanding) 7,184 7,184
Surplus 1,662 1,662
Retained earnings 24,877 23,028
Accumulated other comprehensive loss (245) (219)
-------- --------
Total Stockholders' Equity 33,478 31,655
------- -------
Total Liabilities and Stockholders' Equity $314,124 $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)
(Unaudited)
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
------ ------- -------- ----------- -----
Balance December 31, 2004 $7,184 $1,662 $23,028 $ (219) $31,655
Comprehensive Income
Net income 2,711 2,711
Net change in
unrealized
depreciation on
investment
securities available
for sale,
net of taxes of $15 (26) (26)
----- ----- ------ ------ -----
Total Comprehensive Income $ 2,685
Dividends paid in cash (862) (862)
----- ----- ------ ------ -----
Balances September 30, 2005 $7,184 $1,662 $24,877 $ (245) $33,478
======= ======= ======== ======= =======
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
------ ------- -------- ------------- -----
Balance December 31, 2003 $7,184 $1,662 $20,727 $ (24) $29,549
Comprehensive Income
Net income 2,384 2,384
Net change in
unrealized
appreciation on
investment
securities available
for sale,
net of taxes of $53 (93) (93)
----- ----- ------ ------ -----
Total Comprehensive Income $ 2,291
Dividends paid in cash (647) (647)
----- ----- ------ ------ -----
Balances September 30, 2004 $7,184 $1,662 $22,464 $ (117) $31,193
====== ======= ======== ======= =======
The accompanying notes are an integral part of these statements.
6
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
(Unaudited)
Nine Months Ended
September 30
2005 2004
Cash Flows from Operating Activities:
Net income $ 2,711 $ 2,384
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 494 500
Net securities amortization 47 208
Provision for loan losses 690 600
Income from insurance investments (182) (170)
Decrease (increase) in interest receivable (202) 205
Decrease in other assets 397 408
Increase in accrued expenses 156 182
------- ------
Net Cash Provided by Operating Activities 4,111 4,317
------- ------
Cash Flows from Investing Activities:
Net change in time deposits in other banks (797) 460
Net change in federal funds sold (6,976) 11,046
Proceeds from maturities of securities
available for sale 7,380 14,267
Proceeds from maturities of securities
held to maturity 670 201
Purchase of securities available for sale (6,186) (6,994)
Purchase of other investments (171) (30)
Net change in loans (7,658) (16,569)
Purchase of property and equipment (153) (172)
-------- ------
Net Cash Provided by (Used in) Investing Activities (13,891) 2,209
-------- ------
Cash Flows from Financing Activities:
Net change in time deposits 4,945 (15,629)
Net change in other deposits 1,883 8,711
Dividends paid in cash (862) (647)
Additional short term borrowings 1,500
Repayment of short term borrowings (3,500)
Repayment of long term debt (375) (604)
Additional long term debt 7,700 1,000
------- ------
Net Cash Provided by (Used in) Financing Activities 11,291 (7,169)
------- --------
Net Increase (Decrease) in Cash and Cash Equivalents 1,511 (643)
Cash and Cash Equivalents, Beginning of Period 6,187 7,214
------- ------
Cash and Cash Equivalents, End of Period $ 7,698 $ 6,571
======= ======
Supplemental Disclosures:
Cash Paid For:
Income taxes $ 911 $ 696
Interest 3,972 3,757
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 September 30, 2005 and the results
of operations for the three month and nine month periods ended
September 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 fair value of securities held to maturity as of
September 30, 2005 and December 31, 2004, are as follows (in
thousands):
2005 2004
---- ----
Amortized Fair Amortized Fair
Cost Value Cost Value
Obligations of states and
political subdivisions $ 491 $ 496 $1,162 $ 1,187
------ ------ ----- ------
Total $ 491 $ 496 $1,162 $ 1,187
====== ====== ===== ======
The amortized cost and fair value of securities available for sale
as of September 30, 2005 and December 31, 2004 are as follows (in
thousands):
2005 2004
---- ----
Amortized Fair Amortized Fair
Cost Value Cost Value
US Treasury securities and
obligations of
US Government
corporations and
agencies $17,423 $17,321 $18,248 $18,164
Mortgage-backed securities 3,636 3,639 4,669 4,693
Obligations of states and
political subdivisions 2,424 2,420 1,811 1,817
Other investments 28 28 28 28
------ ------ ----- ------
Total $23,511 $23,408 $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 and nine month periods ended September
30, 2005 and 2004 are as follows (in thousands):
Nine Months Ended Three Months Ended
September 30, September 30,
2005 2004 2005 2004
----- ----- ----- ------
Taxable $ 481 $ 511 $ 164 $ 166
Non-taxable 77 96 24 29
----- ----- ----- -----
Total $ 558 $ 607 $ 188 $ 195
===== ===== ===== =====
NOTE 3 OTHER INVESTMENTS:
Other investments totaling $ 1,336,000 as of September 30, 2005
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 September 30, 2005 and December
31, 2004 is as follows (in thousands):
2005 2004
------ -------
Commercial $ 50,835 $ 52,814
Real estate - construction 11,362 8,850
- mortgages 149,914 140,761
Consumer 43,763 46,092
------- -------
Loans outstanding $255,874 $248,517
======= =======
In addition to loans to fund construction and traditional mortgage
loans, portions of the portfolio identified as commercial are also
secured by real estate.
NOTE 5 ALLOWANCE FOR LOAN LOSSES:
A summary of transactions in the allowance for loan losses for the
nine months ended September 30, 2005 and 2004 follows:
2005 2004
-------- --------
Balance, beginning of period $ 2,530 $ 2,463
Provisions charged to operating expenses 690 600
Loan recoveries 144 256
Loan charge-offs (445) (956)
-------- -------
Balance, end of period $ 2,919 $ 2,363
======= =======
9
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 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
certain executives. The carrying value of these investments was
$5,991,000 at September 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 September 30, 2005 and December 31, 2004 are set forth
below (in thousands):
2005 2004
------ --------
Time deposits over $100,000 $ 42,454 $ 39,402
All other time deposits 104,018 102,125
------- -------
Total time deposits $146,472 $141,527
Interest expense for time deposits over $100,000 for the nine month
and three month periods ended September 30, 2004 and September 30,
2003 are set forth below (in thousands):
Nine Months Three Months
Ended September 30 Ended September 30
2005 2004 2005 2004
----- ----- ----- ------
$ 997 $ 943 $ 360 $ 304
The following is a summary of the maturity distribution of all time
deposits of $100,000 or more as of September 30, 2005 (in thousands):
Amount
--------
1-90 Days $ 5,660
91-365 Days 15,788
1-3 Years 17,098
3-5 Years 3,908
------
Total $42,454
======
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
contributions in 2005 due to the inability of the investment portfolio
to meet its expected return in recent years. The Bank has recognized
liabilities of $438,000 at September 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 nine month periods ended
September 30, 2005 and 2004 (in thousands of dollars):
2005 2004
------ ------
Service Cost $ 92 $ 86
Interest Cost 134 122
Expected return on plan assets (141) (131)
Amortization of unrecognized
prior service cost 8 11
Recognized net actuarial loss 20 8
----- ------
Net periodic expense $ 113 $ 96
===== =====
NOTE 9 DEBT INSTRUMENTS:
The Company continues 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 in long term
debt and repaid $375,000 to the FHLB. Also, during the first quarter
of 2005, the Company initiated short term borrowings from the FHLB of
$1,500,000 and made repayments of $3,500,000. As of September 30,
2005, the Company had no balances of short term borrowings. The
interest rates of the notes payable as of September 30, 2005 range
from 2.51% to 6.12%. The weighted average interest rate was 4.25% at
September 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
At September 30, 2005, earnings for Highlands Bankshares year to date during
2005 represent an increase of 13.72% over the same period in 2004. The Company
experienced a 6.68% growth in net interest income although a 9.43% increase in
interest income was offset by a 16.87% increase in overall interest expense. Non
interest expense was relatively flat compared to a year ago, increasing 1.81%
for the first nine months of 2005 as compared to the same period in 2004. To a
large extent, the base of operations of the Company in terms of full time
employees and physical infrastructure has remained constant over the past
several quarters. During this same time period, assets, particularly loans, have
increased, contributing to greater profitability. Income for the nine months
ended produced a Return on Average Assets of 1.17% compared to 1.06% for the
same period in 2004 and .85% for the first nine months of 2003. Return on
Average Equity (ROAE) for the nine months ended September 30, 2005 was 10.8%
compared to 10.38% for the same period a year ago and 8.75% for the first three
quarters of 2003.
Total assets have increased 4.71% since December 31, 2004 and stand at
$314,124,000 at September 30, 2005. Although loan demand appears to have slowed
slightly in the third quarter of 2005, the Company has experienced a 2.96%
increase in loans since December 31, 2004, (an increase on an annualized basis
of 3.95%). As earnings on loans represent the largest portion of the Company's
income, continued strong loan demand represents a key factor in the Company's
continued profitability. Demand for the Company's deposit products remains
adequate to, in combination with borrowings from the Federal Home Loan Bank,
fund loan growth.
13
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Overview (continued)
Income for the quarter ended September 30, 2005 increased 7.77% as compared to
the third quarter of 2004. Net interest income for the quarter increased 6.74%
as compared to last year, despite a 30.74% increase in interest expense.
Non-interest income was flat year over year as increases in service charges on
accounts and other miscellaneous fee income offset a $39,000 decrease in
insurance earnings. Increases in legal and professional fees contributed a large
portion of 2.81% increase in non interest expense. Earnings for the quarter
produced a Return on Average Equity of 11.21% and a Return on Average Assets of
1.19%
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 September 30, 2005 as compared to the same quarter
in 2004 are substantially the same as the causes discussed for the nine months
ended September 30, 2005 as compared to the nine months ended September 30,
2004.
Net Interest Income
Year To Date
Although average balances of earning assets increased on 3.01% and the average
ratio of earning assets to interest bearing liabilities increased only slightly
(from 1.22 times in 2004 to 1.24 times in 2005), net interest income, on a fully
taxable equivalent basis, for the nine months ended September 30, 2005 increased
6.54% over the same period in 2004. The Company's net interest margin for the
first three quarters of 2005 increased 16 basis points to 4.79%
An increase of 32 basis points on the average interest cost to interest bearing
liabilities was offset by an increase of 39 basis points on the average rate
earned on earning assets. Average rates earned on each of the categories of
earning assets, Loans, Federal Funds sold, interest bearing deposits, and
securities, increased only slightly. However, average balances of loans, a
comparatively higher earning asset, represented 87.66% of total earning assets
during 2005 compared to 82.78% during 2004. This increase in loans was a heavy
contributor to the 39 basis point increase. The average loan to deposit ratio
for the first three quarters of 2005 was 97.72% compared to 88.79% for the first
nine months of 2004.
The subsidiary banks have increasingly used debt instruments from the Federal
Home Loan Bank (FHLB) to fund loan growth versus paying above market rates to
attract time deposits. As a result the average balances of borrowed funds, both
long-term and overnight, increased 161.72% as compared to a year ago. Average
balances of interest bearing deposits decreased 2.34% as compared to 2004 while
average rates on interest bearing deposits increased 25 basis points, causing an
increase of $320,000 in interest expense paid on deposits.
The table on page 15 summarizes the Company's net interest margin for nine month
period ended September 30, 2005 as compared to 2004.
14
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Net Interest Income (continued)
Quarter Ended September 30
Net interest income for the quarter ended September 30, 2005 increased 6.65% as
compared to the same quarter a year ago. A 5.39% increase in the average
balances of earning assets and an increase of 44 basis points on the rates
earned on these assets was offset in part by an increase in average balances of
interest bearing liabilities of 4.36% and a 50 basis point increase in the
average rates paid on these liabilities.
As with the nine month comparison, quarterly net interest income for the third
quarter of 2005 as compared to the third quarter of 2004 was impacted by the
increase in average loans, both in whole and as a percent of earning assets.
While average rates earned on each category of earning assets increased
marginally, (with the exception of earnings on Federal Funds sold, which
experienced large rate increases), the overall average rates on earning assets
increased significantly as loans, a relatively higher earning asset, increased
as a percentage of total earning assets.
Because of the recent increases by the Federal Reserve Board in the target rate
of Federal Funds sold, and the subsequent increase in market rates paid to
depositors, average rates paid on deposits continues to increase as evidenced by
a 32 basis point increase in average rates paid on money market accounts, a 36
basis point increase in average rates paid on savings accounts, and an increase
of 46 basis points for interest on time deposits.
The table on page 16 summarizes the Company's net interest margin for three
month period ended September 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 FOR THE NINE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
(Dollar Amounts in Thousands)
September 30, 2005 September 30, 2004
---------------------------------- -----------------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Earning Assets
Loans (1,3) $252,118 $13,620 7.22% $ 231,218 $ 12,417 7.18%
Federal funds sold 8,675 202 3.11% 16,521 128 1.03%
Interest bearing
deposits 1,320 26 2.63% 1,469 13 1.18%
Investments
Taxable (4) 22,565 481 2.85% 26,632 511 2.56%
Tax exempt (2,4) 2,921 123 5.63% 3,366 152 6.03%
----- ----- ---- ----- ----- -----
Total Earning Assets 287,599 14,452 6.72% 279,206 13,221 6.33%
------ ---- ------ -----
Noninterest Earning Assets
Cash and due from banks 6,949 6,715
Allowance for loan
losses (2,716) (2,395)
Insurance contracts 5,898 5,635
Other assets 12,323 10,725
------ ------
Total Assets $310,053 $299,886
======== ========
Interest Bearing Liabilities
Money markets $ 25,244 133 .70% $ 23,361 64 .37%
Savings 48,882 307 .84% 52,597 219 .56%
Time deposits 143,892 3,234 3.00% 147,286 3,071 2.79%
Short term debt 38 1 2.40%
Long term debt 14,561 475 4.36% 5,578 197 4.72%
------ ----- ---- ------ ----- -----
Total Interest Bearing
Liabilities 232,617 4,150 2.39% 228,822 3,551 2.07%
----- ---- ----- -----
Non Interest Bearing
Liabilities
Demand deposits 39,973 37,054
Other Liabilities 4,744 3,319
Shareholder's Equity 32,719 30,691
------ ------
Total Liabilities and
Shareholder's Equity $310,053 $299,886
======== ========
Net Interest Income $10,302 $9,670
====== =====
Net Yield on Interest Earning
Assets 4.79% 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.
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 FOR THE THREE MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
(Dollar Amounts in Thousands)
September 30, 2005 September 30, 2004
---------------------------------- -------------------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Earning Assets
Loans (1,3) $ 254,577 $ 4,704 7.33% $ 235,163 $4,189 7.09%
Federal funds sold 11,987 101 3.34% 13,119 45 1.36%
Interest bearing deposits 1,560 15 3.81% 1,477 5 1.35%
Investments
Taxable (4) 22,196 164 2.93% 25,242 166 2.62%
Tax exempt (2,4) 2,865 38 5.26% 3,201 46 5.72%
----- ----- ---- ------ ----- -----
Total Earning Assets 293,185 5,022 6.80% 278,202 4,451 6.36%
----- ---- ------ -----
Non Interest Earning Assets
Cash 7,296 6,867
Allowance for loan losses (2,872) (2,369)
Insurance contracts 5,960 5,694
Other assets 10,120 9,123
------ -----
Total Assets $ 313,689 $ 297,517
========= =========
Interest Bearing Liabilities
Money markets 25,031 46 .74% 23,550 25 .42%
Savings 48,626 115 .94% 53,555 78 .58%
Time deposits 145,867 1,165 3.17% 142,567 970 2.71%
Other borrowed money 15,779 167 4.20% 5,791 69 4.74%
------- ----- ----- -------- ----- -----
Total Interest Bearing
Liabilities 235,303 1,493 2.52% 225,463 1,142 2.02%
----- ----- ----- -----
Non Interest Bearing Liabilities
Demand deposits 41,073 37,786
Other Liabilities 3,906 3,290
Shareholder's Equity 33,407 30,978
------ ------
Total Liabilities and
Shareholder's Equity $313,689 $297,517
======== ========
Net Interest Income 3,529 3,309
===== =====
Net Yield on Interest Earning
Assets 4.78% 4.73%
==== =====
(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)
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.
Credit Quality
Balances of non-performing loans increased 62.72% from December 31, 2004 to
September 30, 2005. This is largely due to the addition of the loans of a large
commercial customer being placed in non-accrual status. Balances of loans 30
days or more delinquent have declined from 2.99% at December 31, 2004 to 2.94%
at September 30, 2005.
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
September 30, 2005, December 31, 2004 and September 30, 2004:
September 30, December 31, September 30
2005 2004 2004
---- ---- ----
(in thousands)
Non-accrual loans $1,017 $ 530 $ 653
Loans past due 90 days or more
and still accruing interest 716 535 534
----- ----- -----
Total $1,733 $1,065 $1,187
===== ===== =====
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.
The carrying value of foreclosed property at September 30, 2005 was $45,000. All
foreclosed property held as of September 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 September 30, 2005, the Company had two potential problem loan as defined
in SEC Industry Guide III that would require disclosure. Both of these loans are
described below.
18
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 $1.375 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.
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.
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.
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.
19
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Allowance For Loan Losses (continued)
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
September 30, 2005 and December 31, 2004:
September 30, 2005 December 31, 2004
------------------- ----------------
Loan Allowance Percentage Allowance Percentage
Type Allocation of Loans Allocation of Loans
---- ---------- ---------- ---------- ---------
Commercial $ 667 20% $ 697 21%
Mortgage 931 63% 853 60%
Consumer 1,254 17% 970 19%
Unallocated 67 10
------- ------ ------- ------
Totals $ 2,919 100% $ 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.
As of September 30, 2005, the Company's Allowance as a percentage of loans
outstanding had risen to 1.14% from 1.02% at December 31, 2004. As the Company's
loan portfolio has grown, management has determined that the level of the
Company's allowance for loan losses should increase accordingly. In addition,
due to a recent increase in nonperforming loans and the potential for losses
arising from these loans, an additional provision for loan losses was made
during the third quarter. As a result, the Company's allowance for loan losses
is $389,000 larger at September 30, 2005 than at 2004 and the allowance as
compared to gross loans has increased over this same time period.
20
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 nine month periods
ended September 30, 2005 and September 30, 2004 and for the quarters ended
September 30, 2005 and September 30, 2004 is set forth in the following table
(in thousands):
Quarter Ended Nine Months Ended
September 30, September 30,
2005 2004 2005 2004
Charge-Offs $ (174) $ (237) $ (445) $ (956)
Recoveries 59 67 144 256
------ ------ ----- -----
Total net charge-offs (115) (170) (301) (700)
Components of net charge-offs:
Real estate (8) (121) (9) (386)
Commercial 18 (26) (20) (92)
Installment (125) (23) (272) (222)
------ ------- ----- ------
Total $ (115) $ (170) $ (301) $ (700)
======= ====== ======= ======
Non Interest Income
Non interest income year to date increased 6.53% compared to the same period in
2004. Year over year increases in service charges on deposit accounts and
increases in earnings on investments in insurance contracts were offset by a
$41,000 decrease in income from sales of credit life and accident and health
insurance. Although decreases in expenses related to required claim and benefit
payments have had a positive impact on the earnings of HBI Life Insurance
Company, continued declines in the volume of new installment loans, the primary
market for credit life and accident and health insurance, has negatively
impacted the volume of new insurance sales, causing the decline in insurance
earnings.
21
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Non Interest Expense
Total non interest expense for the first nine months of 2005 increased 1.81% as
compared to the same period a year ago. Declines in data processing expense and
directors fees were offset by increases in salary and benefits expense,
occupancy and equipment expense, and legal and professional fees.
Salary expenses increased $139,000 year to date as compared to 2004. Of this
increase, $100,000 is attributable to the average cost per employee. Other
increases were due to customary pay increases and increased costs of The Grant
County Bank's defined benefit pension plan. The remainder of the increase in
salary and benefits expense is attributable to an increase in the number of full
time equivalent employees.
Legal and professional fees increased 26.12% year to date as compared to the
first nine months of 2004. Costs associated with Sarbanes-Oxley Rule 404
compliance were responsible for the majority of this increase. During the third
quarter of 2005, an increase in on-site engagements of auditing and consulting
firms as compared to the engagements during the same period in 2004 caused legal
and professional fees for the quarter to increase $81,000 as compared to the
third quarter of 2004. Management expects legal and professional fees
experienced during the fourth quarter of 2005 to remain substantially the same
or decrease slightly as compared to the third quarter, but to remain elevated as
compared to the fourth quarter of 2004.
Data processing expense year to date has fallen 9.45% as compared to 2004, due
mainly to a decrease in the contractual rate charged to the subsidiary banks by
a supplier of account processing functions.
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 first nine months of 2005, the Company acquired
an additional $7,700,000 in long-term borrowings from the FHLB and made
repayments of $375,000.
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 or third quarters of 2005. Management
prefers to fund growth through longer term vehicles and expects future instances
of overnight borrowings to be minimal.
22
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Borrowed Money (continued)
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
an equity interest in Capon Valley Bank, a subsidiary company. This debt
instrument was obtained as both a precautionary 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.
Purchase of The National Bank of Davis
On August 22, 2005, Highlands Bankshares entered into an agreement to purchase
the outstanding shares of common stock of the National Bank of Davis ("Davis"),
located in Davis, West Virginia. The Agreement can be found by accessing the
website of the Securities and Exchange Commission under the filings of Highlands
Bankshares, Inc. and as part of the Current Report on Form 8-K filed August, 23,
2005.
The Agreement was consummated on October 31, 2005 and the shareholders of Davis
were paid $10,400 per share for a total purchase price of $5,200,000. In
addition to this amount, Highlands has incurred approximately $200,000
additional expenses related to the purchase. Upon purchase, Davis became a
wholly owned subsidiary of Highlands Bankshares, and will be later merged into
The Grant County Bank, with Grant County Bank surviving the merger. This merger
is expected to occur during the second half of the month of November 2005. ,
Funding for the purchase was provided by a special, one time , dividend from The
Grant County Bank to Highlands Bankshares. The Company believes the purchase
will be immediately accretive to earnings due to reductions in overhead expenses
and expanded loan operations that a larger institution may offer.
The purchase of Davis adds two banking locations and 12 full time equivalent
employees to the operations of Highlands.
Following is selected historical financial data for The National Bank of Davis.
The September 30, 2005 balance sheet, and income statement are unaudited. The
December 31, 2004 balance sheet was audited by a public accounting firm who
rendered an unqualified opinion. Since The National Bank of Davis was not
required to file with the Securities and Exchange Commission, the audit was not
required to be conducted in compliance with PCAOB standards. Thus, certain
auditing standards required by the PCAOB were not applicable to the audit of The
National Bank of Davis.
23
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Purchase of The National Bank of Davis (continued)
The National Bank of Davis
Balance Sheets
(in thousands of dollars)
December 31, September 30,
2004 2005
Assets
Cash and cash equivalents $ 1,152 $ 615
Federal funds sold 4,735 5,764
Securities (net of valuation allowance) 10,287 9,876
Other investments 8 8
Loans 8,405 8,709
Allowance for loan losses (165) (167)
Bank premises and equipment (net of depreciation) 712 676
Interest receivable 152 106
Investment in insurance contracts 346 353
Other assets 93 62
----- -----
Total Assets $ 25,725 $ 26,002
======= =======
Liabilities
Noninterest bearing demand deposits 5,687 5,492
Interest bearing demand deposits and savings 8,903 9,578
Time deposits 9,329 9,120
Accrued expenses and other liabilities 110 72
----- ------
Total Liabilities 24,029 24,262
------ ------
Shareholders' Equity
Common stock 50 50
Surplus 200 200
Retained Earnings 1,463 1,565
Accumulated other comprehensive loss (17) (75)
------- ------
Total Shareholders' Equity 1,696 1,740
----- -----
Total liabilities and shareholders' equity $ 25,725 $ 26,002
======== =======
24
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Purchase of The National Bank of Davis (continued)
The National Bank of Davis
Statement of Income
(in thousands of dollars)
Twelve Month Nine Month
Period Ended Period Ended
December 31, September 30,
2004 2005
---------- ----------
Interest Income
Interest and fees on loans $ 636 $ 465
Interest on federal funds sold 50 105
Interest on securities 516 321
------ ------
Total Interest Income 1,202 891
Interest Expense
Interest on deposits 271 180
------ ------
Net Interest Income 931 711
Provision for Loan Losses 15 --
------ ------
Net Interest Income after Provision
For Loan Losses 916 711
------ ------
Noninterest Income
Service Charges 48 37
Investment in insurance contracts 12 6
Other noninterest income 41 10
------ ------
Total noninterest income 101 53
------ ------
Noninterest expense
Salaries and employee benefits 411 310
Equipment & occupancy expense 183 119
Data processing expense 26 32
Other non interest expense 298 196
------ ------
Total noninterest expense 918 657
------ ------
Income Before Income Taxes 99 107
Provision for Income Taxes (Refund) (11) 6
------ ------
Net Income $ 110 $ 101
====== ======
25
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 October 1, 2005, the subsidiary banks
could pay dividends to Highlands Bankshares, Inc. of approximately $5,633,000
without permission of the regulatory authorities. The special dividend in
October 2005 from The Grant County Bank (Grant) to Highlands Bankshares to fund
the acquisition of The National Bank of Davis exceeds Grant's dividend limit as
of the date of the dividend. As part of the regulatory application process for
the acquisition, the applicable banking authorities approved this dividend and
have implicitly agreed that the special, one time, dividend will not restrict
Grant's ability to pay dividends to the parent company in the coming periods.
26
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 September 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 September 30, 2005 and December 31, 2004:
September 30, 2005 December 31, 2004
Actual Regulatory Actual Regulatory
Ratio Minimum Ratio Minimum
------ -------- ------ --------
Total Risk Based Capital
Ratio
Highlands Bankshares 15.59% 8.00% 14.71% 8.00%
Capon Valley Bank 13.26% 8.00% 12.82% 8.00%
The Grant County Bank 16.03% 8.00% 15.68% 8.00%
Tier 1 Leverage Ratio
Highlands Bankshares 10.55% 3.00% 10.14% 3.00%
Capon Valley Bank 8.55% 3.00% 8.57% 3.00%
The Grant County Bank 11.18% 3.00% 11.01% 3.00%
Tier 1 Risk Based Capital
Ratio
Highlands Bankshares 14.33% 4.00% 13.58% 4.00%
Capon Valley Bank 12.01% 4.00% 11.57% 4.00%
The Grant County Bank 14.83% 4.00% 14.64% 4.00%
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.
27
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.
Also as a result of the low interest rate environment in recent periods,
depositors have seemed 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 as time deposit balances have risen during 2005. At
December 31, 2004 balances of interest bearing transaction accounts were
$75,342,000 but by September 30, 2005 balances in these accounts had fallen to
$72,809,000. Over the same time period, balances of time deposits have increased
from $141,527,000 to $146,472,000. Were interest rates to rise sharply in the
coming periods, some of the monies now in interest bearing transaction and
savings accounts may further 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, coupled with relatively unchanged balances of
deposits, created the need during the later quarters of 2004 and the first part
of 2005 for increased borrowings from the FHLB. During 2004, Management decided
that the best funding strategy for loan growth was to fund growth through
reduction in balances of comparatively lower earning assets like securities and
federal funds sold and to borrow funds from the FHLB rather than pay above
market rates for deposits. The result of this was that during 2004 deposits
balances fell, especially balances of time deposits. Balances of federal funds
sold and securities also fell. Net interest margin increased as a result. During
2005, deposit balances have begun to increase slightly, and this, coupled with
cash flows resulting from operations, have allowed federal funds sold balances
to increase 174.14% from December 31, 2004 to September 30, 2005. It is
management's belief that loan growth in the coming quarter will not have to be
funded through increased deposits which would be obtained by increasing deposit
rates above the competition.
Although it is expected that deposits rates will continue to rise, management
expects that with a significant portion of its loan portfolio repricing within
the next year, that rising rates will not have a significant impact on the
Company's net interest earnings.
28
Item 3 Quantitative and Qualitative Disclosures About Market Risk (continued)
The following table illustrates the Company's sensitivity to interest rate
changes as of September 30, 2005 (in thousands):
HIGHLANDS BANKSHARES, INC.
INTEREST RATE SENSITIVITY ANALYSIS
SEPTEMBER 30, 2005
(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
------- ------- ------ ------ -------- -------
EARNING ASSETS
Loans $38,568 $88,668 $94,862 $15,337 $18,439 $255,874
Fed funds sold 10,982 10,982
Securities 10,133 7,330 5,308 1,790 674 25,235
Time deposits in other
banks 1,145 203 100 1,448
------ ------ ------ ------ ----- ------
Total 60,828 96,201 100,270 17,127 19,113 293,539
------ ------ ------ ------ ----- -------
INTEREST BEARING LIABILITIES
Interest bearing
transaction 24,399 24,399
Savings accounts 48,410 48,410
Time deposits 17,094 62,042 53,554 13,782 146,472
Other borrowed money 407 1,234 3,390 3,546 7,125 15,702
------ ------ ------ ------ ----- ------
Total 90,310 63,276 56,944 17,328 7,125 234,983
------ ------ ------ ------ ----- -------
Rate sensitivity GAP $(29,482) $32,925 $43,326 $ (201) $11,988 $ 58,556
Cumulative GAP $(29,482) $ 3,443 $46,769 $46,568 $58,556
Ratio of cumulative
interest sensitive
assets to
cumulative interest
sensitive liabilities 67.35% 102.24% 122.21% 120.44% 124.92%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
29
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 in
an effort to prevent fraudulent activity of either an amount material to
these results or in any amount 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.
30
Part II Other Information
Item 1. Legal Proceedings - Not Applicable
Item 2. Unregistered Sale of Equity
Securities and Use of Proceeds - Not Applicable
Item 3. Defaults Upon Senior Securities - Not Applicable
Item 4. Submission of Matters to a Vote
of Security Holders - Not Applicable
Item 5. Other Information - Not Applicable
Item 6. Exhibits
2 Plan of Acquisition is incorporated herein by reference to Highlands
Bankshares Inc.'s Form 8-K filed on August 23, 2005)
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.
31
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 & Chief Executive Officer
/s/ R. ALAN MILLER
---------------------------
R. Alan Miller
Chief Financial Officer
Date: November 11, 2005