-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NY9W7Vzv31E86RPcSoVaz4y+4gzhGaZC6KRlIL0HQ6+Sz3Z8A3fpHZiOhxvRKYry 2dLsLsj+kFqDSaPOpzDY7w== 0000796534-03-000004.txt : 20030331 0000796534-03-000004.hdr.sgml : 20030331 20030331110406 ACCESSION NUMBER: 0000796534-03-000004 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20021231 FILED AS OF DATE: 20030331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NATIONAL BANKSHARES INC CENTRAL INDEX KEY: 0000796534 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 541375874 STATE OF INCORPORATION: VA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-15204 FILM NUMBER: 03627867 BUSINESS ADDRESS: STREET 1: PO BOX 90002 CITY: BLACKSBURG STATE: VA ZIP: 24062-9002 BUSINESS PHONE: 5405522011 MAIL ADDRESS: STREET 1: 100 SOUTH MAIN STREET STREET 2: PO BOX 90002 CITY: BLACKSBURG STATE: VA ZIP: 24062-9002 10-K 1 form10k.txt FORM 10K 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended Commission file number December 31, 2002 0-15204 National Bankshares, Inc. -------------------------------------------------------------------------- (Exact name of Registrant as specified in its charter) Virginia 54-1375874 - --------------------------------- ----------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 101 Hubbard Street Blacksburg, Virginia 24060 - ---------------------------------------- (Address of principal executive offices) Registrant's telephone number, including area code (540) 951-6300 -------------------- Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $2.50 per Share --------------------------------------------------------------------- (Title of Class) Indicate by a check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X ----- Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Act). Yes X No ----- ----- The aggregate market value of the voting common equity held by nonaffiliates of the Registrant at $26.75, the price at which the common equity was sold as of June 30, 2002, the last business day of Registrant's most recently completed second quarter, was $88,230,408. Indicate the number of shares outstanding of each of the Registrant's classes of common stock, as of the latest practicable date. Class Outstanding at March 3, 2003 - ------------------------------ ------------------------------ Common Stock, $2.50 Par Value 3,511,377 DOCUMENTS INCORPORATED BY REFERENCE Selected information from the Registrants' Annual Report to Stockholders for the year ended December 31, 2002, is incorporated by reference into Parts I and II of this report. Selected information from the Registrant's Proxy Statement for the Annual Meeting to be held April 8, 2003 and filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference into Part III of this report. (This report contains 81 pages.) (The Index of Exhibits are on pages 47 & 48.) Table of Contents Page Part I Item 1. Business 3 Item 2. Properties 32 Item 3. Legal Proceedings 32 Item 4. Submission of Matters to a Vote of Security Holders 32 Executive Officers of the Registrant 33 Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 35 Item 6. Selected Financial Data 35 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 35 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 35 Item 8. Financial Statements and Supplementary Data 37 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 38 Part III Item 10. Directors and Executive Officers of the Registrant 38 Item 11. Executive Compensation 38 Item 12. Security Ownership of Certain Beneficial Owners and Management 38 Item 13. Certain Relationships and Related Transactions 38 Item 14. Controls and Procedures 39 Part IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 39 Signatures 43 Index to Exhibits 47-48 2 Part I ($ In Thousands Except Per Share Data) Item 1. Business. - ----------------- History and Business National Bankshares, Inc. (Bankshares) is a financial holding company organized under the laws of Virginia in 1986 and registered under the Bank Holding Company Act (BHCA). Bankshares conducts a good deal of its business operations through its two wholly-owned bank subsidiaries, The National Bank of Blacksburg (NBB), Bank of Tazewell County (BTC) and through National Bankshares Financial Services, Inc. (NBFS) doing business as National Bankshares Investment Services and National Bankshares Insurance Services, collectively referred to as "The Company". The National Bank of Blacksburg The National Bank of Blacksburg was originally chartered as the Bank of Blacksburg in 1891. Its state charter was converted to a national charter in 1922 and it became The National Bank of Blacksburg. NBB operates a full-service banking business from its headquarters in Blacksburg, Virginia, and its thirteen area branch offices. NBB offers general retail and commercial banking services to individuals, businesses, local government units and institutional customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks, savings bond sales and utility payment services; and providing other miscellaneous services normally offered by commercial banks. NBB also conducts a general trust business. Through its trust operation, NBB offers a variety of personal and corporate trust services. NBB makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans. At December 31, 2002, NBB had total assets of $381,099. Total deposits at this date were $340,751. NBB's net income for 2002 was $6,426 which produced a return on average assets of 1.76% and a return on average stockholders' equity of 17.57%. Refer to footnote 12 of the Company's 2002 Annual Report to Stockholders for NBB's risk-based capital ratios. Bank of Tazewell County The antecedents of BTC are in a charter issued on September 28, 1889 for Clinch Valley Bank. On December 22, 1893, a second charter was issued in substantially the same form for Bank of Clinch Valley. In 1929, Bank of Clinch Valley merged with Farmers Bank under the charter of the former, and the name of the new institution became Farmers Bank of Clinch Valley. Bank of Tazewell County resulted from the 1964 merger of Bank of Graham, Bluefield, Virginia with 3 Farmers Bank of Clinch Valley. BTC provides general retail and commercial banking services to individuals, businesses and local government units. These services include commercial, real estate and consumer loans. Deposit accounts offered include demand deposit accounts, interest-bearing demand deposit accounts, money market deposit accounts, savings accounts and certificates of deposit. Other services include automatic funds transfer, collections, night depository, safe deposit, travelers checks, savings bond sales and utility payment services; and providing other miscellaneous services normally offered by commercial banks. BTC also conducts a general trust business. At December 31, 2002 BTC had total assets of $300,347. Total deposits at this same date were $267,553. BTC's net income for 2002 was $3,499 which produced a return on average assets of 1.22% and a return on average stockholders' equity of 11.68%. Refer to footnote 12 of the Company's 2002 Annual Report to Stockholders for BTC's risk-based capital ratios. National Bankshares Financial Services On April 9, 2001 National Bankshares Financial Services Inc., a wholly-owned subsidiary began offering non-deposit investment products and insurance products for sale to the public. NBFS is working with Bankers Insurance, LLC, a joint effort of Virginia Banks originally sponsored by the Virginia Bankers Association. In another cooperative effort, NBFS is working with UVEST Financial Services Group, Inc. to offer investment services. Commercial Loans NBB and BTC make both secured and unsecured loans to businesses and to individuals for business purposes. Loan requests are granted based upon several factors including credit history, past and present relationships with the bank and marketability of collateral. Unsecured commercial loans must be supported by a satisfactory balance sheet and income statement. Collateralized business loans may be secured by a security interest in marketable equipment, accounts receivable, business equipment and/or general intangibles of the business. In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate. The risks associated with commercial loans are related to the strength of the individual business, the value of loan collateral and the general health of the economy. Residential Real Estate Loans Loans secured by residential real estate are originated by both bank subsidiaries. NBB sells a substantial percentage of the residential real estate loans it originates in the secondary market on a servicing released basis. There are occasions when a borrower or the real estate do not qualify under secondary market criteria, but the loan request represents a reasonable credit risk. Also, an otherwise qualified borrower may choose not to have their mortgage loan sold. On these occasions, if the loan meets NBB's internal underwriting criteria, the loan will be closed and placed in NBB's portfolio. Some residential loans originated by BTC are held in the bank's loan portfolio and others are sold in the secondary market. In their secondary market operations, NBB and BTC participate in insured loan programs sponsored by the Department of Housing and 4 Urban Development, the Veterans Administration and the Virginia Housing Development Authority. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Construction Loans NBB makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals. These loans are subject to the same credit criteria as commercial and residential real estate loans. Although BTC offers construction loans, its involvement in this area of lending is more limited than NBB's due to the nature of its market area. In addition to the risks associated with all real estate loans, construction loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the bank's loan customer, is unable to finish the construction project as planned because of financial pressures unrelated to the project. Loans to customers that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures. Consumer Loans NBB and BTC routinely make consumer loans, both secured and unsecured. The credit history and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative changes in a customer's financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans. Sales and Purchases of Loans NBB and BTC will occasionally buy or sell all or a portion of a loan. These purchases and sales are in addition to the secondary market residential mortgage loans regularly sold by NBB. Both banks will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan will exceed the bank's legal lending limit to a single borrower; (ii) the full amount of the loan, when combined with a borrower's previously outstanding loans, will exceed the bank's legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with the bank; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location or in one particular type of loan. The banks will consider purchasing a loan, or a participation in a loan, from another financial institution (including from another subsidiary of the Company) 5 if the loan meets all applicable credit quality standards and (i) the bank's loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase. The following table sets forth, for the three fiscal years ended December 31, 2002, 2001 and 2000 the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods. Percentage of Period Class of Service Total Revenues - ------ ---------------- -------------- December 31, 2002 Interest and Fees on Loans 66.90% Interest on Investments 20.65% December 31, 2001 Interest and Fees on Loans 55.84% Interest on Investments 21.37% December 31, 2000 Interest and Fees on Loans 66.74% Interest on Investments 21.22% Market Area The National Bank of Blacksburg Market Area NBB's primary market area consists of the northern portion of Montgomery County, all of Giles County, all of Pulaski County, the City of Radford, the City of Galax and adjacent portions of Carroll and Grayson Counties, Virginia. This area includes the towns of Blacksburg and Christiansburg in Montgomery County, the towns of Pearisburg, Pembroke and Rich Creek, in Giles County, and the towns of Dublin and Pulaski in Pulaski County. The local economy is diverse and is oriented toward higher education, retail and service, light manufacturing and agriculture. Montgomery County's largest employer is Virginia Polytechnic Institute and State University (VPI & SU) located in Blacksburg. VPI & SU is the Commonwealth's land grant college and also its largest university. Employment at VPI & SU has remained relatively stable over the past three years, and it is not expected to change materially in the next few years. A second state supported university, Radford University, is located in NBB's service area. It too has provided stable employment opportunities in the region. The State of Virginia has announced significant cuts in financial support to both universities. To date, these cuts have not translated into large reductions in employment. Giles County's primary employer is the Celanese Corp. plant, a manufacturer of the material from which cigarette filters are made. Employment at this plant has remained relatively stable over the past several years. Pulaski County's major employer is the Volvo Heavy Trucks production facility. During 2000, the Volvo company laid off a significant number of workers, however the company has recently consolidated manufacturing from another plant at the Pulaski County location and has recalled a portion of the laid off employees. The county also has several large furniture plants, most notably Pulaski Furniture and Ethan Allen. The City of Galax is located in the Virginia-North Carolina 6 furniture-manufacturing region. Three furniture companies, Vaughan Bassett Furniture Company, Vaughan Furniture Company, Inc. and Webb Furniture Company together employ the largest percentage of the area's work force. The Galax economy is stable, but furniture manufacturing has been negatively affected in the recent economic downturn. Several other small manufacturing concerns are located in Montgomery, Giles and Pulaski Counties and in the City of Galax. These concerns manufacture diverse products and are not dependent on one sector of the economy. Agriculture and tourism are also important to the region, especially in Giles County and in the area near Galax. Since 1988, Montgomery County has developed into a regional retail center, with the construction of several large shopping areas. Two area hospitals, each of which are affiliated with different large health care systems, have constructed additional facilities attracting health care providers to Montgomery County, making it a center for basic health care services. VPI & SU's Corporate Research Center has brought small high tech companies to Blacksburg, and further expansion is planned. NBB's primary market area offers the advantages of a good quality of life, scenic beauty, moderate climate and the cultural attractions of two major universities. The region has marketed itself as a retirement destination, and it has had some recent success attracting retirees, particularly from the Northeast and urban Northern Virginia. These marketing efforts are expected to continue. Bank of Tazewell County Market Area Most of BTC's business originates from Tazewell County, Virginia and Mercer County, West Virginia. This includes the towns of Tazewell, Richlands and Bluefield, Virginia and Bluefield, West Virginia. BTC also has offices located in the Towns of Wytheville, Marion and Abingdon located in Wythe, Smyth and Washington Counties, Virginia, respectively. BTC's primary market area has largely depended on the coal mining industry and farming for its economic base. In recent years, coal companies have mechanized reducing the number of individuals required for the production of coal. However, there are still a number of support industries for the coal mining business that continue to provide employment in the area. Additionally, several new businesses have been established in the area, and Bluefield, West Virginia has emerged as a regional medical center. Real estate values remain stable and comparable to other areas in Southwest Virginia. BTC's expanded market areas in Wythe, Smyth and Washington Counties have a diverse economic base, with manufacturing, agriculture, education and service industries all represented. 7 Competition The banking and financial service business in Virginia, generally, and in NBB's and BTC's market areas specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. The Company's bank subsidiaries compete for loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions and other nonbank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than NBB and BTC. In order to compete, NBB and BTC rely upon service-based business philosophies, personal relationships with customers, specialized services tailored to meet customers' needs and the convenience of office locations. In addition, the banks are generally competitive with other financial institutions in their market areas with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts. Registrant's Organization and Employment Bankshares, NBB, BTC and NBFS are organized in a holding company/subsidiary structure. Until January 1, 2002, Bankshares had no employees, except for officers, and it conducted substantially all of its operations through its subsidiaries. Until January 1, 2002, all compensation paid to Bankshares officers was paid by the subsidiary banks, except for fees paid to Chairman, President and Chief Executive Officer James G. Rakes and to Corporate Officer Cameron L. Forrester for their service as directors of the Company. On January 1, 2002, several administrative functions that serve multiple subsidiaries were moved to the holding company level. These functions include audit, compliance, loan review and human resources. Employees performing these functions who were formerly employed at the bank level are now employed at the holding company level. At December 31, 2002, NBB employed 129.5 full time equivalent employees at its main office, operations center and branch offices. BTC at December 31, 2002 employed 102 full time equivalent employees in its various offices and operational areas. Bankshares had 12 and NBFS had 3 full time employees at December 31, 2002. Certain Regulatory Considerations Bankshares, NBB and BTC are subject to various state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking, financial institutions, including Bankshares, NBB and BTC, are disadvantaged relative to other competitors who are not as highly regulated, and their costs of doing business are much higher. The following is a brief summary of the material provisions of certain statutes, rules and regulations which affect Bankshares, NBB and/or BTC. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations which are applicable to the businesses of Bankshares, NBB and/or 8 BTC. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of Bankshares, NBB and/or BTC. National Bankshares, Inc. Bankshares is a bank holding company within the meaning of the BHCA and Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of Bankshares also are governed by the Gramm-Leach-Bliley Act of 1999. The Bank Holding Company Act. The BHCA is administered by the Federal Reserve Board, and Bankshares is required to file with the Federal Reserve Board an annual report and any additional information the Federal Reserve Board may require under the BHCA. The Federal Reserve Board also is authorized to examine Bankshares and its subsidiaries. The BHCA requires every bank holding company to obtain the approval of the Federal Reserve Board before (i) it or any of its subsidiaries (other than a bank) acquires substantially all the assets of any bank; (ii) it acquires ownership or control of any voting shares of any bank if after the acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of the bank; or (iii) it merges or consolidates with any other bank holding company. The BHCA and the Change in Bank Control Act, together with regulations promulgated by the Federal Reserve Board, require that, depending on the particular circumstances, either Federal Reserve Board approval must be obtained or notice must be furnished to the Federal Reserve Board and not disapproved prior to any person or company acquiring "control" of a bank holding company, such as Bankshares, subject to certain exemptions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of Bankshares. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities of Bankshares. The regulations provide a procedure for challenging the rebuttable control presumption. Under the BHCA, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in nonbanking activities, unless the Federal Reserve Board, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be incident to banking. Under recent amendments to the BHCA, included in the Gramm-Leach-Bliley Act of 1999 (see below), any bank holding company, all the depository institution subsidiaries of which are well-capitalized, well managed (as those terms are defined in the BHCA) and have a satisfactory or better rating under the Community Reinvestment Act as of their last examination, may file an election with the Federal Reserve Board to become a Financial Holding Company. A Financial Holding Company may engage in any activity that is (i) financial in nature (ii) incidental to a financial activity or (iii) complementary to a financial activity. The BHCA provides a long list of "financial activities", including: insurance underwriting; securities dealing and underwriting; providing financial, investment or economic arising services; and merchant banking activities. Financial Holding Companies may also engage in other activities that the Federal Reserve Board has determined are permissible under the BHCA, by regulation or order. The Federal Reserve Board imposes certain capital requirements on Bankshares under the BHCA, including a minimum leverage ratio and a minimum ratio of 9 "qualifying" capital to risk-weighted assets. Subject to its capital requirements and certain other restrictions, Bankshares can borrow money to make a capital contribution to NBB or BTC, and these loans may be repaid from dividends paid from NBB or BTC to Bankshares (although the ability of NBB or BTC to pay dividends are subject to regulatory restrictions). Bankshares can raise capital for contribution to NBB and BTC by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws. The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the GLBA), enacted on November 12, 1999, broadly rewrote financial services legislation. The GLBA permits significant combinations among different sectors of the financial services industry; allows for significant expansion of financial service activities by Bank holding companies and provides for a regulatory framework by various governmental authorities responsible for different financial activities; and offers certain financial privacy protections to consumers. The GLBA repealed affiliation and management interlock prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new substantive provisions to the non-banking activities permitted under the BHCA with the creation of the financial holding company. The GLBA preempts most state laws that prohibit financial holding companies from engaging in insurance activities. The GLBA permits affiliations between banks and securities firms within the same holding company structure, and the Act permits financial holding companies to directly engage in a broad range of securities and merchant banking activities. The Gramm-Leach-Bliley Act has led to important changes in the manner in which financial services are delivered in the United States. Bank holding companies and their subsidiary banks are able to offer a much broader array of financial services; however, there is greater competition in all sectors of the financial services market. The Virginia Banking Act. All Virginia bank holding companies must register with the Virginia State Corporation Commission (the Commission) under the Virginia Banking Act. A registered bank holding company must provide the Commission with information with respect to the financial condition, operations, management and intercompany relationships of the holding company and its subsidiaries. The Commission also may require such other information as is necessary to keep itself informed about whether the provisions of Virginia law and the regulations and orders issued under Virginia law by the Commission have been complied with, and may make examinations of any bank holding company and its subsidiaries. The Virginia Banking Act allows bank holding companies located in any state to acquire a Virginia bank or bank holding company if the Virginia bank or bank holding company could acquire a bank holding company in their state and the Virginia bank or bank holding company to be acquired has been in existence and continuously operated for more than two years. The Virginia Banking Act permits bank holding companies from throughout the United States to enter the Virginia market, subject to federal and state approval. 10 NBB and BTC General. NBB is a national banking association incorporated under the laws of the United States and is subject to examination by the Office of the Comptroller of the Currency (the OCC). Deposits in NBB are insured by the FDIC up to a maximum amount (generally $100,000 per depositor, subject to aggregation rules). The OCC and the FDIC regulate or monitor all areas of NBB's operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates payable on deposits, interest rates or fees chargeable on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The OCC requires NBB to maintain certain capital ratios. NBB is required by the OCC to prepare quarterly reports on NBB's financial condition and to conduct an annual audit of its financial affairs in compliance with minimum standards and procedures prescribed by the OCC. NBB also is required by the OCC to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While appropriate for safety and soundness of banks, these requirements impact banking overhead costs. BTC is organized as a Virginia-chartered banking corporation and is regulated and supervised by the Bureau of Financial Institutions (BFI) of the Virginia State Corporation Commission. In addition, as a federally insured bank, BTC is regulated and supervised by the Federal Reserve Board, which serves as its primary federal regulator and is subject to certain regulations promulgated by the FDIC. Under the provisions of federal law, federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these banks are prohibited from engaging in certain tie-in-arrangements in connection with any extension of credit or the providing of any property of service. The Virginia State Corporation Commission and the Federal Reserve Board conduct regular examinations of BTC reviewing the adequacy of the loan loss reserves, quality of the loans and investments, propriety of management practices, compliance with laws and regulations and other aspects of the bank's operations. In addition to these regular examinations, Virginia chartered banks must furnish to the Federal Reserve Board quarterly reports containing detailed financial statements and schedules. Community Reinvestment Act. NBB and BTC are subject to the provisions of the Community Reinvestment Act of 1977 (the CRA), which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank's record in meeting the credit needs of the community served by the bank, including low and moderate-income neighborhoods. Under the implementing CRA regulations, banks have the option of being assessed for CRA compliance under one of several methods. Small banks are evaluated differently than larger banks and technically are not subject to some data collection requirements. The focus of the regulations is on the volume and distribution of a bank's loans, with particular emphasis on lending activity in low and moderate-income areas and to low and moderate-income persons. The regulations place substantial importance on a bank's product delivery system, particularly branch locations. The regulations require banks, other than small banks, to 11 comply with significant data collection requirements. The regulatory agency's assessment of the bank's record is made available to the public. Further, this assessment is required for any bank which has applied to, among other things, establish a new branch office that will accept deposits, relocate an existing office, or merge, consolidate with or acquire the assets or assume the liabilities of a federally regulated financial institution. It is likely that banks' compliance with the CRA, as well as other fair lending laws, will face ongoing government scrutiny and that costs associated with compliance will continue to increase. NBB has received a CRA rating of "Outstanding" in its last examination by federal bank regulators. BTC was rated as "Satisfactory". Federal Deposit Insurance Corporation Improvement Act of 1991. The difficulties encountered nationwide by financial institutions during 1990 and 1991 prompted federal legislation designed to reform the banking industry and to promote the viability of the industry and of the deposit insurance system. FDICIA, which became effective on December 19, 1991, bolsters the deposit insurance fund, tightens bank regulation and trims the scope of federal deposit insurance. The legislation bolsters the bank deposit insurance fund with $70 billion in borrowing authority and increases to $30 billion from $5 billion the amount the FDIC can borrow from the U.S. Treasury to cover the cost of bank failures. The loans, plus interest, would be repaid by premiums that banks pay on domestic deposits over the next fifteen years. Among other things, FDICIA requires the federal banking agencies to take "prompt corrective action" in respect to banks that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." If a depository institution's principal federal regulator determines that an otherwise adequately capitalized institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, it may require the institution to submit a corrective action plan, restrict its asset growth and prohibit branching, new acquisitions and new lines of business. An institution's principal federal regulator may deem the institution to be engaging in an unsafe or unsound practice if it receives a less than satisfactory rating for asset quality, management, earnings or liquidity in its most recent examination. Among other possible sanctions, an undercapitalized depository institution may not pay dividends and is required to submit a capital restoration plan to its principal federal regulator. In addition, its holding company may be required to guarantee compliance with the capital restoration plan under certain circumstances. If an undercapitalized depository institution fails to submit or implement an acceptable capital restoration plan, it can be subject to more severe sanctions, including an order to sell sufficient voting stock to become adequately capitalized. More severe sanctions and remedial actions can be mandated by the regulators if an institution is considered significantly or critically undercapitalized. 12 In addition, FDICIA requires regulators to draft a new set of non-capital measures of bank safety, such as loan underwriting standards and minimum earnings levels. The legislation also requires regulators to perform annual on-site bank examinations, places limits on real estate lending by banks and tightens auditing requirements. In April 1995, the regulators adopted safety and soundness standards as required by FDICIA in the following areas: (i) operational and managerial; (ii) asset quality earnings and stock valuation; and (iii) employee compensation. FDICIA reduces the scope of federal deposit insurance. The most significant change ended the "too big to fail" doctrine, under which the government protects all deposits in most banks, including those exceeding the $100,000 insurance limit. The FDIC's ability to reimburse uninsured deposits--those over $100,000 and foreign deposits--has been sharply limited. Since December 1993, the Federal Reserve Board's ability to finance undercapitalized banks with extended loans from its discount window has been restricted. In addition, only the best capitalized banks will be able to offer insured brokered deposits without FDIC permission or to insure accounts established under employee pension plans. Branching. In 1986, the Virginia Banking Act was amended to remove the geographic restrictions governing the establishment of branch banking offices. Subject to the approval of the appropriate federal and state bank regulatory authorities, BTC as a state bank, may establish a branch office anywhere in Virginia. National banks, like NBB, are required by the National Bank Act to adhere to branch banking laws applicable to state banks in the states in which they are located. Under current Virginia law, NBB may open branch offices throughout Virginia with the prior approval of the OCC. In addition, with prior approval of the OCC, NBB will be able to acquire existing banking operations in Virginia. As a state bank, BTC is subject to Virginia state branching laws, with state banking regulatory and Federal Reserve Bank approval, BTC is able to acquire existing banking operations in the state. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) allows bank holding companies to acquire banks in any state, without regard to state law, except that if the state has a minimum requirement for the amount of time a bank must be in existence, that law must be preserved. Under the Virginia Banking Act, a Virginia bank or all of the subsidiaries of Virginia holding companies sought to be acquired must have been in continuous operation for more than two years before the date of such proposed acquisition. The Interstate Act also permits banks to acquire out-of-state branches through interstate mergers, if the state has not opted out of interstate branching. De novo branching, where an out-of-state bank holding company sets up a new branch in another state, requires a state's specific approval. An acquisition or merger is not permitted under the Interstate Act if the bank, including its insured depository affiliates, will control more than 10% of the total amount of deposits of insured depository institutions in the United States, or will control 30% or more of the total amount of deposits of insured depository institutions in any state. 13 Virginia has, by statute, elected to opt-in fully to interstate branching under the Interstate Act. Under the Virginia statute, Virginia state banks may, with the approval of the Virginia State Corporation Commission, establish and maintain a de novo branch or acquire one or more branches in a state other than Virginia, either separately or as part of a merger. Procedures also are established to allow out-of-state domiciled banks to establish or acquire branches in Virginia, provided the "home" state of the bank permits Virginia banks to establish or acquire branches within its borders. The activities of these branches are subject to the same laws as Virginia domiciled banks, unless such activities are prohibited by the law of the state where the bank is organized. The Virginia State Corporation Commission has the authority to examine and supervise out-of-state state banks to ensure that the branch is operating in a safe and sound manner and in compliance with the laws of Virginia. The Virginia statute authorizes the Bureau of Financial Institutions to enter into cooperative agreements with other state and federal regulators for the examination and supervision of out-of-state banks with Virginia operations, or Virginia domiciled banks with operations in other states. Likewise, national banks, with the approval of the OCC, may branch into and out of the state of Virginia. Any Virginia branch of an out-of-state national bank is subject to Virginia law (enforced by the OCC) with respect to intrastate branching, consumer protection, fair lending and community reinvestment as if it were a branch of a Virginia bank, unless preempted by federal law. The Interstate Act permits banks and bank holding companies from throughout the United States to enter Virginia markets through the acquisition of Virginia institutions and makes it easier for Virginia bank holding companies and Virginia state and national banks to acquire institutions and to establish branches in other states. Competition in market areas served by the Company has increased as a result of the Interstate Act and the Virginia interstate banking statutes. Deposit Insurance. The FDIC establishes rates for the payment of premiums by federally insured financial institutions. A Bank Insurance Fund (the BIF) is maintained for commercial banks, with insurance premiums from the industry used to offset losses from insurance payouts when banks fail. Beginning in 1993, insured depository institutions like NBB and BTC paid for deposit insurance under a risk-based premium system. Beginning in 1997, all banks, including NBB and BTC, were subject to an additional FDIC assessment which funds interest payments for bank issues to resolve problems associated with the savings and loan industry. This assessment will continue until 2018-2019. The assessment will vary over the period from 1.29 cents to 2.43 cents per $100 of deposits. Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act of 1999 (the GLBA) allows national banks, with OCC approval, to acquire financial subsidiaries to engage in any activity that is financial in nature or incidental to a financial activity, as defined in the Bank Holding Act, except (i) insurance underwriting, (ii) merchant or insurance portfolio investments, and (iii) real estate development or investment. Well-capitalized national banks are also given the authority to engage in municipal bond underwriting. 14 To establish or acquire a financial subsidiary, a national bank must be well-managed, and the consolidated assets of its financial subsidiary must not exceed the lesser of 45% of the consolidated total assets of the bank or $50 billion. The relationship between a national bank and a financial subsidiary are subject to a variety of supervisory enhancements from regulators. The GLBA also provides that state banks that establish or acquire financial subsidiaries are required to comply with the same safeguards imposed on the financial subsidiaries of national banks. Government Policies. The operations of NBB and BTC are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, the Federal Reserve Board regulates money and credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Limits on Dividends and Other Payments. As a national bank, NBB, may not pay dividends from its capital; all dividends must be paid out of net profits then on hand, after deducting expenses, losses, bad debts, accrued dividends on preferred stock, if any, and taxes. In addition, a national bank is prohibited from declaring a dividend on its shares of common stock until its surplus equals its stated capital, unless there has been transferred to surplus no less than one-tenth of the bank's net profits of (i) the preceding two consecutive half-year periods (in the case of an annual dividend) or (ii) the preceding half-year period (in the case of a quarterly or semi-annual dividend). The approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or to fund the retirement of preferred stock. The OCC has promulgated regulations that became effective on December 13, 1990, which significantly affect the level of allowable dividend payments for national banks. The effect is to make the calculation of national banks' dividend-paying capacity consistent with generally accepted accounting principles. The allowance for loan and lease losses will not be considered an element of "undivided profits then on hand" and provisions to the allowance are treated as expenses and therefore not part of "net profits." Accordingly, a national bank with an allowance greater than its statutory bad debts may not include the excess in calculating undivided profits for dividend purposes. Further, a national bank may be able to use a portion of its earned capital surplus account as "undivided profits then on hand," depending on the composition of that account. As a state member bank subject to the regulations of the Federal Reserve Board, BTC must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits, as defined by the Federal Reserve Board, for that year, combined with its retained net profits for the preceding two years. In addition, a state member bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and 15 bad debts. For this purpose, bad debts are generally defined to include the principal amount of loans which are in arrears with respect to interest by six months or more, unless such loans are fully secured and in the process of collection. Moreover, for purposes of this limitation, a state member bank is not permitted to add the balance in its allowance for loan losses account to its undivided profits then on hand; however, it may net the sum of its bad debts as so defined against the balance in its allowance for loan losses account and deduct from undivided profits only bad debts as so defined in excess of that account. In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that depletes a bank's capital base could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings. Virginia law also imposes restrictions on the ability of BTC to pay dividends. A Virginia state bank is permitted to declare a dividend out of its "net undivided profits", after providing for all expenses, losses, interest and taxes accrued or due by the bank. In addition, a deficit in capital originally paid in must be restored to its initial level, and no dividend can be paid which could impair the bank's paid in capital. The Bureau of Financial Institutions further has authority to limit the payment of dividends by a Virginia bank if it determines the limitation is in the public interest and is necessary to ensure the bank's financial soundness. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements. Capital Requirements. The Federal Reserve Board has adopted risk-based capital guidelines which are applicable to Bankshares and BTC. The Federal Reserve Board guidelines redefine the components of capital, categorize assets into different risk classes and include certain off-balance sheet items in the calculation of risk-weighted assets. The minimum ratio of qualified total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8.0%. At least half of the total capital must be comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted assets of 4.0%. The remainder may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan and lease loss reserves. The OCC has adopted similar regulations applicable to NBB. In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 capital to total average assets less intangibles) guidelines that are applicable to Bankshares and BTC. The OCC has adopted similar regulations applicable to NBB. These guidelines provide for a minimum ratio of 4.0% for banks that meet certain specified criteria, including that they have the highest regulatory CAMELS rating and are not anticipating or experiencing significant growth and have well-diversified risk. All other banks will be required to maintain an additional cushion of at least 100 to 200 basis points, based upon their particular circumstances and risk profiles. The guidelines also provide 16 that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Bank regulators from time to time have indicated a desire to raise capital requirements applicable to banking organizations beyond current levels. In addition, the number of risks which may be included in risk-based capital restrictions, as well as the measurement of these risks, is likely to change, resulting in increased capital requirements for banks. Bankshares, NBB and BTC are unable to predict whether higher capital ratios would be imposed and, if so, at what levels and on what schedule. Other Legislative and Regulatory Concerns Other legislative and regulatory proposals regarding changes in banking and the regulation of banks, thrifts and other financial institutions are periodically considered by the executive branch of the federal government, Congress and various state governments, including Virginia. New proposals could significantly change the regulation of banks and the financial services industry. It cannot be predicted what might be proposed or adopted or how these proposals would affect the Company. Other Business Concerns The banking industry is particularly sensitive to interest rate fluctuations, as the spread between the rates which must be paid on deposits and those which may be charged on loans is an important component of profit. In addition, the interest which can be earned on a bank's invested funds has a significant effect on profits. Rising interest rates typically reduce the demand for new loans, particularly the real estate loans which represent a significant portion of NBB's and BTC's loan demand, as well as certain NBB loans in which BTC participates. Company Website National Bankshares maintains a website at www.nationalbankshares.com. Beginning with this Form 10-K, the Company will make available through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the material is electronically filed with the Securities and Exchange Commission. 17 Statistical Disclosure by National Bankshares, Inc. and Subsidiaries (The Company) I. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential A. Average Balance Sheets The following table presents, for the years indicated, condensed daily average balance sheet information. ($ in thousands)
December 31, -------------------------------------------- Assets 2002 2001 2000 =============================================================================================== Cash and due from banks $ 10,737 $ 10,221 $ 11,355 Interest - bearing deposits 17,765 10,986 10,683 Federal funds sold 2,644 18,419 6,149 Securities available for sale: Taxable 43,882 69,486 87,813 Nontaxable 52,995 40,196 31,302 Securities held to maturity: Taxable 48,815 46,043 9,029 Nontaxable 45,801 33,084 14,542 Mortgage loans held for sale 955 808 519 Loans, net 404,717 376,958 310,624 Other assets 27,472 29,491 18,365 -------------------------------------------- Total assets $ 655,783 $ 635,692 $ 500,381 =============================================================================================== Liabilities and Stockholders' Equity =============================================================================================== Noninterest-bearing demand $ 74,269 $ 66,793 $ 56,709 Deposits Interest-bearing demand deposits 147,749 116,529 85,713 Savings deposits 49,151 47,175 43,138 Time deposits 312,129 338,642 248,113 -------------------------------------------- Total deposits $ 583,298 $ 569,139 $ 433,673 Short-term borrowings 311 295 9,011 Other liabilities 2,279 2,798 2,015 -------------------------------------------- Total liabilities $ 585,888 $ 572,232 $ 444,699 Stockholders' equity 69,895 63,460 55,682 -------------------------------------------- Total liabilities and Stockholders' equity $ 655,783 $ 635,692 $ 500,381 ===============================================================================================
18 B. Analysis of Net Interest Earnings The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest-earning assets for the years indicated.
---------------------------------------------------------------------------------------------------------- December 31, 2002 December 31, 2001 December 31, 2000 ---------------------------------------------------------------------------------------------------------- Average Average Average Average Yield/ Average Yield/ Average Yield/ ($ in thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate ---------------------------------------------------------------------------------------------------------- Interest-earning Assets: Loans, net (1)(2)(3) $410,437 $32,556 7.93% $381,778 $33,584 8.80% $314,685 $28,454 9.04% Taxable securities 92,697 5,490 5.92% 115,529 7,501 6.56% 96,842 6,760 6.98% Nontaxable Securities (1) 98,796 6,885 6.97% 73,280 5,091 6.95% 45,844 3,420 7.46% Federal funds sold 2,644 42 1.59% 18,419 652 3.54% 6,149 338 5.50% Interest bearing Deposits 17,765 276 1.55% 10,986 577 5.25% 10,683 689 6.45% ---------------------------------------------------------------------------------------------------------- Total interest- Earning assets $622,339 $45,249 7.27% $599,992 $47,405 7.91% $474,203 $39,661 8.36% ========================================================================================================== Interest-bearing Liabilities: Interest-bearing Demand deposits $147,749 $ 2,219 1.50% $116,529 $ 2,518 2.16% $ 85,713 $ 2,243 2.62% Savings deposits 49,151 508 1.03% 47,175 919 1.95% 43,138 1,135 2.63% Time deposits 312,129 13,032 4.18% 338,642 19,326 5.71% 248,113 14,157 5.71% Short-term Borrowings 311 5 1.61% 295 8 2.71% 1,727 118 6.83% Long-term debt --- --- --- --- --- --- 7,284 510 7.00% ---------------------------------------------------------------------------------------------------------- Total interest- Bearing liabilities $509,340 $15,764 3.09% $502,641 $22,771 4.53% $385,975 $18,163 4.71% ========================================================================================================== Net interest income and interest rate spread $29,485 4.18% $24,634 3.38% $21,498 3.66% ========================================================================================================== Net yield on average Interest-earning Assets 4.74% 4.11% 4.53% ==========================================================================================================
(1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 34%. (2) Loan fees of $660 in 2002, $608 in 2001 and $381 in 2000 are included in total interest income. (3) Nonaccrual loans are included in average balances for yield computations. 19 C. Analysis of Changes in Interest Income and Interest Expense The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).
========================================================================================== 2002 Over 2001 2001 Over 2000 ------------------------------------------------------------------------------------------ Changes Due To Changes Due To ------------------------------ ------------------------------- Net Dollar Net Dollar ($ in thousands) Rates(2) Volume(2) Change Rates(2) Volume(2) Change ============================================================================================================================= Interest income:(1) Loans $ (3,442) $ 2,414 $ (1,028) $ (791) $ 5,921 $ 5,130 Taxable securities (619) (1,392) (2,011) (430) 1,171 741 Nontaxable securities 16 1,778 1,794 (249) 1,920 1,671 Federal funds sold (239) (371) (610) (157) 471 314 Interest bearing deposits (540) 239 (301) (131) 19 (112) - ----------------------------------------------------------------------------------------------------------------------------- Increase(decrease) in income on interest- earning assets $ (4,824) $ 2,668 $ (2,156) $ 1,758 $ 9,502 $ 7,744 - ----------------------------------------------------------------------------------------------------------------------------- Interest expense: Interest-bearing demand deposits $ (877) $ 578 $ (299) $ (437) $ 712 $ 275 Savings deposits (448) 37 (411) (315) 99 (216) Time deposits (4,824) (1,421) (6,294) 3 5,166 5,169 Short-term borrowings (3) --- (3) (46) (110) Long-Term Borrowings --- --- --- --- (64) (510) (510) - ----------------------------------------------------------------------------------------------------------------------------- Increase(decrease) in expense of interest-bearing liabilities $ (6,201) $ (806) $ (7,007) $ (795) $ 5,403 $ 4,608 - ----------------------------------------------------------------------------------------------------------------------------- Increase (decrease) in net interest income $ 1,377 $ 3,473 $ 4,851 $ (963) $ 4,099 $ 3,136 =============================================================================================================================
(1) Taxable equivalent basis using a Federal income tax rate of 34%. 20 (2) Variances caused by the change in rate times the change in volume have been allocated to rate and volume changes proportional to the relationship of the absolute dollar amounts of the change in each. II. Investment Portfolio A. Book Value of Investments The amortized costs and fair values of securities available for sale as of December 31, 2002, 2001 and 2000 were as follows:
============================================================================== December 31, ------------------------------------------------------------------------------ 2002 2001 2000 ------------------------------------------------------------------------------ Amortized Fair Amortized Fair Amortized Fair ($ in thousands) Costs Values Costs Values Costs Values ======================================================================================================================== Available for sale: U.S. Treasury $3,748 $3,962 $6,248 $6,248 $6,246 $6,331 U.S. Government agencies and corporations 7,038 7,132 5,340 5,375 54,815 54,034 States and political subdivisions 68,876 70,692 51,030 51,189 35,456 35,606 Mortgage-backed securities (1) 16,244 16,809 13,178 13,415 11,818 11,776 Corporate debt securities 16,993 17,411 9,066 9,093 14,341 14,058 Federal Home Loan Bank stock 1,655 1,655 1,411 1,411 1,329 1,329 Federal Reserve Bank stock 209 209 209 209 209 209 Other securities 1,670 1,864 1,328 1,485 442 442 ------------------------------------------------------------------------------ Total securities available for sale $116,433 $119,734 $ 87,810 $88,667 $124,656 $123,785 ========================================================================================================================
The amortized costs of securities held to maturity as of December 31, 2002, 2001 and 2000 were as follows:
============================================= December 31, --------------------------------------------- ($ in thousands) 2002 2001 2000 ========================================================================================= Held to maturity: U.S. Treasury $ --- $ --- $ --- U.S. Government agencies and corporations 10,013 17,025 8,500 States and political subdivisions 52,610 49,230 17,288 Mortgage-backed securities (1) 8,989 13,723 288 Corporate 27,948 22,831 6,483 --------------------------------------------- Total securities held to maturity $ 99,560 $ 102,809 $ 32,559 =========================================================================================
(1) The majority of mortgage-backed securities and collateralized mortgage obligations held at December 31, 2002 were backed by U.S. agencies. Certain holdings are required to be periodically subjected to the Financial Institution Examination Council's (FFIEC) high risk mortgage security test. These tests address possible fluctuations in the average life and price sensitivity 21 which are the primary risks associated with this type of security. Such tests are usually subject to regulatory review. Except for U.S. Government securities, the Company has no securities with any issuer that exceeds 10% of stockholders' equity. B. Maturities and Associated Yields The following table presents the maturities for those securities available for sale and held to maturity as of December 31, 2002 and weighted average yield for each range of maturities.
======================================================================================= Maturities and Yields December 31, 2002 --------------------------------------------------------------------------------------- ($ in thousands except for % data) < 1 Year 1-5 Years 5-10 Years > 10 Years None Total ========================================================================================================================== Available for Sale: - ------------------- U.S. Treasury $1,544 $2,418 $--- $--- $--- $3,962 5.44% 5.72% --- --- --- 5.61% - -------------------------------------------------------------------------------------------------------------------------- U.S. Government agencies --- 2,548 2,741 1,843 --- 7,132 --- 5.09% 4.82% 5.88% --- 5.19% - -------------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities --- 363 2,687 13,759 --- 16,809 --- 3.56% 3.68% 5.76% --- 5.38% - -------------------------------------------------------------------------------------------------------------------------- States and Political 317 855 --- 1,803 --- 2,975 Subdivision - taxable 7.02% 7.03% --- 7.33% --- 7.21% - -------------------------------------------------------------------------------------------------------------------------- States and Political Subdivision 3,207 6,243 27,177 31,091 --- 67,717 - nontaxable(1) 6.75% 6.74% 6.08% 6.22% --- 6.24% - -------------------------------------------------------------------------------------------------------------------------- Corporate 1,025 4,969 11,417 --- --- 17,411 6.96% 5.90% 5.77% --- --- 5.88% - -------------------------------------------------------------------------------------------------------------------------- Federal Home Loan Bank stock --- --- --- --- 1,655 1,655 --- --- --- --- 5.25% 5.25% - -------------------------------------------------------------------------------------------------------------------------- Federal Reserve Bank stock --- --- --- --- 209 209 --- --- --- --- 6.00% 6.00% - -------------------------------------------------------------------------------------------------------------------------- Other securities 634 --- --- --- 1,230 1,864 1.10% --- --- --- 1.30% 1.29% - -------------------------------------------------------------------------------------------------------------------------- Total 6,727 17,396 44,022 48,496 3,093 119,734 5.96% 6.02% 5.80% 6.12% 3.76% 5.92% - -------------------------------------------------------------------------------------------------------------------------- Held to Maturity - ---------------- U.S. Treasury --- --- --- --- --- --- --- --- --- --- --- --- - -------------------------------------------------------------------------------------------------------------------------- U.S. Government agencies 1,000 7,000 2,013 --- --- 10,013 7.86% 5.04% 4.41% --- --- 5.19% - -------------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities --- 40 3 8,946 --- 8,989 --- 7.64% 9.00% 5.95% --- 5.95% - -------------------------------------------------------------------------------------------------------------------------- States and Political --- 1,349 683 2,000 --- 4,032 Subdivision - taxable --- 6.11% 5.98% 5.32% --- 5.69% - -------------------------------------------------------------------------------------------------------------------------- States and Political 2,255 2,955 25,599 17,769 --- 48,578 Subdivision - nontaxable 7.03% 7.06% 6.13% 6.27% --- 6.28% - -------------------------------------------------------------------------------------------------------------------------- 22 Corporate 898 16,098 10,952 --- --- 27,948 6.66% 6.13% 6.72% --- --- 6.37% - -------------------------------------------------------------------------------------------------------------------------- Other securities --- --- --- --- --- --- --- --- --- --- --- --- - -------------------------------------------------------------------------------------------------------------------------- Total 4,153 27,442 39,250 28,715 --- 99,560 7.15% 5.95% 6.21% 6.10% --- 6.15% ==========================================================================================================================
(1) Rates shown represent weighted average yield on a fully taxable basis. 23 III. Loan Portfolio The Company concentrates its lending activities in commercial and industrial loans, real estate mortgage loans both residential and business, and loans to individuals. The following tables set forth (i) a comparison of the Company's loan portfolio by major category of loans as of the dates indicated and (ii) the maturities and interest rate sensitivity of the loan portfolio at December 31, 2002. A. Types of Loans
================================================================ December 31, ---------------------------------------------------------------- ($ in thousands) 2002 2001 2000 1999 1998 ===================================================================================================== Commercial and industrial loans $209,368 $189,764 $163,929 $149,386 $110,509 Real estate mortgage loans 82,193 77,339 71,163 58,829 48,724 Real estate construction loans 22,294 19,573 16,726 14,669 12,827 Loans to individuals 96,762 113,413 110,176 73,825 69,493 ---------------------------------------------------------------- Total loans $410,617 $400,089 $361,994 $296,709 $241,553 Less unearned income and deferred fees (1,278) (1,775) (2,313) (1,916) (2,296) ---------------------------------------------------------------- Total loans, net of unearned income $409,339 $398,314 $359,681 $294,793 $239,257 Less allowance for loans losses (5,092) (4,272) (3,886) (3,231) (2,679) ---------------------------------------------------------------- Total loans, net $404,247 $394,042 $355,795 $291,562 $236,578 =====================================================================================================
B. Maturities and Interest Rate Sensitivities
============================================================= December 31, 2002 -------------- --------------- -------------- --------------- After ($ in thousands) <1 Year 1-5 Years 5 Years Total ======================================= ============== =============== ============== =============== Commercial and industrial $50,675 $98,804 $59,889 $209,368 Real estate construction 18,806 3,488 --- 22,294 Less loans with predetermined interest rates 10,847 22,631 19,896 53,374 -------------- --------------- -------------- --------------- Loans with adjustable rates $58,634 $79,661 $39,993 $178,288 ======================================= ============== =============== ============== ===============
24 C. Risk Elements 1. Nonaccrual, Past Due and Restructured Loans The following table presents aggregate amounts for nonaccrual loans, restructured loans, other real estate owned, net and accruing loans which are contractually past due ninety days or more as to interest or principal payments.
======================================================== December 31, -------------------------------------------------------- ($ in thousands) 2002 2001 2000 1999 1998 - ------------------------------------------------------------------------------------------------------- Nonaccrual loans: Commercial and industrial $ 102 $ 175 $ 65 $ 65 $--- Real estate mortgage 152 11 5 33 28 Real estate construction --- --- --- --- --- Loans to individuals 34 168 18 53 --- - ------------------------------------------------------------------------------------------------------- $ 288 $ 354 $ 88 $151 $ 28 - ------------------------------------------------------------------------------------------------------- Restructured loans: Commercial and industrial --- --- --- 40 --- - ------------------------------------------------------------------------------------------------------- Total nonperforming loans $ 288 $ 354 $ 88 $191 $ 28 Other real estate owned, net 537 211 540 447 628 - ------------------------------------------------------------------------------------------------------- Total nonperforming assets $ 825 565 $628 $638 $656 ======================================================== - ------------------------------------------------------------------------------------------------------- Accruing loans past due 90 days or more: Commercial and industrial Real estate mortgage $ 462 $ 303 $242 $ 99 $186 Real estate construction 119 277 664 704 160 Loans to individuals --- --- --- --- --- 396 400 415 274 204 - ------------------------------------------------------------------------------------------------------- $ 977 $ 980 $1,321 $1,077 $550 =======================================================================================================
24 The effect of nonaccrual and restructured loans on interest income is presented below: ===================================== ($ in thousands) 2002 2001 2000 ====================================================================== Scheduled interest: Nonaccrual loans $ 16 $ 37 $ 11 Restructured loans --- --- --- ------------------------------------- Total scheduled interest $ 16 $ 37 $ 11 ------------------------------------- Recorded interest: Nonaccrual loans $ --- $ 7 $--- Restructured loans $ --- --- --- ------------------------------------- Total recorded interest $ --- $ 7 $--- ====================================================================== Interest is recognized on the cash basis for all loans carried in nonaccrual status. Loans generally are placed in nonaccrual status when the collection of principal or interest is ninety days or more past due, unless the obligation is both well-secured and in the process of collection. 25 2. Potential Problem Loans At December 31, 2002, management was unaware of any potential problem loans other than those presented in the table above. 3. Foreign Outstandings At December 31, 2002, 2001, and 2000, there were no foreign outstandings. 4. Loan Concentrations The Company does a general banking business, serving the commercial, agricultural and personal banking needs of its customers. NBB's trade territory consists of the northern portion of Montgomery County, all of Giles County, all of Pulaski County, the City of Radford, the City of Galax and adjacent portions of Carroll and Grayson Counties, Virginia. NBB's operating results are closely correlated with the economic trends within this area which are, in turn, influenced by the area's three largest employers, Virginia Polytechnic Institute and State University, Montgomery County Schools and Celanese Corp. Other industries include a wide variety of manufacturing, retail and service concerns. Much of BTC's business originates from the communities of Tazewell and Bluefield and other communities in Tazewell County, Virginia and in Mercer County, West Virginia. BTC also serves the counties of Wythe, Smyth and Washington in Virginia. BTC's primary service area has largely depended on the coal mining industry and farming for its economic base. In recent years, coal companies have mechanized and reduced the number of persons engaged in the production of coal. There are still a number of support industries for the coal mining business that continue to provide employment in the area. Additionally, several new businesses have been established in the area and Bluefield, West Virginia has emerged as a regional medical center. The ultimate collectibility of the loan portfolios and the recovery of the carrying amounts of repossessed property are susceptible to changes in the market conditions of these areas. At December 31, 2002 and 2001, approximately $202 million and $177 million, respectively, of the loan portfolio were concentrated in commercial real estate. This represents approximately 49% and 44% of the loan portfolio at December 31, 2002 and 2001, respectively. Included in commercial real estate at December 31, 2002 and 2001 was approximately $97 million and $101 million, respectively, in loans for college housing and professional office 26 buildings. Loans secured by residential real estate were approximately $116 million and $119 million at December 31, 2002 and 2001, respectively. This represents approximately 28% and 30% of the loan portfolio at December 31, 2002 and 2001, respectively. Loans secured by automobiles were approximately $24 million and $32 million at December 31, 2002 and 2001, respectively. This represents approximately 6% of the loan portfolio at December 31, 2002 and 8% at December 31, 2001. The Company has established operating policies relating to the credit process and collateral requirements in loan originations. Loans to purchase real and personal property are generally collateralized by the related property and with loan amounts established based on certain percentage limitations of the property's total stated or appraised value. Credit approval is primarily a function of collateral and the evaluation of the creditworthiness of the individual borrower or project based on available financial information. 27 IV. Summary of Loan Loss Experience A. Analysis of the Allowance for Loan Losses The following tabulation shows average loan balances at the end of each period; changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off by loan category; and additions to the allowance which have been charged to operating expense:
============================================================================ December 31, ---------------------------------------------------------------------------- ($ in thousands) 2002 2001 2000 1999 1998 ================================================================================================================= Average net loans outstanding $404,717 $380,970 $310,624 $266,431 $225,613 ============================================================================ Balance at beginning of year $4,272 $3,886 $3,231 $2,679 $2,438 Charge-offs: Commercial and industrial loans 276 141 55 185 32 Real estate mortgage loans 61 32 --- 33 80 Real estate construction loans --- --- --- --- --- Loans to individuals 1,234 955 715 760 526 ---------------------------------------------------------------------------- Total loans charged off 1,571 1,128 770 978 638 ---------------------------------------------------------------------------- Recoveries: Commercial and industrial loans 13 8 3 51 --- Real estate mortgage loans --- --- --- 1 2 Real estate construction loans --- --- --- --- 190 Loans to individuals 127 98 93 78 63 ---------------------------------------------------------------------------- Total recoveries 140 106 96 130 255 ---------------------------------------------------------------------------- Net loans charged off 1,431 1,022 674 848 383 ---------------------------------------------------------------------------- Additions charged to operations 2,251 1,408 1,329 1,400 624 ---------------------------------------------------------------------------- Balance at end of year $5,092 $4,272 $3,886 $ 3,231 $2,679 ============================================================================ Net charge-offs to average net loans Outstanding 0.35% 0.27% 0.21% 0.32% 0.17% =================================================================================================================
Factors influencing management's judgment in determining the amount of the loan loss provision charged to operating expense include the quality of the loan portfolio as determined by management, the historical loan loss experience, diversification as to type of loans in the portfolio, the amount of secured as compared with unsecured loans and the value of underlying collateral, banking industry standards and averages, and general economic conditions. 28 B. Allocation of the Allowance for Loan Losses The allowance for loan losses has been allocated according to the amount deemed necessary to provide for anticipated losses within the categories of loans for the years indicated as follows:
=================================================================================================================== December 31, ------------------------------------------------------------------------------------------------------------------- 2002 2001 2000 1999 1998 ------------------------------------------------------------------------------------------------------------------- Percent Percent Percent of Percent of Percent of of of Loans in Loans in Loans in Loans in Loans in Each Each Each Each Each Category to Category to Category to Category to Category to Total Loans Total Loans Total Loans ($ in Allowance Total Loans Allowance Total Loans Allowance Allowance Allowance thousands) Amount Amount Amount Amount Amount ================================================================================================================================== Commercial and industrial loans $235 50.98% $557 47.43% $255 45.29% $555 50.35% $222 45.75% - ---------------------------------------------------------------------------------------------------------------------------------- Real estate mortgage loans 911 20.01% 50 19.33% 120 19.66% 119 19.83% 73 20.17% - ---------------------------------------------------------------------------------------------------------------------------------- Real estate construction loans --- 5.44% --- 4.89% --- 4.62% --- 4.94% --- 5.31% - ---------------------------------------------------------------------------------------------------------------------------------- Loans to individuals 3,092 23.57% 2,909 28.35% 1,709 30.43% 978 24.88% 497 28.77% - ---------------------------------------------------------------------------------------------------------------------------------- Unallocated 854 756 1,802 1,579 1,887 - ---------------------------------------------------------------------------------------------------------------------------------- $5,092 100.00% $4,272 100.00% $3,886 100.00% $3,231 100.00% $2,679 100.00% ===================================================================================================================
29 Loan Loss Allowance The adequacy of the allowance for loan losses is based on management's judgement and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit as well as other internal and external factors such as general economic conditions. The evaluation of the allowance for loan losses is performed by the internal credit review department. Guidance for the evaluations performed are established by the regulatory authorities who periodically review the results for compliance. As a part of this process, loans are grouped principally into two classes. The first involves loans that are individually reviewed and direct allocations made based on collateral values, financial statements of the borrower, their cash flow capabilities to repay, and other documentation. In addition, an estimate is made for losses inherent to this portfolio. The second class includes pools of loans. Allocations from this analysis are derived and based on historical loss averages. The unallocated portion of the allowance for loan losses is the residual amount after allocation to the above classes. An unallocated component is maintained to cover uncertainties that could affect management's estimate of possible losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general loss in the portfolio. As previously stated, adequacy of the allowance for loan losses is subject to periodic regulatory review. These reviews cover the allocation process and overall adequacy of the allowance for loan losses. Regulatory authorities at their discretion may set minimum levels for the allowance and/or require the charge-off of loans as a result of their examination. This independent grading process by regulators serves as a standard to gauge the effectiveness of the internal credit review process. 30 V. Deposits A. Average Amounts of Deposits and Average Rates Paid Average amounts and average rates paid on deposit categories in excess of 10% of average total deposits are presented below:
======================================================================= December 31, ----------------------------------------------------------------------- 2002 2001 2000 ----------------------------------------------------------------------- Average Average Average Average Rates Average Rates Average Rates Paid ($ in thousands) Amounts Paid Amounts Paid Amounts - ----------------------------------------------------------------------------------------------------- Noninterest-bearing demand deposits $ 74,269 --- $ 66,793 --- $ 56,709 --- Interest-bearing demand deposits 147,749 1.50% 116,529 2.16% 85,713 2.62% Savings deposits 49,151 1.03% 47,175 1.95% 43,138 2.63% Time deposits 312,129 4.18% 338,642 5.71% 248,113 5.71% - ----------------------------------------------------------------------------------------------------- Average total deposits $583,298 3.10% $569,139 4.53% $433,673 4.64% =====================================================================================================
B. Time Deposits of $100,000 or More The following table sets forth time certificates of deposit and other time deposits of $100,000 or more:
==================================================================== December 31, 2002 ==================================================================== Over 3 Months Over 6 Months 3 Months Through 6 Through 12 or Less Months Months Over 12 ($ in thousands) Months Total - ---------------------------------------------------------------------------------------------------- Total time deposits of $100,000 or more $18,641 $18,532 $22,494 $29,594 $89,261 ====================================================================================================
31 VI. Return on Equity and Assets The ratio of net income to average stockholders' equity and to average total assets, and certain other ratios are presented below: ======================================== December 31, ---------------------------------------- 2002 2001 2000 ============================================================================= Return on average assets 1.53% 1.15% 1.46% - ----------------------------------------------------------------------------- Return on average equity 14.33% 11.53% 13.13% - ----------------------------------------------------------------------------- Dividend payout ratio 34.01% 41.29% 40.87% - ----------------------------------------------------------------------------- Average equity to average assets 10.66% 9.98% 11.13% ============================================================================= Item 2. Properties Bankshares' headquarters and one branch office of NBB are located at 101 Hubbard Street, Blacksburg, Virginia. NBB's Main Office is at 100 South Main Street, Blacksburg, Virginia. In addition to the Bank's Main Office location and the Hubbard Street branch office, NBB owns eleven branch offices: Three in the Town of Blacksburg; one in the Town of Christiansburg; and three in the County of Giles, two in Pulaski County, one in the City of Radford and one in the City of Galax. A fourteenth branch office is under construction in Downtown Christiansburg in Montgomery County. This office is expected to open in Summer, 2003. Bank of Tazewell County owns the land and building of seven of its ten offices. The bank leases the land and building for three offices. The Main Office is located at Main Street, Tazewell, Virginia. Three additional branches are located in Tazewell, and two are located in Bluefield, Virginia. The bank also has branch offices in Richlands, Wytheville, Abingdon, and Marion, Virginia. Management believes that its existing facilities are adequate to meet present needs and any anticipated growth. NBB owns all its computer and data processing hardware and is a licensee of the software it utilizes. BTC utilizes this same system for data processing. Item 3. Legal Proceedings Bankshares, NBB, BTC, and NBFS are not currently involved in any material pending legal proceedings, other than routine litigation incidental to NBB's and BTC's banking business. Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ None 32 Executive Officers of the Registrant Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an unnumbered item in Part I of this report in lieu of being included in the Proxy Statement for the Annual Meeting of Stockholders to be held on April 8,2003. The following is a list of names and ages of all executive officers of Bankshares; their terms of office as officers; the positions and offices within Bankshares held by each officer; and each person's principal occupation or employment during the past five years. ================================================================================ Year Elected an Name Age Offices and Positions Held Officer/Director - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- James G. Rakes 58 Chairman, President and Chief Executive 1986 Officer, National Bankshares, Inc.; President and Chief Executive Officer of The National Bank of Blacksburg since 1983. President and Treasurer of National Bankshares Financial Services, Inc. since 2001. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- J. Robert Buchanan 51 Treasurer, National Bankshares, Inc.; 1998 Cashier and Senior Vice President/Chief Financial Officer of The National Bank of Blacksburg since 1998. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Marilyn B. Buhyoff 54 Secretary & Counsel, National 1989 Bankshares, Inc.; Secretary & Counsel of the National Bank of Blacksburg since 1989 and Senior Vice President/ Administration, since 1992. Secretary of National Bankshares Financial Services, Inc. since 2001. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- F. Brad Denardo 50 Corporate Officer, National Bankshares, 1989 Inc.; Executive Vice President/Chief Operating Officer of the National Bank of Blacksburg since 2002; prior thereto Executive Vice President/Loans of The National Bank of Blacksburg since 1989. - -------------------------------------------------------------------------------- 33 - -------------------------------------------------------------------------------- Cameron L. Forrester 54 Corporate Officer, National Bankshares, 2001 Inc.; President and Chief Executive Officer of Bank of Tazewell County since 1998; prior thereto Vice President of First Virginia Bank, Clinch Valley (formerly Premier Bank, N. A.) ================================================================================ 34 Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Effective December 1, 1999, National Bankshares, Inc.'s common stock began trading on the Nasdaq SmallCap Market under the symbol "NKSH". Prior to December 1, 1999, National Bankshares, Inc.'s common stock was traded on a limited basis in the over-the-counter market and was not listed on any exchange or quoted on Nasdaq. As of December 31, 2002 there were 1,024 stockholders of Bankshares common stock. Information concerning Market Price and Dividend Data is set forth under "Common Stock Information and Dividends" on page 12 of Bankshares' 2002 Annual Report to Stockholders and is incorporated herein by reference. Prices prior to December 1, 1999 do not necessarily reflect the prices which would have prevailed had there been an active trading market, nor do they reflect unreported trades, which may have been at lower or higher prices. Item 6. Selected Financial Data The table entitled "Selected Consolidated Financial Data" on page 4 of Bankshares' 2002 Annual Report to Stockholders is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information contained under "Management's Discussion and Analysis" on pages 5 through 12 of Bankshares' 2002 Annual Report to Stockholders is incorporated herein by reference. Critical Accounting Policies General The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company use historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from previously acceptable method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the transactions could change. 35 Allowance for the Loan Losses The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring an estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The Company's allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values in inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized either the formula or specific allowance. Item 7A. Quantitative and Qualitative Disclosures About Market Risk See "Analysis of Interest Rate Sensitivity" set forth below. Additional information is set forth under the section "Interest Rate Sensitivity" on pages 36 through 37 and the section "Derivatives and Market Risk Exposure" on page 11 of Bankshares' 2002 Annual Report to Stockholders and is incorporated herein by reference. 36 Analysis of Interest Rate Sensitivity The following discussion of interest rate sensitivity contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements. The Company uses simulation analysis to forecast its balance sheet and monitor interest rate sensitivity. One test used by Bankshares is shock analysis which measures the effect of a hypothetical, immediate and parallel shifts in interest rates. The following table shows the results of a rate shock of 100, 200, and 300 basis points and the effects on net income and return on average assets and return on average equity at December 31, 2003.
($ in thousands, except for percent data) - ---------------------------- ------------------------ -------------------------- -------------------------------- Rate Shift Change in Net Income Return on Average Equity Return on Average Assets - ---------------------------- ------------------------ -------------------------- -------------------------------- 300 $ (3,927) 11.56% 1.28% - ---------------------------- ------------------------ -------------------------- -------------------------------- - ---------------------------- ------------------------ -------------------------- -------------------------------- 200 (2,507) 13.27% 1.48% - ---------------------------- ------------------------ -------------------------- -------------------------------- - ---------------------------- ------------------------ -------------------------- -------------------------------- 100 (1,239) 14.78% 1.66% - ---------------------------- ------------------------ -------------------------- -------------------------------- - ---------------------------- ------------------------ -------------------------- -------------------------------- (-) 100 1,193 17.61% 2.00% - ---------------------------- ------------------------ -------------------------- -------------------------------- - ---------------------------- ------------------------ -------------------------- -------------------------------- (-) 200 1,628 18.11% 2.06% - ---------------------------- ------------------------ -------------------------- -------------------------------- - ---------------------------- ------------------------ -------------------------- -------------------------------- (-) 300 1,199 17.61% 2.00% - ---------------------------- ------------------------ -------------------------- --------------------------------
Simulation analysis allows the Company to test asset and liability management strategies under rising and falling rate conditions. As a part of simulation process, certain estimates and assumptions must be made dealing with, but not limited to, asset growth, the mix of assets and liabilities, rate environment, local and national economic conditions. Asset growth and the mix of assets can to a degree be influenced by management. Other areas such as the rate environment and economic factors cannot be controlled. For this reason actual results may vary materially from any particular forecast or shock analysis. This shortcoming is offset to a degree by the periodic reforecasting of the balance sheet to reflect current trends and economic conditions. Shock analysis must also be updated periodically as a part of the asset and liability management process. Item 8. Financial Statements and Supplementary Data The following consolidated financial statements of the Registrant and the Independent Auditor's Report set forth on pages 13 through 36 of Bankshares' 2002 Annual Report to Stockholders are incorporated herein by reference: 37 1. Independent Auditor's Report 2. Consolidated Balance Sheets - December 31, 2002 and 2001 3. Consolidated Statements of Income - Years ended December 31, 2002, 2001 and 2000 4. Consolidated Statements of Changes in Stockholders' Equity - Years ended December 31, 2002, 2001 and 2000 5. Consolidated Statements of Cash Flows - Years ended December 31, 2002, 2001 and 2000 6. Notes to Consolidated Financial Statements - December 31, 2002, 2001 and 2000 Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure None Part III Item 10. Directors and Executive Officers of the Registrant Executive Officers of Bankshares as of December 31, 2002 are listed on page 33 and 34 herein. Information with respect to the directors of Bankshares is set out under the caption "Election of Directors" on pages 2 through 4 of Bankshares' Proxy Statement dated March 13, 2003 which information is incorporated herein by reference. Item 11. Executive Compensation The information set forth under "Executive Compensation" on pages 6 through 10 of Bankshares' Proxy Statement dated March 13, 2003 is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management And Related Stockholder Matters Certain responses to this Item will be included under the caption "Stock Ownership of Directors and Executive Officers" on pages 1 and 2 of Bankshares' Proxy Statement for the Annual Meeting of Stockholders to be held April 8, 2003, which was filed on March 13, 2003. 38 The following table summarizes information concerning National Bankshares equity compensation plans at December 31, 2002:
Number of Shares Number of Shares to Remaining be Issued upon Weighted Average Available for Exercise of Exercise Price of Future Issuance Outstanding Options Outstanding Options Under Equity and Warrants and Warrants Compensation Plans (Excluding Shares Plan Category Reflected in First Column) - --------------------------------------- --------------------- --------------------- -------------------- Equity compensation plans approved by shareholders-1999 Stock Incentive Plan 51,500 $ 24.06 198,500 Equity compensation plans not approved by shareholders N/A N/A N/A --------------------- --------------------- -------------------- Total 51,500 $ 24.06 198,500 ===================== ===================== ====================
Item 13. Certain Relationships and Related Transactions The information contained under "Certain Transactions With Officers and Directors" on page 14 of Bankshares' Proxy Statement dated March 13, 2003 is incorporated herein by reference. Item 14. Controls and Procedures Under the supervision and with the participation of management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures within 90 days of the filing of this annual report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. Disclosure controls and procedures are our controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as part of this report: 39 2002 Annual Report 1. Financial Statements: To Stockholders Page(s)* Independent Auditor's Report 13 Consolidated Balance Sheets - December 31, 2002 and 2001 14 Consolidated Statements of 15 Income - Years ended December 31, 2002, 2001 and 2000 Consolidated Statements of Changes in Stockholders' Equity - Years 16 ended December 31, 2002, 2001 and 2000 Consolidated Statements of Cash 17 Flows - Years ended December 31, 2002, 2001 and 2000 Notes to Consolidated Financial Statements - December 18-36 31, 2002, 2001 and 2000 2. Financial Statement Schedules: None *Incorporated by reference from the indicated pages of the 2002 Annual Report to Stockholders. 3. Exhibits: Page No. in Exhibit No. Description Sequential System - ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, of (incorporated National Bankshares, Inc. herein by reference to Exhibit 3(a) of the Annual Report on Form 10K for Fiscal year ended December 31, 1993) 4(i) Specimen copy of certificate for National (incorporated Bankshares, Inc. common stock, $2.50 par herein by reference value to Exhibit 4(a) of the Annual Report on Form 10K for Fiscal year ended December 31, 1993) 4(i) Article Four of the Articles of (incorporated Incorporation of National Bankshares, Inc. herein by included in Exhibit No.3(a) reference to Exhibit 4(b) of the Annual Report on Form 10K for Fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated (incorporated June 18, 1990, by and between Information herein by Technology, Inc. and The National Bank of reference to Blacksburg Exhibit 10(e) of the Annual Report on Form 10K for Fiscal year ended December 31, 1992) *10(iii)(A) National Bankshares, Inc. 1999 (incorporated herein Stock Option Plan by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on June 4, 1999) *10(iii)(A) Employment Agreement dated January 2002 (incorporated herein between National Bankshares, Inc. and by reference to James G. Rakes Exhibit 10(iii)(A) of Form 10Q for the period ended June 30, 2002) *10(iii)(A) Employee Lease Agreement dated August 14, (incorporated herein 2002, between National Bankshares, Inc. by reference to and The National Bank of Blacksburg Exhibit 10 (iii)(A) of Form 10Q for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated Pages 51-59 January 5, 2003, between National Bankshares, Inc. and Marilyn B. Buhyoff *10(iii)(A) Change in Control Agreement dated Pages 60-68 2003, January 8, between National Bankshares, Inc. and F. Brad Denardo *10(iii)(A) Change in Control Agreement dated Pages 69-79 1998, June 1, between Bank of Tazewell County and Cameron L. Forester 41 13(i) 2002 Annual Report to Stockholders (such Report, except to the extent incorporated herein by reference, is being furnished for the information of the Commission only and is not deemed to be filed as part of this Report on Form 10-K) 21(i) Subsidiaries of National Bankshares, Inc. Page 80 23 Consent of Yount, Hyde & Barbour, P.C. to Page 81 incorporation by reference of independent auditor's report included in this Form 10-K, into registrant's registration statement on Form S-8. 99(a) Certification of Chief Executive Officer Page 82 Pursuant to 18 U.S.C. Section 1350 99(b) Certification of Chief Financial Officer Page 83 Pursuant to 18 U.S.C. Section 1350 *Indicates a management contract or compensatory plan required to be filed herein. (b) Reports on Form 8-K filed during the last quarter of the period covered by this report: None (c) Exhibits required by Item 601 of Regulation S-K: See Item 15(a)3 above. (d) Financial Statement Schedules required by Regulation S-X: See Item 15(a)2 above. 42 Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, National Bankshares, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. National Bankshares, Inc. I, James G. Rakes,Chairman, President and Chief Executive Officer of National Bankshares, Inc., certify that: 1. I have reviewed this annual report on Form 10-K of National Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 14 and 15d - 14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, 43 summarize and report financial date and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weakness. Date: 03-21-03 -------- /s/ James G. Rakes - --------------------------- James G. Rakes Chairman President and Chief Excutive Officer I, J. Robert Buchanan, Treasurer (Chief Financial Officer) of National Bankshares, Inc. certify that: 1. I have reviewed this annual report on Form 10-K of National Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 14 and 15d - 14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and 44 procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial date and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weakness. Date: 03-21-03 -------- /s/ J. Robert Buchanan - --------------------------- J. Robert Buchanan Treasurer (Chief Financial Officer) 45 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Name Date Title - ---- ---- ----- /s/ L. A .Bowman 03-12-03 Director - ----------------------- -------------- L. A. Bowman /s/ A. A. Crouse 03-24-03 Director - ----------------------- -------------- A. A. Crouse /s/ J. A. Deskings, Sr. 03-12-03 Director - ----------------------- -------------- J. A. Deskins, Sr. /s/ P. a. Duncan 03-12-03 Director - ----------------------- -------------- P. A. Duncan /s/ C. L. Forrester 03-12-03 Director - ----------------------- -------------- C. L. Forrester /s/ W. T. Peery 03-12-03 Director - ----------------------- -------------- W. T. Peery /s/ J. G. Rakes 03-12-03 Chairman of the - ----------------------- -------------- Board President J. G. Rakes and Chief Executive Officer - National Bankshares, Inc. /s/ J. M. Shuler 03-12-03 Director - ----------------------- -------------- J. M. Shuler /s/ J. R. Stewart 03-12-03 Director - ----------------------- -------------- J. R. Stewart 46 Index to Exhibits Page No. in Exhibit No. Description Sequential System - ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, (incorporated of National Bankshares, Inc. herein by reference to Exhibit 3(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 4(i) Specimen copy of certificate for National (incorporated Bankshares, Inc. common stock, $2.50 par herein by value reference to Exhibit 4(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 4(i) Article Fourth of the Articles of (incorporated Incorporation of National Bankshares, Inc. herein by included in Exhibit No. 3(a)) reference to Exhibit 4(b) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated (incorporated June 18, 1990, by and between Information herein by Technology, Inc. and The National Bank of reference to Blacksburg Exhibit 10(e) of the Annual Report on Form 10K for fiscal year ended December 31, 1992) *10(iii)(A) National Bankshares, Inc. 1999 Stock (incorporated Option Plan herein by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on June 4, 1999) *10(iii)(A) Employment Agreement dated January 2002 (incorporated between National Bankshares, Inc. and herein by James G. Rakes reference to Exhibit 10(iii)(A) of Form 10Q for the period ended June 30, 2002) 47 Page No. in Exhibit No. Description Sequential System - ----------- ----------- ----------------- *10(iii)(A) Employment Lease Agreement dated August (incorporated 14, 2002, between National Bankshares, herein by Inc. and The National Bank of Blacksburg reference to Exhibit 10(iii)(A) for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January Pages 49-57 5, 2003, between National Bankshares, Inc. and Marilyn B. Buhyoff *10(iii)(A) Change in Control Agreement dated January 8, Pages 58-66 2003, between National Bankshares, Inc. and F. Brad Denardo *10(iii)(A) Change in Control Agreement dated June 1, Pages 67-77 1998, between Bank of Tazewell County and Cameron L. Forester 13(i) 2001 Annual Report to Stockholders (such Report, except to the extent incorporated herein by reference, is being furnished for the information of the Commission only and is not deemed to be filed as part of this Report on Form 10-K) 21(i) Subsidiaries of National Bankshares, Inc. Page 78 23 Consent of Yount, Hyde & Barbour, P.C. to Page 79 incorporation by reference of independent auditor's report included in this Form 10-K, into registrant's registration statement on Form S-8. 99 (a) Certification of Chief Executive Officer Page 80 Pursuant to 18 U.S.C. Section 1350 99 (b) Certification of Chief Financial Officer Page 81 Pursuant to 18 U.S.C. Section 1350 * Indicates a management contract or compensatory plan required to be filed herein. 48 EX-10 2 ex10forrester.txt CHANGE IN CONTROL AGREEMENT FORRESTER CHANGE IN CONTROL AGREEMENT THIS AGREEMENT is entered into as of the 1st day of June, 1998 by and between BANK OF TAZEWELL COUNTY, a Virginia corporation (the "Company"), and CAMERON L. FORRESTER (the "Executive"). RECITALS I. As of the Agreement Effective Date, the Executive serves as President of the Company and is key member of management of the Company and its affiliates and his services and knowledge are valuable to the Company and its affiliates. II. The Board (as defined below) has determined that it is in the best interests of the Company and its shareholders to assure that the Company and its affiliates will have the continued dedication of the Executive, notwithstanding the possibility, threat or occurrence of a Change in Control (as defined below) of the Company. The Board believes it is imperative to diminish the inevitable distraction of the Executive by virtue of the personal uncertainties and risks created by a pending or threatened Change in Control and to encourage the Executive's full attention and dedication to the Company and its affiliates currently and in the event of any threatened or pending Change in Control. Therefore, in order to accomplish these objectives, the Board has caused the Company to enter into this Agreement. NOW THEREFORE, it is hereby agreed as follows: 1. CERTAIN DEFINITIONS (a) "Agreement Effective Date" means June 1, 1998. (b) The "Agreement Term" means the period commencing on the Agreement Effective Date and ending on the earlier of (i) the Agreement Regular Termination Date or (ii) the date this Agreement terminates pursuant to Section 7. The "Agreement Regular Termination Date" means the third anniversary of the Agreement Effective Date, provided, however, that commencing on the third anniversary of the Agreement Effective Date, and on each biannual anniversary of such third anniversary date (such date and each biannual anniversary thereof shall be hereinafter referred to as the "Renewal Date"), unless this Agreement previously terminated, the Agreement Regular Termination Date shall be automatically extended for two years from the latest Renewal Date, unless at least one year prior to the latest Renewal Date the Company shall give notice to the Executive in accordance with Section 10(c) of this Agreement that the Agreement Regular Termination Date shall not be so extended. (c) "Board" means the Board of Directors of the Company if the reference is not to the Board of the Parent, or the Board of Directors of the Parent Company if the reference is to the Board of the Parent Company. (d) "Cause" means: (i) the willful and continued failure of the Executive to substantially perform his duties with the Company or one of its affiliates (other than any such failure resulting from incapacity due to physical or mental illness), after a written demand for substantial performance is 67 delivered to the Executive by the Board which specifically identifies the manner in which the Board believes that the Executive has not substantially performed his duties, or (ii) the willful engaging by the Executive in illegal conduct or gross misconduct which is materially and demonstrably injurious to the Company. For purposes of this provision, no act or failure to act, on the part of the Executive, shall be considered "willful" unless it is done, or omitted to be done, by the Executive in bad faith or without reasonable belief that the Executive's action or omission was in the best interests of the Company. Any act, or failure to act, based upon authority given pursuant to a resolution duly adopted by the Board or based upon the advice of counsel for the Company shall be conclusively presumed to be done, or omitted to be done, by the Executive in good faith and in the best interests of the Company. The cessation of employment of the Executive shall not be deemed to be for Cause unless and until there shall have been delivered to the Executive a copy of a resolution duly adopted by the affirmative vote of not less than three quarters of the entire membership of the Board at a meeting of the Board called and held for such purpose (after reasonable notice is provided to the Executive in accordance with Section 10(c) of this Agreement and the Executive is given an opportunity, together with counsel, to be heard before the Board), finding that, in the good faith opinion of the Board, the Executive is guilty of the conduct described in paragraph (i) or (ii) above, and specifying the particulars thereof in detail. (e) The "Change in Control Date" means the first date during the Agreement Term on which a Change in Control (as defined in Section 2) occurs. Anything in this Agreement to the contrary notwithstanding, if a Change in Control occurs and if the Executive's employment with the Company is terminated prior to the date on which the Change in Control occurs, and if it is reasonably demonstrated by the Executive that such termination of employment either (i) was the request of a third party who has taken steps reasonably calculated to effect a Change in Control or (ii) otherwise arose in connection with or anticipation of a Change in Control, then for all purposes of this Agreement the "Change in Control Date" shall mean the date immediately prior to the date of such termination of employment. (f) "Company" means the Bank of Tazewell County, a Virginia corporation. (g) "Coverage Period" means the period of time beginning with the Change in Control Date and ending on the earliest to occur of (i) the Executive's death and (ii) the sixty-first day after the second anniversary of the Change in Control Date. (h) "Disability" means the absence of the Executive from his duties with the Company on a full-time basis for one year as a result of incapacity due to mental or physical illness or injury which is determined to be total and permanent by a physician selected by the Company or its insurers and acceptable to the Executive or the Executive's legal representative. If the Company determines in good faith that the Disability of the Executive has occurred, it may give to the Executive written notice in accordance with Section 10(c) of this Agreement of its intention to terminate the Executive's employment. In such event, the Executive's employment with the Company shall terminate effective on the 30th day after receipt of such notice by the Executive (the "Disability Effective Date"), provided that, within the 30 days after such receipt, the Executive shall not have returned to full-time performance of his duties. (i) "Good Reason" means any good faith determination made by the Executive (which determination shall be conclusive) that any of the following has occurred: 68 (i) the occurrence, on or after the Agreement Effective Date and during the Coverage Period, of any of the following: (A) the assignment to the Executive of any duties inconsistent in any material adverse respect with the Executive's position (including status, offices, titles and reporting requirements), authority, duties or responsibilities immediately prior to the Change in Control, or any other action by the Company which results in a diminution in such position, authority, duties or responsibilities, excluding for this purpose an isolated, insubstantial and inadvertent action not taken in bad faith and which is remedied by the Company promptly after receipt of notice thereof given by the Executive in accordance with Section 10(c)of this Agreement. (B) a reduction by the Company in the Executive's rate of annual base salary, benefits (including, without limitation, incentive or bonus pay arrangements, stock plan benefits, and retirement and welfare plan coverage) and perquisites as in effect immediately prior to the Change in Control or as the same may be increased from time to time thereafter, other than an isolated, insubstantial and inadvertent failure not occurring in bad faith and which is remedied by the Company promptly after receipt of notice thereof given by the Executive in accordance with Section 10(c) of this Agreement; (C) the Company's requiring the Executive to be based at any office or location more than 35 miles from the facility where the Executive is located at the time of the Chance in Control or the Company's requiring the Executive to travel on Company business to a substantially greater extent then required immediately prior to the Change in Control Date (but determined without regard to travel necessitated by reason of any anticipated Change in Control); (D)any purported termination by the Company of the Executive's employment otherwise than as expressly permitted by this Agreement; or (E) any failure by the Company to comply with and satisfy Section 9(c) of this Agreement by obtaining satisfactory agreement from any successor to assume and perform this Agreement. (ii) any event or condition described in paragraph (i) of this Section 1(i) which occurs on or after the Agreement Effective Date, but prior to a Change in Control, but was at the request of a third party who effectuates the Change in Control, notwithstanding that it occurred prior to the Change in Control, but such event or condition shall not be considered to actually have occurred until the Change in Control Date. (j) "Covered Termination" means a termination of Executive's employment during the Coverage Period (i) by the Company for any reason other than Cause or the Executive's Disability or death, or (ii) by the Executive for Good Reason. (k) "Noncovered Termination" means a cessation of Executive's employment, which is not a Covered Termination. 69 (l) "Parent Company" means National Bankshares, Inc., a Virginia corporation, which as of the Agreement Effective Date is the sole shareholder of the Company. 2. CHANGE IN CONTROL. "Change in Control" means the occurrence, during the Agreement Term, of either an "Acquisition of Controlling Ownership" (as defined in Section 2(a) below), a "Change in the Incumbent Board" (as defined in Section 2(b) below), a "Business Combination" (as defined in Section 2(c) below), or a "Liquidation or Dissolution" (as defined in Section 2(d) below). (a) "Acquisition of Controlling Ownership" means the acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of either (x) the then outstanding shares of common stock of the Company or the Parent Company (the "Outstanding Common Stock") or (y) the combined voting power of the then outstanding voting securities of the Company or the Parent Company entitled to vote generally in the election of directors (the "Outstanding Voting Securities"). Notwithstanding the foregoing, for purposes of this Section 2(a) the following acquisitions shall not constitute a Change in Control: (i) any acquisition directly from the Company or the Parent Company, (ii) any acquisition by the Company or the Parent Company, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or the Parent Company or any corporation controlled by the Company or the Parent Company, or (iv) any acquisition by any corporation pursuant to a transaction which complies with paragraphs (i), (ii) and (iii) of) of this Section 2(c). (b) "Change in the Incumbent Board," means that individuals who, as of the Agreement Effective Date, constitute the Board of the Parent Company (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board. For this purpose, any individual who becomes a director subsequent to the Agreement Effective Date whose election, or nomination for election by the Parent Company's shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be thereupon considered a member of the Incumbent Board (with his predecessor thereafter ceasing to be a member), but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a Person other than the Board of the Parent Company. (c) "Business Combination" means the consummation of a reorganization, merger or consolidation or sale or other disposition of all or substantially all of the assets of the Company or the Parent Company (a "Business Combination") unless all of the following occur: (i) all or substantially all of the individuals and entities who were the beneficial owners respectively, of the Outstanding Common Stock and Outstanding Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 60% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled 70 to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or the Parent Company or all or substantially all of the Company's assets or the Parent Company's assets either directly or through one or more subsidiaries, in substantially the same proportions as their ownership, immediately prior to such Business Combination of the Outstanding Common Stock and Outstanding Voting Securities, as the case may be, (ii) no Person (excluding any corporation resulting from such Business Combination or any employee benefit plan (or related trust) of the Company or the Parent Company or such corporation resulting from such Business Combination) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination, or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination, and (iii) at least a majority of the members of the board of directors of the corporation resulting from such Business Combination were members of the Incumbent Board or were elected by such majority at the time of the execution of the initial agreement, or of the action of the Board, providing for such Business Combination. (d) "Liquidation or Dissolution" means the approval by the shareholders of the Parent Company of a complete liquidation or dissolution of the Parent Company. 3. OBLIGATIONS OF THE EXECUTIVE TO REMAIN EMPLOYED. The Executive agrees that in the event any person or group attempts a Change in Control, he shall not voluntarily leave the employ of the Company without Good Reason (i) until such attempted Change in Control terminates or (ii) if a Change in Control shall occur, until the change in Control Date. For purposes of the foregoing clause (i), Good Reason shall be determined as if a Change in Control had occurred when such attempted Change in Control became known to the Board. 4. OBLIGATIONS UPON THE EXECUTIVE'S TERMINATION. (a) Notice of Termination. Any termination of the Executive's employment by the Company or by the Executive, other than by reason of death, shall be communicated by Notice of Termination to the other party hereto given. For purposes hereof: (i) "Notice of Termination" means a written notice given in accordance with Section 10(c) of this Agreement which (A) states whether such termination is for Cause, Good Reason or Disability, (B) indicates the specific termination provision in this Agreement relied upon, if any, (C) to the extent applicable, sets forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive's employment under the provision so indicated, and (D) if the Date of Termination is other than date of receipt of such notice, specifies the termination date. The failure by the Executive or the Company to set forth in the Notice of Termination any fact or circumstance which contributes to a showing of Good Reason, Cause or Disability shall not waive any right of the Executive or the Company, respectively, hereunder or preclude the Executive or the Company, respectively, from asserting such fact or circumstance in enforcing the Executive's or the Company's rights hereunder. 71 (ii) "Date of Termination" means (A) if the Executive's employment is terminated by reason of Disability, the Disability Effective Date, (B) if the Executive's employment is terminated by the Company for any reason other than Disability, the date of the Executive's receipt of the Notice of Termination or any later date specified therein, as the case may be, and (C) if the Executive's employment is terminated by the Executive for any reason, the date of the Company's receipt of the Notice of Termination or any later date specified therein, as the case may be: (b) Obligations of the Company in a Covered Termination. If the Executive's employment shall cease by reason of a Covered Termination, then: (i) the Company shall pay or cause to be paid to the Executive in a lump sum in cash within 30 days after the Date of Termination an amount equal to the product of (A) [two] and (B) the sum of the Executive's (1) highest aggregate annual base salary from the Company and its affiliated companies in effect at any time during the 24 month period ending on the Change in Control Date and (2) highest aggregate annual bonuses (including any deferrals thereof) from the Company and its affiliated companies payable for the Company's two fiscal years immediately preceding the fiscal year which includes the Change in Control Date (such other amount may be hereinafter sometimes referred to as the "Change in Control Benefit"); and (ii) to the extent not theretofore paid or provided, the Company shall timely pay or cause to be paid or provide or cause to be provided to the Executive any other amounts or benefits required to be paid or provided or which the Executive is eligible to receive under any compensation arrangement, plan, program, policy or practice or contract or agreement of the Company and its affiliated companies (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"). (c) Obligations of the Company in a Noncovered Termination. If the Executive's employment shall cease by reason of a Noncovered Termination, this Agreement shall terminate without further obligations to the Executive other than the obligation timely to pay or cause to be paid or provide or cause to be provided to the Executive his Other Benefits. 5. FULL SETTLEMENT. (a) No Offset or Mitigation. The Company's obligation to make the payments provided for in this Agreement and otherwise to perform its obligations hereunder shall not be affected by any set-off, counterclaim, recoupment, defense or other claim, right or action which the Company may have against the Executive. In no event shall the Executive be obligated to seek other employment or take any other action by way of mitigation of the amounts payable to the Executive under any of the provisions of this Agreement and such amounts shall not be reduced whether or not the Executive obtains other employment. (b) Executive's Expenses in Dispute Resolution. The Company agrees to pay as incurred, to the full extent permitted by law, all legal fees and expenses which the Executive may reasonably incur as a result of any contest (regardless of the outcome thereof) by the Company, the Executive or others of the validity or enforceability of, or liability under, any provision of this Agreement or any guarantee of performance thereof (including as a result of any contest by the Executive about the amount of any payment pursuant to this Agreement), plus in each case interest on any delayed payment at the applicable Federal rate provided for in Section 7872(f)(2)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). 72 (c) Payment prior to Dispute Resolution. If there shall be any dispute between the Company and the Executive in the event of any termination of Executive's employment, then, unless and until there is a final, nonappealable judgment by a court of competent jurisdiction declaring that such termination was a Noncovered Termination, that the determination by the Executive of the existence of Good Reason was not made in good faith, or that the Company is not otherwise obligated to pay any amount or provide any benefit to the Executive and his dependents or other beneficiaries, as the case may be, under Section 4(b), the Company shall pay all amounts, and provide all benefits, to the Executive and his dependents or other beneficiaries, as the case may be, that the Company would be required to pay or provide pursuant to Section 4(b) as though such termination were not a Noncovered Termination. Notwithstanding the foregoing, the Company shall not be required to pay any disputed amounts pursuant to this Section 5(c) except upon receipt of an adequate bond, letter of credit or undertaking by or on behalf of the Executive to repay all such amounts to which the Executive is ultimately adjudged by such court not to be entitled. 6. PAYMENT LIMITATIONS. (a) Excise Tax Payment Limitation. Notwithstanding anything contained in this Agreement or any other agreement or plan to the contrary, the payments and benefits provided, to, or for the benefit of, the Executive under this Agreement or under any other plan or agreement which became payable or are taken into account as a result of the Change in Control (the "Payments") shall be reduced (but not below zero) to the extent necessary so that no payment to be made, or benefit to be provided, to the Executive or for his benefit under this Agreement or any other plan or agreement shall be subject to the imposition of an excise tax under Section 4999 of the Code (such reduced amount is hereinafter referred to as the "Limited Payment Amount"). Unless the Executive and the Company shall otherwise agree, the Company shall reduce or eliminate the Payments to the Executive by first reducing or eliminating those payments or benefits which are not payable in cash and then by reducing or eliminating cash payments, in each case in reverse order beginning with payments or benefits which are to be paid the farthest in time from the Determination (as hereinafter defined). Any notice given by the Executive pursuant to the preceding sentence shall take precedence over the provisions of any other plan, arrangement or agreement governing Executive's rights and entitlements to any benefits or compensation. (b) Excise Tax Payment Limitation Determinations. All determinations required to be made under this Section 6 shall be made by the Company's public accounting firm (the "Accounting Firm"). The Accounting Firm shall provide its calculations, together with detailed supporting documentation, both to the Company and the Executive within fifteen days after the receipt of notice from the Company that there has been a Payment (or at such earlier times as is requested by the Company) and, with respect to any Limited Payment Amount, a reasonable opinion to the Executive that he is not required to report any excise tax on his federal income tax return with respect to the Limited Payment Amount (collectively, the "Determination"). In the event that the Accounting Firm is serving as an accountant or auditor for the individual, entity or group effecting the Change in Control, the Executive shall appoint another nationally recognized public accounting firm to make the determination required hereunder (which accounting firm shall then be referred to as the Accounting Firm hereunder). All fees, costs and expenses (including, but not limited to, the costs of retaining experts) of the Accounting Firm shall be borne by the Company. The Determination by the Accounting Firm shall be binding upon the Company and the Executive (except as provided in Section 6(c) below). 73 (c) Excise Tax Excess Payments Considered a Loan. If it is established pursuant to a final determination of a court or an Internal Revenue Service (the "IRS) proceeding which has been finally and conclusively resolved, that Payments have been made to, or provided for the benefit of, the Executive by the Company, which are in excess of the limitations provided in Section 6(a) (hereinafter referred to as an "Excess Payment"), such Excess Payment shall be deemed for all purposes to be a loan to the Executive made on the date the Executive received the Excess Payment and the Executive shall repay the Excess Payment to the Company on demand, together with interest on the Excess Payment at the applicable federal rate (as defined in Section 1274(d) of the Code) from the date of Executive's receipt of such Excess Payment until the date of such repayment. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the Determination, it is possible that Payments which will not have been made by the Company should have been made (an "Underpayment"), consistent with the calculations required to be made under this Section 6. In the event that it is determined (i) by the Accounting Firm, the Company (which shall include the position taken by the Company, or together with its consolidated group, on its federal income tax return) or the IRS or (ii) pursuant to a determination by a court, that an Underpayment has occurred, the Company shall pay an amount equal to such Underpayment to the Executive within ten days of such determination together with interest on such amount at the applicable federal rate from the date such amount would have been paid to the Executive until the date of payment. (d) Banking Payment Limitation. Notwithstanding anything contained in this Agreement or any other agreement or plan to the contrary, the payments and benefits provided to, or for the benefit of, the Executive under this Agreement or under any other plan or agreement shall be reduced (but not below zero) to the extent necessary so that no payment to be made, or benefit to be provided, to the Executive or for his benefit under this Agreement or any other plan or agreement shall be in violation of the golden parachute and indemnification payment limitations and prohibitions of 12 CFR Section 359. 7. TERMINATION OF AGREEMENT. This Agreement shall be effective as of the Agreement Effective Date and shall normally continue until the later of the Agreement Regular Termination Date or, if a Change in Control has occurred, until the end of the Coverage Period. Notwithstanding the foregoing, this Agreement shall terminate in any event upon the Executive's cessation of employment in a Noncovered Termination. 8. CONFIDENTIAL INFORMATION. (a) No Disclosure by Executive. The Executive shall hold in a fiduciary capacity for the benefit of the Company all secret or confidential information, knowledge or data relating to the Company or any of its affiliated companies, and their respective businesses, which shall have been obtained by the Executive during the Executive's employment by the Company or any of its affiliated companies and which shall not be or become public knowledge (other than by acts by the Executive or representatives of the Executive in violation of this Agreement). After termination of the Executive's employment with the Company, the Executive shall not, without the prior written consent of the company or as may otherwise be required by law or legal process, communicate or divulge any such information, knowledge or date to anyone other than the Company and those designated by it. (b) Remedies for Breach. It is recognized that damages in the event of breach of Section 8(a) above the Executive would be difficult, if not impossible, to ascertain, and it is therefore specifically agreed that the Company, in addition to and without limiting any other remedy or right it may have, shall have the right to an injunction or other equitable relief in any 74 court of competent jurisdiction, enjoining any such breach. The existence of this right shall not preclude the Company from pursing any other rights and remedies at law or in equity, which it may have. (c) Breach Not Basis to Withhold Payment. In no event shall an asserted violation of the provisions of this Section 8 constitute a basis for deferring or withholding any amounts otherwise payable to the Executive under this Agreement. 9. BENEFIT AND SUCCESSORS. (a) Executive's Benefit. This Agreement shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, executors, administrators, successors, heirs, distributes, devisees and legatees. If the Executive should die and any amount remains payable hereunder after his death, any such amount, unless otherwise agreed by the Company or provided herein, shall be paid in accordance with the terms of this Agreement to the Executive's devisee, legatee or other designee of such payment or, if there is no such designee, the Executive's estate. (b) Company's Benefit. This Agreement shall inure to the benefit of and be binding upon the Company and its successors and assigns. (c) Assumption by Successor to Company. The Company will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company to assume expressly and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession had taken place. As used in this Agreement, "Company" shall mean the Company as hereinbefore defined and any successor to its business and/or assets as aforesaid which assumes and agrees to perform this Agreement by operation of law, or otherwise. 10. MISCELLANEOUS. (a) Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Virginia, without reference to principles of conflict of laws. The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. (b) Amendment. This Agreement may not be amended or modified otherwise than by a written agreement executed by the parties hereto or their respective successors and legal representatives. (c) Notices. All notices and other communications hereunder shall be in writing and shall be given by hand delivery to the other party or by registered or certified mail, return receipt requested, postage prepaid, addressed as follows: If to the Executive: Cameron L. Forrester 220 Church Street Tazewell, Virginia 24651 75 If to the Company: Bank of Tazewell County Care of the Chairman of the Board 309 East Main Street P.O. Box 687 Tazewell, Virginia 24651-0687 or to such other address as either party shall have furnished to the other in writing in accordance herewith. Notice and communications shall be effective when actually received by the addressee. (d) Severability. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement. (e) Tax Withholding. The Company may withhold from any amounts payable under this Agreement such Federal, state, local or foreign taxes as shall be required to be withheld pursuant to any applicable law or regulation. (f) Waiver. The Executive's or the Company's failure to insist upon strict compliance with any provision of this Agreement or the failure to assert any right the Executive or the Company may have hereunder, including, without limitation, the right of the Executive to terminate employment for Good Reason pursuant to this Agreement, shall not be deemed to be a waiver of such provision or right or any other provision or right of this Agreement. (g) Executive's Employment. The Executive and the Company acknowledge that, except as may otherwise be provided under any other written agreement between the Executive and the Company, the employment of the Executive by the Company is "at will" and, subject to paragraph (ii) of Section 1(i) hereof deeming a termination to have occurred on or after the occurrence of a Change in Control Date, the Executive's employment and/or this Agreement may be terminated by either the Executive or the Company at any time prior to the Change in Control Date, in which case the Executive shall have no further rights under this Agreement. (h) Nonexclusivity of Rights. Except as expressly provided in Section 6, nothing in this Agreement shall prevent or limit the Executive's continuing or future participation in any plan, program, policy or practice provided by the Company or any of its affiliated companies and for which the Executive may qualify, nor shall anything herein limit or otherwise affect such rights as the Executive may have under any contract or agreement with the Company or any of its affiliated companies. Amounts which are vested benefits or which the Executive is otherwise entitled to receive under any plan, policy, practice or program of or any contract or agreement with the Company or any of its affiliated companies at or subsequent to the Executive's termination shall be payable in accordance with such plan, policy, practice or program of or any contract or agreement with the Company or any of its affiliated companies at or subsequent to the Executive's termination shall be payable in accordance with such plan, policy, practice or program or contract or agreement except as explicitly modified by this Agreement. (i) Statutory References. Any reference in this Agreement to a specific statutory provision shall include that provision and any comparable provision or provisions of future legislation amending, modifying, supplementing or superseding the referenced provision. (j) Nonassignability. This Agreement is personal to the Executive, and without the prior written consent of the Company, no right, benefit or interest hereunder shall be subject in any manner to anticipation, alienation, sale, 76 transfer, assignment, pledge, encumbrance or charge, except by will or the laws of descent and distribution, and any attempt thereat shall be void; and no right, benefit or interest hereunder shall, prior to receipt of payment, be in any manner liable for or subject to the recipient's debts, contracts, liabilities, engagements or torts. (k) Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be considered an original and all of which together shall constitute one agreement. (l) Employment with Affiliates. Employment with the Company for purposes of this Agreement shall include employment with any corporation or other entity in which the Company has a direct or indirect ownership interest of 50% or more of the total combined voting power of the then outstanding securities of such corporation or other entity entitled to vote generally in the election of directors or which has a direct or indirect ownership interest of 50% or more of the total combined voting power of the then outstanding securities of the Company entitled to vote generally in the election of directors. IN WITNESS WHEREOF, the Executive has hereunto set the Executive's hand and, pursuant to the authorization from its Board of Directors, the Company has caused these presents to be executed in its name on its behalf, all as of the day and year first above written. /s/ CAMERON L. FORRESTER ----------------------------- CAMERON L. FORRESTER, Executive BANK OF TAZEWELL COUNTY By /s/ WM. T. PEERY --------------------------------- William T. Peery Chairman of the Board of Directors 77 EX-13 3 annual2002.txt 2002 ANNUAL REPORT National Bankshares, Inc. 2002 Annual Report National Bankshares, Inc. strives to be an exceptional community bank holding company dedicated to providing shareholder value by offering financial services to customers through subsidiary financial services to customers through subsidiary financial institutions and affiliated companies in an efficient, friendly, personalized, and cost-effective manner. We recognize that to do this, our financial institutions must retain the ability to make decisions locally and must actively participate in the communities they serve. We are committed to offering competitive and fair employment opportunities and to maintaining the highest standards in all aspects of our business. Financial Highlights $ In thousands, except per share data 2002 2001 2000 - ------------------------------------------------------------------------------ Net income $ 10,014 7,314 7,309 Basic and diluted net income per share 2.85 2.08 2.08 Cash dividends per share 0.97 0.86 0.85 Book value per share 20.82 18.59 17.04 Loans, net $ 404,247 394,042 355,795 Total securities 219,294 191,476 156,344 Total assets 684,935 644,623 593,497 Total deposits 608,271 576,618 530,648 Stockholders' equity 73,101 65,261 59,834 Graph of "Cash Dividends Per Share" (dollars) 2000 2001 2002 - ---------------- --------------- --------------- .85 .86 .97 Graph of "Book Value Per Share" (dollars) 2000 2001 2002 - ---------------- --------------- --------------- $17.04 $18.59 $20.82 Table of Contents To Our Stockholders............................................................2 Selected Consolidated Financial Data...........................................4 Management's Discussion and Analysis...........................................5 Independent Auditor's Report..................................................13 Consolidated Financial Statements.............................................14 Notes to Consolidated Financial Statements....................................18 Selected Quarterly Data.......................................................37 Boards of Directors...........................................................38 Corporate Information.........................................................40 1 To Our Stockholders: We are committed to community banking at National Bankshares, Inc. We demonstrate this commitment every business day. Our subsidiary banks, The National Bank and Bank of Tazewell County, have each been a strong presence in their hometowns for more than a century. The banks have a long tradition of exemplary corporate citizenship. Bank employees regularly take leadership roles in civic, cultural, and charitable organizations, and the banks donate to many worthy causes. As our two banks have expanded into new markets, our company's civic involvement has followed. Whenever possible, we believe that bank office managers should live in the area in which they do business. This allows them to become personally familiar with the needs of their communities. And since their customers are often also acquaintances from church or scouts, or neighbors, or lifelong friends, our managers form long-term, personal relationships with the people with whom they do business. We know, however, that personal service is not enough. Our customers expect and deserve service of the highest quality. We strive to provide this, with trained, experienced, and dedicated employees at all levels of the organization. From the newest teller, who completes rigorous training with excellent teller trainers, to the loan officer with decades of experience, each of our employees understands that the reputation of our company depends upon them doing their very best every day. At National Bankshares and its subsidiaries, we hire good people, and we support them with the training they need to do an outstanding job. Even though our business is built on the cornerstone of excellent personal service, we believe that being committed to community banking also includes offering our customers access to a full range of financial services utilizing the most up-to-date technology. Many of our customers choose one or more alternative methods of doing their banking. Those who wish to do so may access their bank checking and savings accounts at ATM's, with debit cards, or by using TeleBanc, our automated voice response system. The National Bank's customers also have the option of worldwide access to their account information, account transfers, and electronic bill payment by using Internet banking. Business customers at both banks frequently take advantage of ACH electronic transfers to automatically make payroll and other recurring payments. As I mentioned, we think that community banking must include a full range of financial services. Our customers should be able to stay in the National Bankshares family for all of their financial needs. That is why we now offer insurance and investments through National Bankshares Financial Services, Inc. 2 Both The National Bank and Bank of Tazewell County have Trust Departments to assist customers with their trust, estate and financial planning needs. We issue our own credit cards and debit cards, and our own employees are available locally to answer merchants' and customers' questions and to resolve any problems they might encounter. Because National Bankshares and its subsidiaries is able to provide a full range of financial services to our customers, and because they are free to choose from a wide array of service delivery options, I believe that the future is bright for community banking in general and for National Bankshares in particular. To insure that future, The National Bank is building a new office in Downtown Christiansburg, and we are looking forward to opening this summer. We have plans for some exciting new bank products this year. The National Bank is currently in the process of installing a new generation of host computer to support the core banking operations at both banks. This will be followed later in the year by enhancements to our computer network. This investment in hardware and software will allow us to provide even better service to our customers. In the coming year, we are looking forward to continuing and expanding our commitment to community banking. Although we are looking ahead to the future, I would like to take a moment to share some highlights of 2002. As you know, the past year was a very good one for National Bankshares, Inc. By taking advantage of the interest rate environment to maximize net interest income, maintaining good levels of non-interest income, and holding the line on non-interest expense, National Bankshares, Inc. achieved record net income of over $10 million, an increase of nearly 37% over 2001. We shared this success with our stockholders by increasing cash dividends per share from $0.86 per share in 2001 to $0.97 per share in 2002. National Bankshares, Inc. ended the year with total assets of nearly $685 million up by almost 6.3% over total assets at December 31, 2001. I would like to thank you, our stockholders, for your confidence and support. We know that you share the commitment and enthusiasm of the directors and employees of National Bankshares, Inc. and each of its subsidiaries to offering our communities the very best in community banking. Picture of /s/ James G. Rakes "James G. Rakes" James G. Rakes Chairman of the Board President and Chief Executive Officer 3 National Bankshares, Inc. and Subsidiaries Selected Consolidated Financial Data $ In thousands, except per share data.
Years ended December 31, 2002 2001 2000 1999 1998 - --------------------------------------------------------------------------------------------------------------- Selected Interest income $ 42,747 45,527 38,358 33,603 31,828 Income Interest expense 15,764 22,771 18,163 14,203 13,928 Statement Net interest income 26,983 22,756 20,195 19,400 17,900 Data: Provision for loan losses 2,251 1,408 1,329 1,400 624 Noninterest income 5,712 5,204 4,082 3,512 3,174 Noninterest expense 17,427 16,953 12,876 11,868 11,061 Income taxes 3,003 2,285 2,763 2,556 2,591 Net income 10,014 7,314 7,309 7,088 6,798 Per Share Basic and diluted net income $ 2.85 2.08 2.08 1.96 1.79 Data: Cash dividends declared 0.97 0.86 0.85 0.80 0.74 Book value per share (1) 20.82 18.59 17.04 14.99 16.00 Selected Loans, net $ 404,247 394,042 355,795 291,562 236,578 Balance Sheet Total securities 219,294 191,476 156,344 137,492 166,754 Data at End Total assets 684,935 644,623 593,497 472,134 445,166 of Year: Total deposits 608,271 576,618 530,648 407,187 382,696 Stockholders' equity 73,101 65,261 59,834 52,723 58,503 Selected Loans, net $ 404,717 380,970 310,624 266,431 225,613 Balance Sheet Total securities 191,493 188,809 142,686 151,424 152,432 Daily Total assets 655,783 635,692 500,381 454,189 420,988 Averages: Total deposits 583,298 569,139 433,673 391,583 359,970 Stockholders' equity (1) 69,895 63,460 55,682 56,196 58,282 Selected Return on average assets 1.53% 1.15% 1.46% 1.56% 1.61% Ratios Return on average equity (1) 14.33% 11.53% 13.13% 12.61% 11.66% Dividend payout ratio 34.01% 41.29% 40.87% 39.70% 41.29% Average equity to average assets (1) 10.66% 9.98% 11.13% 12.37% 13.84% (1) Includes the amount related to common stock subject to ESOP put option excluded from stockholders' equity on the Consolidated Balance Sheets in 1998.
4 Management's Discussion and Analysis ($ In Thousands, except per share data) Performance Summary Net income in 2002 for National Bankshares, Inc. (Bankshares) and its wholly-owned subsidiaries, The National Bank of Blacksburg (NBB), Bank of Tazewell County (BTC) and National Bankshares Financial Services (NBFS), (the Company), was $10,014, an increase of $2,700 or 36.92% over the previous year. This produced a return on average assets and a return on average equity of 1.53% and 14.33%, respectively. Net income for the Company for 2001 was $7,314, an increase of $5 or 0.07% over 2000. The return on average assets and return on average equity for 2001 were 1.15% and 11.53%, respectively. Basic and diluted net income per share over the three-year period was $2.85 per share in 2002, compared to $2.08 in 2001 and 2000. The dividend payout ratio for 2002 was 34.01%, which compares to 41.29% in 2001 and 40.87% in 2000. Graph of "Net Income" ($ in millions) 2000 2001 2002 - ---------------- --------------- --------------- $7.3 $7.3 $10.0 Net Interest Income Net interest income for 2002 was $26,983, an increase of $4,227 or 18.58% over 2001. This increase was primarily the result of the low interest rate environment the Company experienced throughout all of 2002. The yield on earning assets for 2002 was 7.27%, declining 63 basis points during the year. During the same period, the cost to fund earning assets decreased by 127 basis points. These combined to produce an increase in the net interest margin of 64 basis points. As can be seen by this data, the cost to fund earning assets declined at a faster rate than the yield on earning assets. While the current rate environment continues to be generally favorable to the Company's overall profitability, it is the opinion of management that current rate levels are not sustainable over a long period of time. It is believed that, as the general economy recovers, interest rates can be expected to increase to negate or control inflationary pressures. Rising interest rates generally have a short to intermediate term adverse effect on the Company's net interest income and profitability. In the meantime, while interest rates remain at low levels, it is expected that the Company's yield on earning assets will gradually decline as older, higher rate loans and investments mature or are called. In particular, longer-term investments purchased during the period to replace those matured or called may ultimately have a negative impact on net interest income. As indicated by the statement of cash flows, approximately $44,995 in securities available for sale were purchased in 2002. These securities consisted predominately of securities with maturities in excess of five years. In purchasing these securities, the Company has increased the level of interest rate risk in its balance sheet. While the securities have been classified as available for sale, a future rising rate environment and the accompanying decrease in asset value could make the sale of the securities undesirable from a profitability perspective. (In addition, with callable securities purchased during a period of low interest rate levels, the expectation of the call feature being activated is somewhat diminished). Hence, in a rising rate scenario the Company's ability to re-price these assets could be limited and result in a negative impact on the Company's net interest margin. Risk factors which affect interest rates and the general economy include the pace and extent at which the economy recovers, the timing and extent of interest rate increases, and other factors including, but not limited to, future terrorist activities, potiential disruptions in oil supplies and political problems in the Middle East. Net interest income for 2001 was $22,756, an increase of $2,561 or 12.68%. The net interest margin for 2001 was 4.11%, a 42 basis point decrease from 2000. These results were caused in part by the rising interest rate environment that existed throughout 2000, which steadily increased interest expense until January 2001 when the Federal Reserve Bank initiated a series of interest rate reductions to stimulate the faltering national economy. The falling rate environment benefited the Company by the end of 2001. Another factor that affected the interest rate margin was acquisition activity. In late 2000, the Company purchased six branches from AmSouth Bank. While the assumption of the interest expense was immediate, it was not possible to channel the new funds immediately into the loan portfolio due to economic conditions. Surplus funds, instead, were placed in the lower yielding 5 investment portfolio. Accordingly, interest expense grew at a faster rate than interest income, adversely affecting the net interest margin. Interest Rate Sensitivity The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income and fair market values to movement in interest rates. Interest rate sensitivity analyses provides management with information related to repricing opportunities, while interest rate shock simulations indicate potential economic loss due to future interest rate changes. During 1999 and 2000, interest rates rose substantially. In addition to the adverse effects on the net interest margin, the rising rates reduced the Company's ability to respond to interest rate movements. At December 31, 2000, the Company's investment portfolio contained a substantial amount of longer-term securities with call features. Due to the higher interest rate levels, the securities were not called as anticipated. At the time, the net unrealized losses made the sale of the securities impractical, thereby restricting one of management's primary means of controlling the effects of interest rate changes. With the onset of the declining rate environment that began in January 2001, both of the aforementioned problems began to abate. Interest expense, which had been at high levels at the beginning of 2001, declined rapidly and market values of the securities rebounded making the sale of the securities feasible, if deemed necessary. During 2002, the Company continued to benefit from the low interest rate environment. While this favorable interest rate level is expected to continue into 2003, it is not within management's ability to predict the timing or extent of any future interest rate increases. Risk factors and forward looking statements previously discussed under "Net Interest Income" apply. As previously stated, the Company uses simulation analysis to forecast its balance sheet and monitor interest rate sensitivity. One test is a shock analysis that measures the effect of a hypothetical, immediate and parallel shift in interest rates. The following table shows the results of a rate shock and the effects on net income and return on average assets and return on average equity projected at December 31, 2003. For purpose of this analysis noninterest income and expenses are assumed to be flat. ($ In thousands, except for percent data) - --------------------- ------------------- -------------------- ----------------- Rate Shift Change In Net Return On Average Return On ( In basis points) Income Equity Average Assets - --------------------- ------------------- -------------------- ----------------- 300 (-) 3,927 11.56% 1.28% 200 (-) 2,507 13.27% 1.48% 100 (-) 1,239 14.78% 1.65% (-) 100 1,193 17.61% 2.00% (-) 200 1,628 18.11% 2.06% (-) 300 1,199 17.61% 2.00% Simulation analysis allows the Company to test asset and liability management strategies under rising and falling rate conditions. As a part of the simulation process, certain estimates and assumptions must be made. These include, but are not limited to, asset growth, the mix of assets and liabilities, rate environment, and local and national economic conditions. Asset growth and the mix of assets can to a degree be influenced by management. Other areas, such as the rate environment and economic factors, cannot be controlled. For this reason actual results may vary materially from any particular forecast or shock analysis. This shortcoming is offset to a degree by the periodic re-forecasting of the balance sheet to reflect current trends and economic conditions. Shock analysis must also be updated periodically as a part of the asset and liability management process. Provision and Allowance for Loan Losses The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors such as general economic conditions. An internal credit review department performs pre-credit analyses of 6 large credits and also conducts credit review activities that provide management with an early warning of asset quality deterioration. The internal credit review department also prepares regular analyses of the adequacy of the provision for loans losses. These analyses include calculations based upon a mathematical formula that considers identified potential losses and makes pool allocations for historical losses for various loan types. In addition an amount is allocated based upon such factors as changing trends in the loan mix, the effects of changes in business conditions, the effects of any changes in loan policies, and the effects of competition and regulatory factors on the loan portfolio. The internal credit review department has determined that the Company's provision for loan losses is sufficient. Loan loss and other industry indicators related to asset quality are presented in the Loan Loss Data table. Loan Loss Data Table ($ In thousands) 2002 2001 2000 ------------- --------------- ------------ Provision for loan losses $ 2,251 1,408 1,329 Net charge-offs to average net loans 0.35% 0.27% 0.21% Allowance for loan losses to loans, net of unearned income and deferred fees 1.24% 1.07% 1.08% Allowance for loan losses to nonperforming loans 1,768.06% 1,206.78% 4,415.91% Allowance for loan losses to nonperforming assets 617.21% 756.11% 618.79% Nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned 0.20% 0.14% 0.17% Nonaccrual loans $ 288 354 88 Restructured loans --- --- --- Other real estate owned, net 537 211 540 -------------- -------------- ------------ Total nonperforming assets $ 825 565 628 ============== ============== ============ Accruing loans past due 90 days or more $ 977 980 1,321 ============== ============== ============ Note: Nonperforming loans include nonaccrual loans and restructured loans, but do not include accruing loans 90 days or more past due. Several factors contributed to the Company's decision to increase the provision for loan losses in 2002. While overall asset quality remained satisfactory in 2002, the level of exposure to loss increased, particularly in the loans to individuals' category. In addition, much of the growth in 2002 was in the commercial loan category, which increased the Company's exposure to losses resulting from defaults in large dollar loans. While the number of such defaults would only constitute a small number of loans, the sizable dollar amount of the individual credits tends to increase the possibility of greater loss. Declining economic conditions in the Company's market area have also contributed to a higher net charge-off ratio which rose from .26% in 2000 to .27% in 2001 and .35% in 2002. In addition, total nonperforming assets were at $825 on December 31, 2002, an increase of 46% from 2001. Declining economic conditions in the Company's market area have also contributed to a higher net charge-off ratio which rose from .26% in 2000 to .27% in 2001 and .35% in 2002. In addition total nonperforming assets were at $825 on December 31, 2002, an annual increase of 46% from 2001. Nonperforming assets at December 31, 2001 were $565, a decrease of $63 or 10.03% from 2000. Net charge-offs to average net loans for 2001 was 0.27%. The provision for loan losses for 2001 was $1,408, an increase of $79 or 5.94% from 2000. While past efforts directed at improving asset quality have been largely successful, management is unable to estimate when and under what exact terms existing and future problem assets will be resolved. Changing economic conditions, the timing and extent of changes, and the ultimate impact on the Company's asset quality is not within management's ability to predict with any degree of precision. In addition, precise loss predictions may be difficult to determine because of the complex circumstances that surround troubled debts. Noninterest Income Noninterest income for 2002 was $5,712, an increase of $508 or 9.76%. The largest increase occurred in realized gains and losses on securities and other income categories. Non-recurring income described below accounted for much of the increase. Noninterest income for 2001 was $5,204, an increase of $1,122 or 27.49% from 2000. The increase for the most part was due to the acquisition of the six AmSouth Bank branches in late 2000 and a seventh branch from First Union National Bank in the first quarter of 2001. 7 The level of service charges on deposits is driven by demand deposit volume, types of accounts opened, service charge rates in effect, the level of charges such as overdraft fees, and the fee waiver policy for these fees. Service charges on deposit accounts were $2,229 for 2002, a decrease of $17 or 0.76% from 2001. There were no unusual factors that had a material impact on this category in 2002. Service charges on deposit accounts for 2001 were $2,246, an increase of $563 or 33.45% from 2000. The increase was due primarily to the purchase of six branches in late 2000 and a single purchase in the first quarter of 2001. An increase in fee schedules also contributed to the increase, though to a lesser extent. Trust income for 2002 was $968, a decrease of $123 or 11.27% from 2001. Trust income is dependent upon market conditions as well as the types of accounts being handled at any given point in time. Market conditions, which directly affect the value of trust assets managed and in turn trust fees, were less favorable in 2002. Management believes that current market conditions will continue to have a negative impact on trust fees for the foreseeable future. In 2001 trust income was $1,091, an increase of $206 or 23.28% over 2000. This increase was mostly due to a higher level of estate business. Due to its nature, estate business volume and the related income is not within management's ability to predict and may fluctuate considerably from time to time. Credit card income is composed of several types of fees and charges, including transaction or interchange fees, merchant discount fees, and over-limit charges. Given the highly competitive market, which limits the amount of set charges, revenue increases result from growth in the number of merchant accounts processed and increases in the number of customer credit and debit card accounts. Credit card income for 2002 was $1,409, an increase of $182 or 14.83% when compared to 2001, primarily due to increased volume. A portion of this increase was due to reduced charges from the Company's credit card processor. These charges are tiered and, having reached the next higher volume level, the charges decreased accordingly. Increased income in this area was also in part due to volume created by the addition of new merchants. Credit card fees for 2001 were $1,227, an increase of $215 or 21.25% over 2000. This increase was due in part to the purchase of six branches, which expanded the company's service area and also to the introduction of the Company's debit card service to BTC's trade area. Other Income Other income for the year ended December 31, 2002 was $500, an increase of $170 or 51.52%. For 2002 other income contained several non-recurring items. Included in this was nontaxable proceeds from a life insurance policy, which was approximately $36 and a legal expense recovery of $14 from a prior year. Other income also includes commissions from the sale of securities and insurance, which totaled approximately $239 in 2002 and $99 in 2001. Other Income for 2001 was $330, up 127.6% over 2000. Of this increase, approximately $99 was due to income derived from securities and insurance commissions generated by the Company's non-bank subsidiary National Bankshares Financial Services. Net realized gains and losses on securities was $346, an increase of $342 over 2001. In the second and third quarter of 2002, the Company sold investments at a total gain of approximately $335. The remainder of the net increase was due to called securities and routine equity adjustments on certain investments. Net realized gains for 2001 of $4 were primarily due to the write down of the Company's investment in two limited liability companies established for the sale of title insurance and insurance services, offset by the call of a single bond in late 2001. Noninterest Expense Noninterest expense for 2002 was $17,427, an increase of $474 or 2.80% from 2001. The largest increase was in the salaries and employee benefits category, which increased $827 or 10.23%. Net costs of other real estate owned increased to $145 or 16.00%. These items are described in further detail below. Noninterest expense for 2001 was $16,953, an increase of $4,077 or 31.66%. In November of 2000, the Company purchased six AmSouth Bank branches. Since the acquisition was in late 2000, the impact on 2000 was minimal, with the full effect not felt until 2001. Categories such as salaries and benefits, occupancy, intangibles and other operating expense all increased due to these acquisitions. Noninterest expense for 2001 also increased with the purchase of a branch in March of 2001. Salaries and employee benefits, as previously mentioned, increased at a rate higher than average for the company for several reasons. In the first quarter of 2001, the Company's BTC affiliate acquired a branch office in Bluefield, Virginia. Salaries and employee benefits expense for this office were 8 included for nine months in 2001, as opposed to twelve months for 2002. For the first time since it became a participating employer in the National Bankshares, Inc. the Company's BTC affiliate had a contribution expense of $120 to the ESOP in 2002. Additional costs associated with employee health insurance, executive compensation and other benefits also experienced increases. Occupancy expense was $1,692, a decrease from 2001 of $23. While this category included new expenses in part associated with acquisition activity previously mentioned, efforts to restrain expenditures produced an overall decrease. In the second quarter of 2002, the Company's NBB affiliate announced its intent to open a new branch office in Christiansburg, Virginia. The office is expected to open in the second quarter of 2003. The Company's BTC affiliate consolidated two of its Bluefield, Virginia offices into a single office during the fourth quarter of 2002. Occupancy expense for 2001 was $1,715, an increase of $400 or 30.42% over the year 2000. Acquisition activity accounted for a majority of the increase. Data processing expenses decreased by $247 or 18.39% when 2002 and 2001 are compared. This decline was primarily due to a reduction in maintenance costs and the absence of conversion costs associated with the 2001 branch acquisition that were previously discussed. In 2002 the Company was advised by its host computer hardware provider that operating system support would be terminated by the end of 2004. Given the importance of this area, management initiated a project to determine the appropriate course of action. Management has elected to upgrade its host computer system in 2003. Data processing expenses for 2001 were $1,343, an increase of $412 or 44.25% over 2000. The acquisition of six AmSouth Bank branches late in 2000 and the purchase of one branch in March 2001 were the primary contributors to the increase. Credit card processing expenses were up $32 for 2002. An increase in volume offset by two nonrecurring items totaling $52 combined to produce the increase. Of the two nonrecurring items, one represented a refund of certain processing charges. The second, for $10, consisted of a signing bonus connected with acquiring a new vendor. Credit card processing costs for 2001 were $1,004, a decrease of $21 or 2.05% from 2000. The cost decrease was primarily due to a combination of factors. The previously mentioned branch acquisitions and the introduction of debit card services at the company's BTC affiliate added to this expense. A one-time loss experienced in 2000, offset the volume related increases to produce a net decrease. Expenses related to other real estate owned were $145 for 2002. The primary cause of this increase was a $75 write-down of certain properties. These properties had been held for a period of more than ten years. While several sales had taken place over the past few years, they could best be characterized as somewhat slow. This effort, which was designed to accelerate sales of the properties, was in large part successful. The net cost of other real estate owned includes expenses to acquire, maintain and dispose of foreclosed properties. Net gains and losses on disposition are also included. During 2001 these expenses were $125, an increase of $42 or 50.60% over 2000. Other operating expenses were $3,592 for 2002, a decrease of $175 or 4.65% from 2001 Other operating expenses for 2001 were $3,767, an increase of $834 or 28.44%. The majority of the increase was due to acquisition activities, which as expected, increased various categories such as telephone, courier service, and stationery and supplies. Income Taxes Income tax expense increased in 2002 due to the increase in net income and was offset to a degree by a higher level of investment in tax free obligations. Tax exempt interest income continues to be the primary difference between the "expected" and reported income tax expense. The Company's effective tax rates for 2002, 2001 and 2000 were 23.07%, 23.80% and 27.43%, respectively. See Note 10 of Notes to Consolidated Financial Statements for additional information relating to income taxes. Effects of Inflation The Company's consolidated statements of income generally reflect the effects of inflation. Since interest rates, loan demand, and deposit levels are related to inflation, the resulting changes are included in net income. The most significant item, which does not reflect the effects of inflation, is depreciation expense, because historical dollar values used to determine this expense do not reflect the effect of inflation on the market value of depreciable assets after their acquisition. 9 Balance Sheet Total assets for the Company at December 31, 2002 were $684,935. This represents an increase of $40,312 or 6.25% when compared to 2001. Total daily average assets were $655,783 for 2002, which compares to $635,692 for 2001. Growth for 2002 was from the development of the Company's existing franchise as there were no acquisitions in 2002. Total assets for the Company were $644,623 at December 31, 2001. This represents an increase of $51,126 or 8.61% over 2000. This increase was primarily due to the acquisition of a branch from First Union National Bank in March 2001. The transaction included the acquisition of approximately $34,000 in deposits and approximately $9,200 in loans. Graph of "Total Assets" ($ in millions) 2000 2001 2002 - ---------------- --------------- --------------- $593.5 $644.6 $684.9 Loans Loans net of unearned income and deferred fees grew by $11,025 or 2.77% during 2002. As can be seen by the balance sheet, the composition of the loan portfolio shifted toward the commercial category during 2002. Loans to individuals have experienced a moderate decline. It is not known to what extent loans to individuals will ultimately decline or when growth in this area will resume. Loans to individuals generally produce higher yields than other types of loans. A prolonged and substantial run-off of these loans could have a measurable adverse impact on the Company's net interest margin. Loans net of unearned income and deferred fees grew by $38,633 or 10.74% in 2001. Of this amount, approximately $9,200 was due to the First Union National Bank branch purchase referred to previously. Excluding purchased loans, the Company experienced moderately strong growth in 2001. The Company engages in the origination and sale of mortgage loans in the secondary market. In 2002 and 2001, the Company originated $36,915 and $28,247, respectively, and sold $37,214 and $27,102, respectively, of mortgage loans. Graph of "Net Loans" ($ in millions) 2000 2001 2002 - ---------------- --------------- --------------- $355.8 $394.0 $404.2 Securities Securities available for sale at December 31, 2002 were $119,734, an increase of $31,067 or 35.04% over 2001. Securities held to maturity totaled $99,560 at December 31, 2002. These securities decreased by $3,249 or 3.16% from the totals at December 31, 2001. As can be seen in the consolidated statement of cash flows, $44,995 was re-invested in securities available for sale and $16,953 in securities held to maturity. Maturities for bonds purchased were generally longer term, with maximization of yields being the primary objective. Securities available for sale at December 31, 2001 were $88,667. This represents a decrease of $35,118 or 28.37% from December 31, 2000. Securities held to maturity increased $70,250 or 215.76% when the two periods are compared. The increased emphasis on held to maturity represented an effort to manage the level of unrealized gains and losses, which had fluctuated substantially in the prior three years. New volume was the result of the branch acquisitions previously discussed. At December 31, 2002 and 2001, the Company had no investment concentrations in any single issues (excluding U.S. Government) that exceeded ten percent of capital. Deposits Total deposits at December 31, 2002 were $608,271, an increase of $31,653 or 5.49% from December 31, 2001. Noninterest-bearing demand deposits grew by 3.18%, while interest-bearing demand deposits grew by 23.08%. Savings deposits increased by 0.26%, with time deposits declining by 0.54%. Management believes that the increase in interest-bearing demand deposits is in part due to customers' expectations of higher interest rates in the near to intermediate term, which has created a reluctance to commit to longer term deposit instruments. If this trend continues, it would have the effect of making the Company increasingly liability sensitive, which in a rising rate scenario could negatively affect the net interest margin. At December 31, 2001, total deposits were $576,618, an increase of $45,970 or 8.66% over December 31, 2000. Of this increase, approximately $34,000 was due to the purchase of the First Union National Bank branch referred to previously. 10 Derivatives and Market Risk Exposures The Company is not a party to derivative financial instruments with off-balance sheet risks such as futures, forwards, swaps, and options. The Company is a party to financial instruments with off-balance sheet risks such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business to meet the financing needs of its customers. See note 14 of Notes to Consolidated Financial Statements for additional information relating to financial instruments with off-balance sheet risk. Management does not plan any future involvement in high risk derivative products. The Company has investments in mortgage-backed securities, principally GNMA's, with a fair value of approximately $26,199, which includes $2,006 of structured notes. In addition, the Company has investments in non-mortgage-backed structured notes with fair value of approximately $2,041. See Note 3 of Notes to Consolidated Financial Statements for additional information relating to securities. The Company's securities and loans are subject to credit and interest rate risk, and its deposits are subject to interest rate risk. Management considers credit risk when a loan is granted and monitors credit risk after the loan is granted. The Company maintains an allowance for loan losses to absorb losses in the collection of its loans. See Note 5 of Notes to Consolidated Financial Statements for information relating to the allowance for loan losses. See Note 15 of Notes to Consolidated Financial Statements for information relating to concentrations of credit risk. The Company has an asset/liability program to manage its interest rate risk. This program provides management with information related to the rate sensitivity of certain assets and liabilities and the effect of changing rates on profitability and capital accounts. While this planning process is designed to protect the Company over the long-term, it does not provide near-term protection from interest rate shocks, as interest rate sensitive assets and liabilities do not, by their nature, move up or down in tandem in response to changes in the overall rate environment. The Company's profitability in the near term may be temporarily affected either positively by a falling interest rate scenario or negatively by a period of rising rates. See Note 16 of Notes to Consolidated Financial Statements for information relating to fair value of financial instruments and comments concerning interest rate sensitivity. Liquidity Liquidity is the ability to provide sufficient cash flow to meet financial commitments and to fund additional loan demand or withdrawal of existing deposits. Sources of liquidity include deposits, loan principal and interest repayments, sales, calls and maturities of securities, and short-term borrowings. The Company also has available a line of credit with the Federal Home Loan Bank to provide for liquidity needs. The Company maintained an adequate liquidity level during 2002 and 2001. Cash flows from operating activities for 2002 were $14,244. The principal source of cash was net income. Net cash used in investment activities was $43,013. While the majority of the called and maturing securities were re-invested in the securities available for sale category, these funds may not be available in the future to meet liquidity needs. Given the low interest rate environment currently being experienced, a rising rate environment would tend to erode securities values making their sale undesirable from a profitability perspective. A rising rate scenario would further inhibit the activation of any call features. The company experienced a similar situation in the last period of rising rates that occurred in the 1999 and 2000 time periods. (See additional comments under "Interest Rate Sensitivity"). Cash provided by financing activities was $28,792 compared to $39,133 in 2001. The majority of the difference between the two years was in deposits purchased, which totaled $29,862 in 2001 and none in 2002. Time deposits decreased by $1,743 in 2002 and $38,490 in 2001. Other deposits increased $33,396 in 2002. Comments made under "Deposits" apply. Net cash from operating activities for 2001 was $10,017, up from $9,691 in 2000. Cash used in investing activities was $47,987, down from $113,774 in 2000. Purchases of loans and federal funds sold declined substantially from 2000. This corresponded to a substantial increase in cash provided by financing activities in 2000, which was due to acquisition activity. The Company's liquidity position remained satisfactory throughout 2001. The acquisition of the First Union National Bank branch in March 2001 further enhanced liquidity, which was already in satisfactory condition following the late 2000 acquisition of the AmSouth branches. Securities purchases accounted for the largest use of funds, with purchased deposits and an increase in the other deposit category the primary sources. Management is not aware of any other commitments or events that will result in or are reasonably likely to result in a material and adverse decrease in liquidity. Capital Resources Total shareholders' equity at December 31, 2002 was $73,101, an increase of $7,840 or 12.01%. Total average capital to total average assets was 10.66% for 2002, which compares to 9.98% in 2001. Of the increase, net income accounted for $10,014, offset by dividends to shareholders in the amount of $3,406. Net unrealized gains and losses from securities available for sale accounted for the 11 remainder of the increase. There were no shares repurchased by the Company in 2002. Management was authorized to repurchase up to 50,000 shares in 2002 as deemed appropriate considering market conditions. The dividend payout ratio for 2002 was 34.01% and 41.29% for 2001. Total stockholders' equity increased by $5,427 or 9.07% for the year 2001. Growth was the result of net income of $7,314, offset by dividends to shareholders of $3,020. Stock in the amount of $8 was repurchased. Banks are required to apply percentages to various assets, including off-balance sheet assets, to reflect their perceived risk. Regulatory defined capital is divided by risk weighted assets in determining the banks' risk-based capital ratios. No regulatory authorities have advised NBI, NBB or BTC of any specific leverage ratios applicable to them. NBI, NBB and BTC's capital adequacy ratios exceed regulatory requirements and provide added flexibility to take advantage of business opportunities as they arise. See Note 11 of Notes to Consolidated Financial Statements for additional information. Recent Accounting Pronouncements See Note 1 of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements. Branch Acquisitions In a move to improve the Company's competitive position, BTC announced on September 15, 2000 that it would acquire a branch in Bluefield, Virginia from First Union National Bank. The acquisition involved the purchase of approximately $34,000 in deposits and $9,200 in loans. The acquisition was completed in the first quarter of 2001. Common Stock Information and Dividends National Bankshares, Inc.'s common stock is traded on the Nasdaq SmallCap Market under the symbol "NKSH". As of December 31, 2002, there were 1,024 record stockholders of Bankshares common stock. The following is a summary of the market price per share and cash dividend per share of the common stock of National Bankshares, Inc. for 2002 and 2001.
Common Stock Market Prices 2002 2001 Dividends per share --------------- --------------- --------------- --------------- --------------- --------------- High Low High Low 2002 2001 --------------- --------------- --------------- --------------- --------------- --------------- First Quarter $ 23.00 20.03 20.25 18.00 --- --- Second Quarter 30.00 22.00 20.80 17.80 0.46 0.43 Third Quarter 28.45 26.00 24.60 20.00 --- --- Fourth Quarter 31.15 26.75 23.00 20.10 0.51 0.43
NBI's primary source of funds for dividend payments is dividends from its subsidiaries, NBB and BTC. Bank regulatory agencies restrict dividend payments of the subsidiaries, as more fully disclosed in Note 11 of Notes to Consolidated Financial Statements. 12 Independent Auditor's Report To the Board of Directors and Stockholders National Bankshares, Inc. Blacksburg, Virginia We have audited the accompanying consolidated balance sheets of National Bankshares, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years ended December 31, 2002, 2001 and 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Bankshares, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for the years ended December 31, 2002, 2001 and 2000 in conformity with accounting principles generally accepted in the United States of America. Winchester, Virginia January 23, 2003 13 National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets
$ In thousands, except share data. December 31, 2002 and 2001. 2002 2001 ----------- ----------- Assets Cash and due from banks $ 12,316 12,293 Interest-bearing deposits 18,818 15,510 Federal funds sold 1,724 1,080 Securities available for sale, at fair value 119,734 88,667 Securities held to maturity (fair value approximates $103,187 at December 31, 2002 and $103,234 at December 31, 2001) 99,560 102,809 Mortgage loans held for sale 846 1,145 Loans: Real estate construction loans 22,294 19,573 Real estate mortgage loans 82,193 77,339 Commercial and industrial loans 209,368 189,764 Loans to individuals 96,762 113,413 ----------- ----------- Total loans 410,617 400,089 Less unearned income and deferred fees (1,278) (1,775) ----------- ----------- Loans, net of unearned income and deferred fees 409,339 398,314 Less allowance for loan losses (5,092) (4,272) ----------- ----------- Loans, net 404,247 394,042 ----------- ----------- Premises and equipment, net 9,938 10,132 Accrued interest receivable 4,290 4,917 Other real estate owned 537 211 Intangible assets and goodwill, net 10,912 11,866 Other assets 2,013 1,951 ----------- ----------- Total assets $ 684,935 644,623 =========== =========== Liabilities and Noninterest-bearing demand deposits $ 74,032 71,751 Stockholders' Interest-bearing demand deposits 165,216 134,230 Equity Savings deposits 48,956 48,827 Time deposits 320,067 321,810 ----------- ----------- Total deposits 608,271 576,618 ----------- ----------- Other borrowed funds 748 203 Accrued interest payable 700 1,101 Other liabilities 2,115 1,440 ----------- ----------- Total liabilities 611,834 579,362 ----------- ----------- Commitments and contingencies Stockholders' equity: Preferred stock, no par value, 5,000,000 shares authorized; none issued and outstanding --- --- Common stock of $2.50 par value. Authorized 5,000,000 shares; issued and outstanding, 3,511,377 shares 8,778 8,778 Retained earnings 62,525 55,917 Accumulated other comprehensive income, net 1,798 566 ----------- ----------- Total stockholders' equity 73,101 65,261 ----------- ----------- Total liabilities and stockholders equity $ 684,935 644,623 =========== =========== The accompanying notes are an integral part of these consolidated financial statements.
14 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income
$ In thousands, except per share data. Years ended December 31, 2002, 2001 and 2000. 2002 2001 2000 ------------ ------------- ------------- Interest Interest and fees on loans $ 32,420 33,456 28,326 Income Interest on federal funds sold 42 652 338 Interest on interest-bearing deposits 276 577 689 Interest on securities - taxable 5,490 7,501 6,760 Interest on securities - nontaxable 4,519 3,341 2,245 ------------ ------------- ------------- Total interest income 42,747 45,527 38,358 ------------ ------------- ------------- Interest Interest on time deposits of $100,000 or more 3,470 4,605 3,455 Expense Interest on other deposits 12,289 18,158 14,080 Interest on borrowed funds 5 8 628 ------------ ------------- ------------- Total interest expense 15,764 22,771 18,163 ------------ ------------- ------------- Net interest income 26,983 22,756 20,195 Provision for loan losses 2,251 1,408 1,329 ------------ ------------- ------------- Net interest income after provision for loan losses 24,732 21,348 18,866 ------------ ------------- ------------- Noninterest Service charges on deposit accounts 2,229 2,246 1,683 Income Other service charges and fees 260 306 348 Credit card fees 1,409 1,227 1,012 Trust income 968 1,091 885 Other income 500 330 145 Realized securities gains, net 346 4 9 ------------ ------------- ------------- Total noninterest income 5,712 5,204 4,082 ------------ ------------- ------------- Noninterest Salaries and employee benefits 8,912 8,085 6,360 Expense Occupancy and furniture and fixtures 1,692 1,715 1,315 Data processing and ATM 1,096 1,343 931 Credit card processing 1,036 1,004 1,025 Intangible assets and goodwill amortization 954 914 229 Net costs of other real estate owned 145 125 83 Other operating expenses 3,592 3,767 2,933 ------------ ------------- ------------- Total noninterest expense 17,427 16,953 12,876 ------------ ------------- ------------- Income before income taxes 13,017 9,599 10,072 Income tax expense 3,003 2,285 2,763 ------------ ------------- ------------- Net income $ 10,014 7,314 7,309 ============ ============= ============= Basic and diluted net income per share $ 2.85 2.08 2.08 ============ ============= ============= The accompanying notes are an integral part of these consolidated financial statements.
15 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity
$ In thousands, except per share data. Accumulated Other Common Retained Comprehensive Income Comprehensive Stock Earnings (Loss) Income Total ----------- ----------- -------------------- --------------- ----------- Balance at December 31, 1999 $ 8,792 47,384 (3,453) 52,723 Net income --- 7,309 --- 7,309 7,309 Other comprehensive income: Unrealized holding gains on available for sale securities net of deferred taxes of $1,486 --- --- --- 2,884 --- Less: reclassification adjustment, net of income taxes of $3 --- --- --- (6) --- --------------- Other comprehensive income, net of tax of $1,483 --- --- 2,878 2,878 2,878 --------------- Total comprehensive income net of tax of $4,246 --- --- --- 10,187 --- =============== Common stock repurchased (12) (77) --- (89) Cash dividends ($0.85 per share) --- (2,987) --- (2,987) ----------- ----------- -------------------- ------------ - ------------------------------------------------------------------------------------------------------------------- Balance at Decemeber 31,2000 $ 8,780 51,629 (575) 59,834 Net Income --- 7,314 --- 7,314 7,314 Other comprehensive income: Unrealized holding gains on available for sale securities net of deferred taxes of $588 --- --- --- 1,144 --- Less: reclassification adjustment, net of income taxes of $1 --- --- --- (3) --- --------------- Other comprehensive income, net of tax of $587 --- --- 1,141 1,141 1,141 --------------- Total comprehensive income, net of tax of $2,872 --- --- --- 8,455 --- =============== Common stock repurchased (2) (6) --- (8) Cash dividends ($0.86 per share) --- (3,020) --- (3,020) ----------- ----------- -------------------- ------------ - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2001 $ 8,778 55,917 566 65,261 Net income --- 10,014 --- 10,014 10,014 Other comprehensive income: Unrealized holding gains on available for sale securities net of deferred, taxes of $948 --- --- --- 1,841 --- Less: reclassification adjustment, net of income taxes of $118 --- --- --- (228) --- Minimum pension liability adjustment, net of deferred taxes of $235 --- --- --- (381) --- Other comprehensive income, net of tax of $596 --- --- 1,232 1,232 1,232 --------------- Total comprehensive income --- --- --- 11,246 --- =============== Cash dividend ($0.97 per share) --- (3,406) --- (3,406) ----------- ------------ - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2002 $ 8,778 62,525 1,798 73,101 =========== =========== ==================== ============ The accompanying notes are an integral part of these consolidated financial statements.
16 National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows $ In thousands. Years Ended December 31, 2002, 2001 and 2000.
2002 2001 2000 ---------- --------- ---------- Cash Net income $ 10,014 7,314 7,309 Flows Adjustment to reconcile net income to net cash from provided by operating activities: Operating Provision for loan losses 2,251 1,408 1,329 Activities (Benefit) from deferred income taxes (551) (166) (253) Depreciation of premises and equipment 977 1,106 1,015 Amortization of intangibles 954 914 229 Amortization of premiums and accretion of discounts, net 392 367 132 (Gains) losses on sale and calls of securities available for sale, net (331) (4) 4 (Gains) on calls of securities held to maturity, net (15) --- (13) Losses and writedowns on other real estate owned 87 62 26 Originations of mortgage loans held for sale (36,915) (28,247) (20,129) Sales of mortgage loans held for sale 37,214 27,102 20,358 (Gains) losses on sale of fixed assets (11) (2) (4) Net change in: Accured interest receivable 627 132 (1,035) Other assets (34) 235 (258) Accured interest payable (401) (437) 887 Other liabilities (14) 233 94 ---------- --------- ---------- Net cash provided by operating activities 14,244 10,017 9,691 ---------- --------- ---------- Cash Net change in federal funds sold (644) 28,010 (26,290) Flows Net change in interest-bearing deposits (3,308) (1,931) (4,360) from Proceeds from repayments of mortgage-backed Investing securities available for sale 813 3,482 1,558 Activities Proceeds from sales of securities available for sale 11,042 --- 935 Proceeds from calls, maturities, and principal repayments of securities available for sale 4,656 58,403 7,732 Proceeds from calls, maturities, and principal repayments of securities held to maturity 20,017 24,160 3,192 Purchases of securities available for sale (44,995) (25,209) (15,914) Purchases of securities held to maturity (16,953) (94,602) (12,117) Purchases of loan participations (19,440) (4,296) 2,759) Collections of loan participations 3,981 4,702 3,768 Loans purchased, including premium --- (9,255) (42,187) Loan originations and principal collections, net 2,190 (31,740) (24,869) Proceeds from disposal of other real estate owned 255 1,095 271 Recoveries on loans charged off 145 106 95 Additions to premises and equipment (805) (921) (2,839) Proceeds from sale of premises and equipment 33 9 10 ---------- --------- ---------- Net cash used by investing activities (43,013) (47,987) (113,774) ---------- --------- ---------- Cash Deposits acquired, net of premium --- 29,862 85,944 Flows Net change in time deposits (1,743) (38,460) 40,031 from Net change in other deposits 33,396 50,826 (10,807) Financing Net change in other borrowed funds 545 (67) (10,190) Activities Cash dividends paid (3,406) (3,020) (2,987) Common stock repurchased on --- (8) (89) ---------- --------- ---------- Net cash provided by financing activities 28,792 39,133 101,902 ---------- --------- ---------- Net change in cash and due from banks 23 1,163 (2,181) Cash and due from banks at beginning of year 12,293 11,130 13,311 ---------- --------- ---------- Cash and due from banks at end of year $ 12,316 12,293 11,130 ========== ========= ========== Supplemental Interest paid on deposits and borrowed funds $ 16,165 23,208 17,276 Disclosures of Income taxes paid 3,414 2,383 2,958 Cash Flow Information Supplemental Loans charged against the allowance for loan losses 1,576 1,129 770 Disclosures Loans transferred to other real estate owned 668 828 390 of Noncash Unrealized gain on securities available for sale 2,444 1,728 4,361 Activities Minimum pension liability adjustment 689 --- --- The accompanying notes are an integral part of these consolidated financial statements.
17 Notes to Consolidated Financial Statements $ In thousands, except share data and per share data. Note 1: Summary of Significant Accounting Policies The consolidated financial statements include the accounts of National Bankshares, Inc. (Bankshares) and its wholly-owned subsidiaries, the National Bank of Blacksburg (NBB), Bank of Tazewell County (BTC), and National Bankshares Financial Services (NBFS), (the Company). All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following is a summary of the more significant accounting policies. Cash and Cash Equivalents For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks. Securities Debt securities that management has the positive intent and ability to hold to maturity are classified as "held to maturity" and recorded at amortized cost. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as "available for sale" and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The Company has no securities classified as trading securities at December 31, 2002 or 2001. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Loans Held for Sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value on an individual loan basis. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Loans The Company, through its banking subsidiaries, grants mortgage, commercial, and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans. The ability of the Company's debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company's market area. Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoff, generally are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or chargedoff at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Allowance for Loan Losses The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. 18 The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience; the nature, volume, and risk characteristics of the loan portfolio; adverse situations that may affect the borrower's ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures. Premises and Equipment Premises and equipment are stated at cost, net of accumulated depreciation. Depreciation is charged to expense over the estimated useful lives of the assets on the straight-line basis. Depreciable lives include 40 years for premises, 3-10 years for furniture and equipment, and 5 years for computer software. Costs of maintenance and repairs are charged to expense as incurred and improvements are capitalized. Other Real Estate Real estate acquired through, or in lieu of, foreclosure is held for sale and is initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in other operating expenses. Intangible Assets Included in other assets are deposit intangibles of $10,642 and $11,559 at December 31, 2002 and 2001, respectively, and goodwill of $270 and $307 at December 31, 2002 and 2001, respectively. Deposit intangibles are being amortized on a straight-line basis over a ten or fifteen-year period and goodwill is being amortized on a straight-line basis over a fifteen-year period. Stock-Based Compensation At December 31, 2002, the Company had a stock-based employee compensation plan which is described more fully in Note 9. The company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. 19
Years Ended December 31, ---------------------------------------------- 2002 2001 2000 (In thousands, except per share data) Net income, as reported $ 10,014 $7,314 $7,309 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards. (23) (10) (2) -------------- ---------------- -------------- Pro forma net income $ 9,991 $7,304 $7,307 ============== ================ ============== Earnings per share: Basic-as reported $ 2.85 $2.08 $2.08 ============== ================ ============== Basic-pro forma $ 2.85 $2.08 $2.08 ============== ================ ============== Diluted-as reported $ 2.85 $2.08 $2.08 ============== ================ ============== Diluted-pro forma $ 2.84 $2.08 $2.08 ============== ================ ==============
Pension Plan The Company sponsors a defined benefit pension plan, which covers substantially all full-time officers and employees. The benefits are based upon length of service and a percentage of the employee's compensation during the final years of employment. Pension costs are computed based upon the provisions of SFAS No. 87. The Company contributes to the pension plan amounts deductible for federal income tax purposes. Income Taxes Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Trust Assets and Income Assets (other than cash deposits) held by the Trust Departments in a fiduciary or agency capacity for customers are not included in the consolidated financial statements since such items are not assets of the Company. Trust income is recognized on the accrual basis. Earnings Per Share Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. The following shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock. Potential dilutive common stock had no effect on income available to common shareholders.
2002 2001 2000 ------------------ ------------------ ----------------- Average number of common shares outstanding 3,511,377 3,511,380 3,514,586 Effect of dilutive options 5,712 1,216 --- ------------------ ------------------ ----------------- Average number of common shares outstanding used to calculate diluted earnings per share 3,517,089 3,512,596 3,514,586 ================== ================== =================
20 In 2002, 2001 and 2000, stock options representing 9,750, 4,125 and 8,265 shares, respectively, were not included in the computation of diluted net income per share because to do so would have been anti-dilutive. Advertising The Company practices the policy of charging advertising costs to expenses as incurred. Use of Estimates In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of foreclosed real estate and deferred tax assets. Changing economic conditions, adverse economic prospects for borrowers, as well as regulatory agency action as a result of examination, could cause NBB and BTC to recognize additions to the allowance for loan losses and may also affect the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. Comprehensive Income Effective January 1, 2001, the Company changed its method of presentation concerning comprehensive income. Prior to 2001, comprehensive income was reflected as part of the consolidated statement of income. Comprehensive income is now presented as a separate component of the Company's consolidated statement of changes in stockholders' equity. Recent Accounting Pronouncements In December 2001, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others, to reconcile and conform the accounting and financial reporting provisions established by various AICPA industry guides. This Statement is effective for annual and interim financial statements issued for fiscal years beginning after December 15, 2001, and did not have a material impact on the Corporation's consolidated financial statements. On March 13, 2002, the Financial Accounting Standard Board determined that commitments for the origination of mortgage loans that will be held for sale must be accounted for as derivatives instruments, effective for fiscal quarters beginning after April 10, 2002. The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding. Such rate lock commitments on mortgage loans to be sold in the secondary market are considered derivatives. Accordingly, these commitments, including any fees received from the potential borrower, are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of mortgage loans. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments fair value also takes into consideration the difference between current levels of interest rates and the committed rates. The cumulative effect of adopting Statement No. 133 for rate lock commitments as of December 31, 2002, was not material. The Corporation originally adopted Statement No. 133, Accounting for Derivative Instruments and Hedging Activities on January 1, 2001. In April 2002, the Financial Accounting Standards Board issued Statement 145, Recission of FASB No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. The amendment to Statement 13 eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to the recission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions of this Statement related to Statement 13 are effective for transactions occurring after May 15, 2002, with early application encouraged. In June 2002, the Financial Accounting Standards Board issued Statement 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement requires recognition of a liability, when incurred, for costs associated with an exit or disposal activity. The liability should be measured at fair value. The provisions of the Statement are effective for exit or disposal activities initiated after December 31, 2002. 21 The adoption of Statement No. 145 and 146 did not have a material impact on the Company's consolidated financial statements. Effective January 1, 2002, the Corporation adopted Financial Accounting Standards Board Statement No. 142, Goodwill and Other Intangible Assets. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, Statement 142 requires that acquired intangible assets (such as core deposit intangibles) be separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its estimated useful life. Branch acquisition transactions were outside the scope of the Statement and therefore any intangible asset arising from such transactions remained subject to amortization over their estimated useful life. In October 2002, the Financial Accounting Standards Board issued Statement No. 147, Acquisitions of Certain Financial Institutions. The Statement amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, Business Combinations, and Statement No. 142 to branch acquisitions if such transactions meet the definition of a business combination. The provisions of the Statement do not apply to transactions between two or more mutual enterprises. In addition, the Statement amends Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The Company has determined that the acquisitions that generated the intangible assets and goodwill on the consolidated balance sheets in the amounts of $10,912 and $11,866 at December 31, 2002 and 2001, respectively, did not constitute the acquisition of a business, and therefore will continue to be amortized. The Financial Accounting Standards Board issued Statement No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of Statement No. 123, in December 2002. The Statement amends Statement No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Finally, this Statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about the effects of stock options in interim financial information. The amendments to Statement No. 123 are effective for financial statements for fiscal years ending December 15, 2002. The amendment to APB No. 28 is effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. Early application is encouraged for both amendments. The Company continues to record stock options under APB Opinion No. 25, Accounting for Stock Issued to Employees, and has not adopted the alternative methods allowable under Statement No. 148. Note 2: Restriction on Cash As members of the Federal Reserve System, the Company's subsidiary banks are required to maintain certain average reserve balances. For the final weekly reporting period in the years ended December 31, 2002 and 2001, the aggregate amounts of daily average required balances approximated $2,092 and $2,458, respectively. 22 Note 3: Securities The amortized cost and fair value of securities available for sale, with gross unrealized gains and losses, follows:
December 31, 2002 Gross Gross Available for sale: Amortized Unrealized Unrealized Costs Gains Losses Fair Value ------------- ------------ ------------- ----------- U.S. Treasury $ 3,748 214 ----- 3,962 U.S. Government agencies and corporations 7,038 94 ---- 7,132 States and political subdivisions 68,876 1,928 112 70,692 Mortgage-backed securities 16,244 565 ---- 16,809 Corporate debt securities 16,993 485 67 17,411 Federal Home Loan Bank stock-restricted 1,655 ---- ---- 1,655 Federal Reserve Bank stock-restricted 209 ---- ---- 209 Other securities 1,670 194 ---- 1,864 ------------- ------------ ------------- ----------- Total securities available for sale $116,433 3,480 179 119,734 ============= ============ ============= ===========
December 31, 2001 Gross Gross Available for sale: Amortized Unrealized Unrealized Costs Gains Losses Fair Value ------------- ------------ ------------- ----------- U.S. Treasury $ 6,248 242 --- 6,490 U.S. Government agencies and corporations 5,340 43 8 5,375 States and political subdivisions 51,030 605 446 51,189 Mortgage-backed securities 13,178 306 69 13,415 Corporate debt securities 9,066 143 116 9,093 Federal Home Loan Bank stock-restricted 1,411 --- --- 1,411 Federal Reserve Bank stock-restricted 209 --- --- 209 Other securities 1,328 157 --- 1,485 ------------- ------------ ------------- ----------- Total securities available for sale $87,810 1,496 639 88,667 ============= ============ ============= ===========
The amortized cost and fair value of single maturity securities available for sale at December 31, 2002, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities included in these totals are categorized by final maturity at December 31, 2002. Amortized Costs Fair Values --------------- --------------- Due in one year or less $ 6,615 $ 6,727 Due after one year through five years 16,709 17,396 Due after five years through ten years 42,828 44,022 Due after ten years 47,382 48,496 No maturity 2,899 3,093 --------------- --------------- $ 116,433 $ 119,734 =============== =============== 23 The amortized cost and fair value of securities held to maturity, with gross unrealized gains and losses, follows:
December 31, 2002 Gross Held to maturity: Amortized Unrealized Gross Unrealized Costs Gains Losses Fair Value ------------- ---------------- ------------------- ----------------- U.S. Government agencies and corporations $ 10,013 193 ---- 10,206 States and political subdivisions 52,610 1,693 48 54,255 Mortgage-backed securities 8,989 399 --- 9,388 Corporate debt securities 27,948 1,473 83 29,338 ------------- ---------------- ------------------- ----------------- Total securities held to maturity $ 99,560 3,758 131 103,187 ============= ================ =================== =================
December 31, 2001 Gross Held to maturity: Amortized Unrealized Gross Unrealized Costs Gains Losses Fair Value ------------- ---------------- ------------------- ----------------- U.S. Government agencies and corporations $ 17,025 95 29 17,091 States and political subdivisions 49,230 319 381 49,168 Mortgage-backed securities 13,723 123 150 13,696 Corporate debt securities 22,831 579 131 23,279 ------------- ---------------- ------------------- ----------------- Total securities held to maturity $ 102,809 1,116 691 103,234 ============= ================ =================== =================
The amortized cost and fair value of single maturity securities held to maturity at December 31, 2002, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities included in these totals are categorized by final maturity at December 31, 2002. Amortized Fair Costs Values ---------------- ------------- Due in one year or less $ 4,153 $ 4,229 Due after one year through five years 27,442 28,572 Due after five years through ten years 39,250 40,840 Due after ten years 28,715 29,546 $ 99,560 $103,187 ================ ============= At December 31, 2002 and 2001, securities with a carrying value of $31,170 and $30,800, respectively, were pledged to secure trust deposits and for other purposes as required or permitted by law. As members of the Federal Reserve and the Federal Home Loan Bank (FHLB) of Atlanta, NBB and BTC are required to maintain certain minimum investments in the common stock of those entities. Required levels of investment are based upon NBB and BTC's capital and a percentage of qualifying assets. In addition, NBB and BTC are eligible to borrow from the FHLB with borrowings collateralized by qualifying assets, primarily residential mortgage loans totaling approximately $97,769, and NBB and BTC's capital stock investment in the FHLB. 24 Note 4: Loans to Officers and Directors In the ordinary course of business, the Company, through its banking subsidiaries, has granted loans to executive officers and directors of Bankshares and its subsidiaries amounting to $5,505 at December 31, 2002 and $5,782 at December 31, 2001. During the year ended December 31, 2002 total principal additions were $4,769 and principal payments were $5,046. Note 5: Allowance for Loan Losses An analysis of the allowance for loan losses follows:
Years ended December 31, 2002 2001 2000 ------------ ------------ ------------ Balance at beginning of year $ 4,272 3,886 3,231 Provision for loan losses 2,251 1,408 1,329 Loans charged-off (1,571) (1,128) (770) Recoveries of loans previously charged-off 140 106 96 ------------ ------------ ------------ Balance at end of year $ 5,092 4,272 3,886 ============ ============ ============
The following is a summary of information pertaining to impaired loans: December 31, 2002 2001 ---------- ---------- Impaired loans without a valuation allowance $ 46 275 Impaired loans with a valuation allowance 93 65 ---------- ---------- Total impaired loans $ 139 340 ========== ========== Valuation allowance related to impaired loans $ 33 39 ========== ========== Years ended December 31, 2002 2001 2000 ---------- ----------- ---------- Average investment in impaired loans $ 397 671 657 Interest income recognized on impaired loans 11 57 43 Interest income recognized on a cash basis on impaired loans --- --- --- ---------- ----------- ---------- No additional funds are committed to be advanced in connection with impaired loans. Nonaccrual loans excluded from impaired loan disclosure under FASB 114 at December 31, 2002 and 2001 were $166 and $59, respectively. If interest on these loans had been accrued, such income would have been $16 and $4 respectively. No nonaccrual loans were excluded from impaired loans, disclosed under FASB 114, at December 31, 2000. Loans past due greater than 90 days which continue to accrue interest totaled $977 and $980 at December 31, 2002 and 2001, respectively. 25 Note 6: Premises and Equipment A summary of the cost and accumulated depreciation of premises and equipment follows: December 31, 2002 2001 -------------- -------------- Premises $ 11,193 11,051 Furniture and equipment 7,772 7,435 Construction-in-progress 254 13 -------------- -------------- 19,219 18,499 Accumulated depreciation (9,281) (8,367) -------------- -------------- $ 9,938 10,132 ============== ============== Depreciation expense for the years ended December 2002, 2001 and 2000 amounted to $977, $1,106 and $1,015, respectively. The Company leases branch facilities under noncancellable operating leases. The future minimum lease payments under these leases (with initial or remaining lease terms in excess of one year) as of December 31, 2002 are as follows: $282 in 2003, $282 in 2004, $277 in 2005, $272 in 2006, $274 in 2007, and $1,269 thereafter. Note 7: Deposits The aggregate amount of time deposits in denominations of $100 or more at December 31, 2002 and 2001 was $89,261 and $77,214, respectively. At December 31, 2002 the scheduled maturities of time deposits are as follows: -------------------------- ------------------------------ For the year 2003 $ 208,990 2004 52,483 2005 21,140 2006 7,452 2007 29,441 Thereafter 561 ------------------------------ $ 320,067 ============================== At December 31, 2002 and 2001, overdraft demand deposits reclassified to loans totaled $407 and $703, respectively. Note 8: Employee Benefit Plans Pension Plans Effective January 1, 2002, the NBB plan was amended, restated, and renamed The National Bankshares, Inc. Retirement Income Plan. At the same time, the BTC plan was merged into it, and National Bankshares, Inc. and National Bankshares Financial Services, Inc. were added as participating employers in the pension plan. The merged NBI plan did not alter the eligibility standards of the bank plans, and substantially all employees are covered. The merged NBI plan benefit formula is still based upon the length of service of retired employees and a percentage of qualified W-2 compensation during their final years of employment. The pension plan's assets are invested principally in U.S. Government agency obligations (21%), mutual funds (24%), corporate bonds (24%), equity securities (23%) and cash (8%). Information pertaining to activity in the plans is as follows: 26
December 31, 2002 2001 2000 ------------- ------------ -------------- Change in benefit obligation: Benefit obligation at beginning of year $ 6,014 5,668 5,694 Service cost 353 422 354 Interest cost 429 422 425 Actuarial (gain) loss 593 (53) (142) (Gain) due to plan amendment (89) --- --- Benefits paid (222) (445) (663) ------------- ------------ -------------- Benefit obligation at end of year 7,078 6,014 5,668 ============= ============ ============== Change in plan assets: Fair value of plan assets at beginning of year 4,650 4,692 4,877 Actual return on plan assets (239) 55 202 Employer contribution 315 348 276 Benefits paid (222) (445) (663) ------------- ------------ -------------- Fair value of plan assets at end of year 4,504 4,650 4,692 ------------- ------------ -------------- Funded status: (2,574) (1,364) (976) Unrecognized net actuarial loss 2,177 931 610 Unrecognized prior service cost 73 171 186 Unrecognized transition asset (100) (114) (137) ------------- ------------ -------------- Net accrued pension cost (includes accrued) $ (424) (376) (317) ============= ============ ==============
Amounts recognized in the consolidated balance sheets:
Years ended December 31, 2002 2001 2000 -------------- --------------- ---------------- Accrued benefit liabilities $ (1,113) (376) (317) Intangible asset 73 --- --- Deferred tax asset 235 --- --- Accumulated other comprehensive income 381 --- --- -------------- --------------- ---------------- Net amount recognized $ (424) (376) (317) ============== =============== ================
The components of net periodic cost are as follows:
Years ended December 31, 2002 2001 2000 -------------- --------------- --------------- Service cost $ 353 422 354 Interest cost 429 422 424 Expected return on plan assets (427) (434) (441) Amortization of prior service cost 9 15 15 Recognized net actuarial loss 12 5 8 Amortization of transition asset (13) (23) (23) -------------- --------------- --------------- Net periodic benefit cost $ 363 407 337 ============== =============== ===============
27 The actuarial assumptions are as follows: 2002 2001 2000 --------- --------- --------- Weighted average assumptions as of December 31 Weighted average discount rate 7.00% 7.50% 7.50% Expected return on plan assets 9.00% 9.00% 9.00% Rate of compensation increase 4.00% 5.00% 5.00% 401(k) Plan The Company has a Retirement Accumulation Plan qualifying under IRS Code Section 401(k), in which Bankshares, NBB, BTC, and NSFS are participating employers. Eligible participants in the plan can contribute up to 100% of their total annual compensation to the plan. Employee contributions are matched by the employer based on a percentage of an employee's total annual compensation contributed to the plan. For the years ended December 31, 2002, 2001 and 2000 NBB and BTC contributed $227, $196 and $156 respectively to the plan. Employee Stock Ownership Plan Bankshares has a nonleveraged Employee Stock Ownership Plan (ESOP) which enables employees of Bankshares and its subsidiaries who have one year of service and who have attained the age of 21 prior to the plan's January 1 and July 1 enrollment dates to own Bankshares common stock. Contributions to the ESOP are determined annually by the Board of Directors. Contribution expense amounted to $227, $179 and $162 for the years ended December 31, 2002, 2001 and 2000, respectively. Dividends on ESOP shares are charged to retained earnings. As of December 31, 2002, the number of allocated shares held by the ESOP was 89,098 and the number of unallocated shares was 8,468. All shares held by the ESOP are treated as outstanding in computing the Company's basic net income per share. Upon reaching age 55 with ten years of plan participation, a vested participant has the right to diversify 50% of his or her allocated ESOP shares and Bankshares or the ESOP, with the agreement of the Trustee, would be obligated to purchase those shares. The ESOP contains a put option which allows a withdrawing participant to require Bankshares or the ESOP, if the plan administrator agrees, to purchase his or her allocated shares if the shares are not readily tradable on an established market at the time of its distribution. Note 9: Stock Option Plan The Company has adopted the National Bankshares, Inc. 1999 Stock Option Plan to give key employees of Bankshares and its subsidiaries an opportunity to acquire shares of National Bankshares, Inc. common stock. The purpose of the 1999 Stock Option Plan is to promote the success of Bankshares and its subsidiaries by providing an incentive to key employees that enhances the identification of their personal interest with the long term financial success of the Company and with growth in stockholder value. Under the 1999 Stock Option Plan, up to 250,000 shares of Bankshares common stock may be granted. The 1999 Stock Option Plan is administered by the Stock Option Committee, which is made up of all of the non-employee, outside directors of National Bankshares, Inc. The Stock Option Committee may determine whether options are incentive stock options or nonqualified stock options and may determine the other terms of grants, such as number of shares, term, a vesting schedule, and the exercise price. The 1999 Stock Option Plan limits the maximum term of any option granted to ten years, states that options may be granted at not less than fair market value on the date of the grant and contains certain other limitations on the exercisability of incentive stock options. The options vest 25% after one year, 50% after two years, 75% after three years and 100% after four years. At the discretion of the Stock Option Committee, options may be awarded with the provision that they may be accelerated upon a change of control, merger, consolidation, sale or dissolution of National Bankshares, Inc. At December 31, 2002, there were 198,500 additional shares available for grant under the Plan. 28 A summary of the status of the Company's stock option plan is presented below:
2002 2001 2000 Weighted Weighted Weighted Average Average Average Number of Exercise Number of Exercise Number of Exercise Shares Price Shares Price Shares Price -------------- ------------ ------------ ------------ ---------- ----------- Outstanding, beginning of year 34,000 $ 21.18 18,000 $ 19.57 5,500 $ 22.00 Granted 17,500 29.65 16,000 23.00 12,500 18,50 Exercised --- --- --- --- --- --- Forfeited --- --- --- --- --- --- Expired --- --- --- --- --- --- -------------- ------------ ------------ ------------ ---------- ----------- Outstanding, end of year 51,500 $ 24.06 34,000 $ 21.18 18,000 $ 19.57 ============== ============ ============ ============ ========== =========== Options exercisable at year-end 14,375 $ 20.76 5,875 $ 20.14 1,375 $ 22.00 Weighted-average fair value of options granted during the year $ 5.97 $ 4.89 $ 3.90 -------------- ------------ ------------ ------------ ---------- -----------
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: Years Ended December 31 2002 2001 2000 ----------------- ----------------- ----------------- Dividend yield 1.88% 1.86% 1.79% Expected life 10 years 10 years 10 years Expected volatility 22.14% 22.77% 19.52% Risk-free interest rate 4.31% 4.48% 5.12% Information pertaining to options outstanding at December 31, 2002 is as follows:
Options Outstanding Options Exercisable Remaining Range of Number Weighted Average Number Weighted Average Contractual Life Exercise Price Outstanding Exercise Price Exercisable Exercise Price - ------------------ ----------------- ----------------- ------------------ ------------------ ----------------- 9.83 years $ 29.65 17,500 $ 29.65 --- $ --- 8.83 years 23.00 16,000 23.00 4,000 23.00 7.83 years 18.50 12,500 18.50 6,250 18.50 6.83 years 22.00 5,500 22.00 4,125 22.00 - ------------------ ----------------- ----------------- ------------------ ------------------ -----------------
Note 10: Income Taxes Allocation of income tax expense between current and deferred portions is as follows: Years ended December 31, 2002 2001 2000 ----------- ----------- ----------- Current $ 3,554 $ 2,451 3,016 Deferred (551) (166) (253) ----------- ----------- ----------- Total income tax expense $ 3,003 $ 2,285 2,763 =========== =========== =========== 29 The following is a reconciliation of the "expected" income tax expense, computed by applying the U.S. Federal income tax rate of 34% to income before income tax expense, with the reported income tax expense: Years ended December 31, 2002 2001 2000 ------------ ---------- ---------- Computed "expected" income tax expense $ 4,426 $ 3,264 $3,424 Tax-exempt interest income (1,652) (1,239) (862) Nondeductible interest expense 191 220 168 Other, net 38 40 33 ------------ ---------- ---------- Reported income tax expense $ 3,003 $2,285 2,763 ============ ========== ========== The components of the net deferred tax asset, included in other assets, are as follows:
December 31, 2002 2001 -------------- -------------- Deferred tax assets: Allowance for loan losses and unearned fee income $ 1,514 $ 1,155 Valuation allowance on other real estate owned 14 21 Deferred compensation and other liabilities 349 119 Deposit intangibles and goodwill 87 78 Community development corporation related tax credit 8 11 Other --- 9 1,972 1,393 Deferred tax liabilities: Net unrealized losses on securities available for sale (1,122) (292) Fixed assets (71) (71) Discount accretion on securities (94) (72) Accrued late fee income --- (24) Other (94) (64) -------------- -------------- (1,381) (523) -------------- -------------- Net deferred tax asset $ 591 $ 870 ============== ==============
The Company has determined that a valuation allowance for the gross deferred tax assets is not necessary at December 31, 2002 and 2001 due to the fact that the realization of the entire gross deferred tax assets can be supported by the amount of taxes paid during the carryback period available under current tax laws. Note 11: Restrictions on Dividends Bankshares' principal source of funds for dividend payments is dividends received from its subsidiary banks. For the years ended December 31, 2002, 2001, and 2000, dividends received from subsidiary banks were $3,406, $3,761 and $2,987, respectively. Substantially all of Bankshares' retained earnings are undistributed earnings of its banking subsidiaries, which are restricted by various regulations administered by federal and state bank regulatory agencies. Bank regulatory agencies restrict, without prior approval, the total dividend payments of a bank in any calendar year to the bank's retained net income of that year to date, as defined, combined with its retained net income of the preceding two years, less any required transfers to surplus. At December 31, 2002, retained net income, which was free of such restriction, amounted to approximately $14,410. 30 Note 12: Minimum Regulatory Capital Requirements The Company (on a consolidated basis) and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Banks' financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Banks to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002 and 2001, that the Company and the Banks meet all capital adequacy requirements to which they are subject. As of December 31, 2002, the most recent notifications from the appropriate regulatory authorities categorized the Company and the Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since these notifications that management believes have changed the Company's and the Banks' category. The Company's and the Banks' actual capital amounts and ratios as of December 31, 2002 and 2001 are also presented in the following tables.
To Be Well Capitalized Under Prompt Minimum Capital Corrective Action Actual Requirement Provisions ---------------------- --------------------- ------------------------ Amount Ratio Amount Ratio Amount Ratio ----------- ---------- ---------- ---------- ----------- ------------ December 31, 2002 Total capital (to risk weighted assets) Bankshares consolidated $65,525 13.8% 37,980 8.0% N/A N/A NBB 36,370 13.5% 21,518 8.0% 26,897 10.0% BTC 25,808 12.8% 16,183 8.0% 20,229 10.0% Tier 1 capital (to risk weighted assets) Bankshares consolidated $60,433 12.7% 18,990 4.0% N/A N/A NBB 33,398 12.4% 10,759 4.0% 16,138 6.0% BTC 23,688 11.7% 8,092 4.0% 12,138 6.0% Tier 1 capital (to average assets) Bankshares consolidated $60,433 9.0% 26,791 4.0% N/A N/A NBB 33,398 8.9% 14,924 4.0% 18,655 5.0% BTC 23,688 8.1% 11,632 4.0% 14,541 5.0% ----------- ---------- ---------- ---------- ----------- ------------
31
To Be Well Capitalized Under Prompt Minimum Capital Corrective Action Actual Requirement Provisions ---------------------- --------------------- ------------------------ Amount Ratio Amount Ratio Amount Ratio ----------- ---------- ---------- ---------- ----------- ------------ December 31, 2001 Total capital (to risk weighted assets) Bankshares consolidated $57,231 12.9% 35,511 8.0% N/A N/A NBB 31,383 12.5% 20,150 8.0% 25,188 10.0% BTC 22,567 11.9% 15,105 8.0% 18,881 10.0% Tier 1 capital (to risk weighted assets) Bankshares consolidated $52,959 11.9% 17,756 4.0% N/A N/A NBB 28,781 11.4% 10,075 4.0% 15,113 6.0% BTC 20,897 11.1% 7,553 4.0% 11,329 6.0% Tier 1 capital (to average assets) Bankshares consolidated $52,959 8.4% 25,160 4.0% N/A N/A NBB 28,781 8.3% 13,927 4.0% 17,409 5.0% BTC 20,897 7.5% 11,079 4.0% 13,849 5.0% ----------- ---------- ---------- ---------- ----------- ------------
Note 13: Condensed Financial Statements of Parent Company Financial information pertaining only to Bankshares (Parent) is as follows: Consolidated Balance Sheets December 31, 2002 2001 -------------- ------------- Assets: Cash due from subsidiaries $ 40 76 Securities available for sale 2,913 2,879 Investment in subsidiaries, at equity 70,298 62,428 Refundable income taxes due from subsidiaries --- 29 Other assets 59 29 -------------- ------------- Total assets 73,310 65,457 ============== ============= Liabilities and Stockholders'Equity: Other liabilities $ 209 196 Stockholders' equity 73,101 65,261 -------------- ------------- Total liabilities and stockholders' equity $ 73,310 65,457 ============== ============= 32
Condensed Statements of Income Years Ended December 31, 2002 2001 2000 ------------- ----------- ------------ Income: Dividends from subsidiaries $ 3,406 3,761 2,987 Interest on securities - taxable 27 12 11 Interest on securities - nontaxable 86 91 99 Other income 462 --- 40 Securities gains (losses) 319 (13) (3) ------------- ----------- ------------ 4,300 3,851 3,134 Expenses: Other expenses 798 207 157 ------------- ----------- ------------ Income before income tax benefit (expense) and equity in undistributed net income of subsidiaries 3,502 3,644 2,977 Applicable income tax benefit (expense) (1) 69 36 ------------- ----------- ------------ Income before equity in undistributed net income of subsidiaries 3,501 3,713 3,013 Equity in undistributed net income of subsidiaries 6,513 3,601 4,296 ------------- ----------- ------------ Net income $ 10,014 7,314 7,309 ============= =========== ============
Condensed Statements of Cash Flows
Years ended December 31, 2002 2001 2000 --------------- ------------- -------------- Cash Flows from Operating Activities: Net income $ 10,014 $ 7,314 7,309 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiaries (6,513) (3,601) (4,296) Amortization of premiums and accretion of discounts, net 5 5 6 Securities (gains) losses (319) 13 3 Net change in refundable income taxes due from subsidiaries --- (18) 48 Net change in other assets (29) 3 (34) Net change in other liabilities 12 102 10 --------------- ------------- -------------- Net cash provided by operating activities 3,170 3,818 3,046 --------------- ------------- -------------- Cash Flows from Investing Activities: Purchases of securities available for sale (730) (777) (529) Proceeds from sales of securities available for sale 827 --- 30 Calls of securities available for sale 103 25 562 --------------- ------------- -------------- Net cash provided by (used in) investing activities 200 (752) 63 --------------- ------------- -------------- Cash Flows from Financing Activities: Cash dividends paid (3,406) (3,020) (2,987) Common stock repurchase --- (8) (89) --------------- ------------- -------------- Net cash used in financing activities (3,406) (3,028) (3,076) --------------- ------------- -------------- Net change in cash (36) 38 33 Cash due from subsidiaries at beginning of year 76 38 5 --------------- ------------- -------------- Cash due from subsidiaries at end of year $ 40 76 38 =============== ============= ==============
33 Note 14: Financial Instruments with Off-Balance Sheet Risk The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The Company's exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company may require collateral or other security to support the following financial instruments with credit risk. At December 31, 2002, and 2001, financial instruments were outstanding whose contract amounts represent credit risk: December 31, 2002 2001 --------------- --------------- Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 64,788 78,749 Standby letters of credit 7,153 6,045 Mortgage loans sold with potential recourse 37,214 27,102 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management's credit evaluation of the customer. Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit. Some of these commitments are uncollateralized and do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. The Company originates mortgage loans for sale to secondary market investors subject to contractually specified and limited recourse provisions. In 2002, the Company originated $36,915 and sold $37,214 to investors, compared to $28,247 originated and $27,102 sold in 2001. Every contract with each investor contains certain recourse language. In general, the Company may be required to repurchase a previously sold mortgage loan if there is major noncompliance with defined loan origination or documentation standards, including fraud, negligence or material misstatement in the loan documents. Repurchase may also be required if necessary governmental loan guarantees are canceled or never issued, or if an investor is forced to buy back a loan after it has been resold as a part of a loan pool. In addition, the Company may have an obligation to repurchase a loan if the mortgagor has defaulted early in the loan term. This potential default period is approximately twelve months after sale of a loan to the investor. The Company maintains cash accounts in other commercial banks. The amount on deposit with correspondent institutions at December 31, 2002 that exceeded the insurance limits of the Federal Deposit Insurance Corporation was $47. Note 15: Concentrations of Credit Risk The Company does a general banking business, serving the commercial and personal banking needs of its customers. NBB's market area, commonly referred to as Virginia's New River Valley and Mountain Empire, consists of Montgomery, Giles and Pulaski Counties and the cities of Radford and Galax, together with portions of adjacent counties. BTC's market area adjoins NBB's and includes the counties of Tazewell, Wythe, Smyth and Washington in Virginia, as well as contiguous portions of McDowell and Mercer Counties in West Virginia. Substantially all of NBB's and BTC's loans are made within their market area. 34 The ultimate collectibility of the banks' loan portfolios and the ability to realize the value of any underlying collateral, if needed, are influenced by the economic conditions of the market area. The Company's operating results are therefore closely correlated with the economic trends within this area. At December 31, 2002 and 2001, approximately $201,639 and $176,667, respectively, of the loan portfolio was concentrated in commercial real estate. This represents approximately 49% and 44% of the loan portfolio at December 31, 2002 and 2001, respectively. Included in commercial real estate at December 31, 2002 and 2001 was approximately $96,674 and $100,640, respectively, in loans for college housing and professional office buildings. Loans secured by residential real estate were approximately $116,337 and $119,437 at December 31, 2002 and 2001, respectively. This represents approximately 28% and 30% of the loan portfolio at December 31, 2002 and 2001 respectively. Loans secured by automobiles were approximately $23,526 and $32,373 at December 31, 2002 and 2001, respectively. This represents approximately 6% of the loan portfolio at December 31, 2002 and 8 % at December 31, 2001. The Company has established operating policies relating to the credit process and collateral in loan originations. Loans to purchase real and personal property are generally collateralized by the related property and with loan amounts established based on certain percentage limitations of the property's total stated or appraised value. Credit approval is primarily a function of collateral and the evaluation of the creditworthiness of the individual borrower or project based on available financial information. Management considers the concentration of credit risk to be minimal. Note 16: Fair Value of Financial Instruments and Interest Rate Risk The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the fair discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company. Loan commitments on which the committed interest rate is less than the current market rate are insignificant at December 31, 2002 and 2001. The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits. The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments: Cash and Due from Banks, Interest-Bearing Deposits, and Federal Funds Sold The carrying amounts approximate fair value. Securities The fair values of securities are determined by quoted market prices or dealer quotes. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments adjusted for differences between the quoted instruments and the instruments being valued. Loans Held for Sale Fair values of loans held for sale are based on commitments on hand from investors or prevailing market prices. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, real estate - commercial, real estate - construction, real estate - mortgage, credit card and other consumer loans. Each loan category is further 35 segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan, as well as estimates for prepayments. The estimate of maturity is based on the Company's historical experience with repayments for loan classification, modified, as required, by an estimate of the effect of economic conditions on lending. Fair value for significant nonperforming loans is based on estimated cash flows which are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information. Deposits The fair value of demand and savings deposits is the amount payable on demand. The fair value of fixed maturity term deposits and certificates of deposit is estimated using the rates currently offered for deposits with similar remaining maturities. Accrued Interest The carrying amounts of accrued interest approximate fair value. Other Borrowed Funds Other borrowed funds, represents treasury tax and loan deposits, and short-term borrowings from the Federal Home Loan Bank. The carrying amount is a reasonable estimate of fair value because the deposits are generally repaid within 120 days from the transaction date. Commitments to Extend Credit and Standby Letters of Credit The only amounts recorded for commitments to extend credit, standby letters of credit and financial guarantees written are the deferred fees arising from these unrecognized financial instruments. These deferred fees are not deemed significant at December 31, 2002 and 2001, and as such, the related fair values have not been estimated. The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows:
December 31, 2002 2001 ----------------------------- ---------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------------- -------------- -------------- ------------- Financial assets: Cash and due from banks $ 12,316 12,316 12,293 12,293 Interest-bearing deposits 18,818 18,818 15,510 15,510 Federal funds sold 1,724 1,724 1,080 1,080 Securities 219,294 222,921 191,476 191,901 Mortgage loans held for sale 846 846 1,145 1,145 Loans, net 404,247 406,844 394,042 457,965 Accrued interest receivable 4,290 4,290 4,917 4,917 Financial liabilities: Deposits $ 608,271 611,448 576,618 577,612 Other borrowed funds 748 748 203 203 Accrued interest payable 700 700 1,101 1,101
Note 17: Branch Acquisitions In a move to improve the Company's competitive position, BTC announced on September 15, 2000 that it would acquire a branch in Bluefield, Virginia from First Union National Bank. The acquisition involved the purchase of approximately $34,000 in deposits and $9,200 in loans. The acquisition was completed in the first quarter of 2001. 36 Selected Quarterly Data (Unaudited) The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2002 and 2001:
2002 -------- First Second Third Fourth Quarter Quarter Quarter Quarter --------------- --------------- -------------- ------------- Income Statement Data: Interest income $ 10,594 10,645 10,760 10,748 Interest expense 4,266 3,960 3,783 3,755 --------------- --------------- -------------- ------------- Net interest income 6,328 6,685 6,977 6,993 Provision for loan losses 646 546 519 540 Noninterest income 1,369 1,546 1,482 1,315 Noninterest expense 4,389 4,348 4,380 4,310 Income taxes 558 790 848 807 --------------- --------------- -------------- ------------- Net income $ 2,104 2,547 2,712 2,651 =============== =============== ============== ============= Per Share Data: Basic net income per share $ 0.60 0.72 0.78 0.75 Cash dividends per share --- 0.46 --- 0.51 Book value per share $ 19.20 19.79 20.80 20.82 Selected Ratios: Return on average assets 1.33% 1.58% 1.65% 1.56% Return on average equity 12.90% 14.92% 15.30% 14.54% Average equity to average assets 10.47% 10.53% 10.63% 10.66%
2001 -------- First Second Third Fourth Quarter Quarter Quarter Quarter --------------- --------------- -------------- ------------- Income Statement Data: Interest income $ 11,381 11,682 11,446 11,018 Interest expense 5,998 6,185 5,695 4,893 --------------- --------------- -------------- ------------- Net interest income 5,383 5,497 5,751 6,125 Provision for loan losses 332 332 377 367 Noninterest income 1,195 1,296 1,312 1,401 Noninterest expense 4,061 4,285 4,176 4,431 Income taxes 569 495 600 621 --------------- --------------- -------------- ------------- Net income $ 1,616 1,681 1,910 2,107 =============== =============== ============== ============= Per Share Data: Basic net income per share $ 0.46 0.48 0.54 0.60 Cash dividends per share --- 0.43 --- 0.43 Book value per share $ 17.91 17.94 18.70 18.59 Selected Ratios: Return on average assets 1.06% 1.04% 1.18% 1.30% Return on average equity 10.54% 10.83% 11.84% 12.69% Average equity to average assets 10.09% 9.63% 9.94% 9.97%
37 Board of Directors National Bankshares, Inc. Board of Directors Picture of "National Bankshares Board of Directors" From left: James G. Rakes, Chairman of the Board, President, Chief Executive Officer, National Bankshares, Inc., President and Chief Executive Officer, The National Bank; President and Treasurer, National Bankshares Financial Services, Inc.; L. Allen Bowman, Vice-Chairman of the Board, Retired; William T. Perry, Retired; Jeffery R. Stewart, Educational Consultant; Paul A. Duncan, President, Holiday Motor Corp.; James A. Deskins, Sr., Retired; James M. Shuler, Delegate, Virginia House of Representatives; Alonzo A. Crouse, Executive Vice President, Secretary, Bank of Tazewell County; Cameron L. Forrester, President and Chief Executive Officer Executive Officer, Bank of Tazewell County. The National Bank Board of Directors Picture of "National Bank Board of Directors" From left: Jeffery R. Stewart, Chairman of the Board, Educational Consultant; L. Allen Bowman, Vice-Chairman of the Board, Retired; Paul A. Duncan, President, Holiday Motor Corp.; James G. Rakes, Chairman, President and Chief Executive Officer, National Bankshares, Inc., President and Chief Executive Officer, The National Bank; President and Treasurer, National Bankshares Financial Services, Inc.; James M. Shuler, Delegate, Virginia House of Representatives; J. Lewis Webb, Jr., Dentist; Ellen G. Burnop, Co-Owner, New River Office Supply; F. Brad Denardo, Executive Vice President/Chief Operating Officer, The National Bank. 38 Bank of Tazewell County Board of Directors Picture of "Bank of Tazewell County Board of Directors Upper row, from left: William T. Perry, Chairman of the Board, Retired; E.P. Greever, Retired; James G. Rakes, Chairman, President and Chief Executive Officer, National Bankshares, Inc., President and Chief Executive Officer, The National Bank; President and Treasurer, National Bankshares Financial Services, Inc.; Jack Harry, President, Harry's Enterprises, Inc.; James G. Gillespie, Jr., President, Jim Sam Gillespie Farm. Lower row, from left: Cameron L. Forrester, President and Chief Executive Officer Executive Officer, Bank of Tazewell County; William H. VanDyke, Vice President, Secretary, Bank of Tazewell County; Charles E. Green, III, Financial Planner, AXA Advisors, L.L.C. The National Bank Adivisory Boards: Montgomery County Advisory Board Dan A. Dodson, W. Clinton Graves, Mary G. Miller, James J. Owens, Robert L. Pack, Arlene A. Saari, James C. Stewart, T. Cooper Via Giles County Adivsory Board Paul B. Collins, John H. Givens, Jr., Robert C. McCracken, Ross E. Martin, Kenneth L. Rakes, Scarlet B. Ratcliffe, Morris D. Reece, H.M. Scanland, Jr. Galax Advisory Board William T. Green, Sr., Jerry R. Mink, Kathy J. Price, James A. Williams, Jr., David F. Wilson Radford/Pulaski County Advisory Board William K. Cunningham, Gary C. Elander, Jack M. Lewis, Jack D. Nunley, Laura B. Turk Bank Of Tazewell County Advisory Boards: Bluefield Advisory Board Michael E. Dye, William H. King, Constance M. Saunders Richlands Advisory Board Steven R. Davis, Marvin D. Harman, Peter M. Mulkey Interstate Advisory Board David P. Carpenter, Andrew J. Hargroves, Keith A. Hungate, A. Susan Keen, David S. Saliba, Steve A. Lester, II, Jimmy A. Stewart 39 Corporate Information National Bankshares, Inc. Executive Officers James G. Rakes, Chairman F. Brad Denardo President and Chief Executive Officer Corporate Officer J. Robert Buchanan Cameron L. Forrester Treasurer Corporate Officer Marilyn B. Buhyoff Secretary and Counsel Annual Meeting The Annual Meeting of Stockholders will be held on Tuesday, April 8, 2003 at 3:00 p.m. at the Best Western Red Lion Inn, 900 Plantation Road, Blacksburg, Virginia. Corporate Stock National Bankshares, Inc. common stock trades on the Nasdaq Stock Market under the symbol "NKSH" Financial Information Investors and analysts seeking financial information about National Bankshares, Inc. should contact: James G. Rakes Chairman, President and Chief Executive Officer (540) 951-6300 or (800) 552-4123 jrakes@nbbank.com Or J. Robert Buchanan Treasurer (540) 951-6300 or (800) 552-4123 bbuchanan@nbbank.com Written requests may be directed to: National Bankshares, Inc. P.O. Box 90002, Blacksburg, VA 24062-9002 Stockholder Services and Stock Transfer Agent Stockholders seeking information about National Bankshares, Inc. stock accounts should contact: Marilyn B. Buhyoff Secretary and Counsel (540) 951-6300 or (800) 552-4123 mbuhyoff@nbbank.com The National Bank of Blacksburg serves as transfer agent National Bankshares, Inc. stock. Written requests and requests for stock transfers may be directed to: National Bankshares, Inc., P.O. Box 90002, Blacksburg, VA 24062-9002 A copy of National Bankshares, Inc.'s annual report to the Securities and Exchange Commission on Form 10-K will be furnished without charge to any stockholder upon written request. Corpporate Office National Bankshares, Inc. 101 Hubbard Street Blacksburg, Virginia 24060 P.O. Box 90002 Blacksburg, Virginia 24062-9002 www.nationalbankshares.com (540) 951-6300 40 EX-21 4 ex21.txt SUBSIDIARIES Exhibit 21 (i) SUBSIDIARIES OF NATIONAL BANKSHARES, INC. 1. The National Bank of Blacksburg a national banking association, with headquarters in Blacksburg, Virginia 2. Bank of Tazewell County Incorporated in Virginia 3. National Bankshares Financial Services, Inc. Incorporated in Virginia d/b/a National Bankshares Investment Services d/b/a National Bankshares Insurance Services EX-23 5 ex23.txt CONSENT OF EXTERNAL AUDITORS Exhibit 23 INDEPENDENT AUDITOR'S CONSENT We consent to the incorporation by reference in Registration Statement No. 333-79979 of National Bankshares, Inc. on Form S-8 of our report, dated January 23, 2003, relating to the consolidated balance sheets of National Bankshares, Inc and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years ended December 31, 2002, 2001 and 2000 appearing in this Annual Report on Form 10-K of National Bankshares, Inc. for the year ended December 31, 2002. /s/ Yount, Hyde & Barbour, P.C. Winchester, Virginia March 31, 2003 EX-99 6 ex99b.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER Exhibit 99 (b) CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 In connection with the Form 10-K of National Bankshares, Inc. for the year ended December 31, 2002, I, J. Robert Buchanan, Treasurer (Chief Financial Officer) of National Bankshares, Inc., hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to the best of my knowledge and belief, that: (1) such Form 10-K for the year ended December 31, 2002, fully complies with the requirements of section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and (2)the information contained in such Form 10-K for the year ended December 31, 2002, fairly presents, in all material respects, the financial condition and results of operations of National Bankshares, Inc. /s/ J. Robert Buchanan - --------------------------- J. Robert Buchanan Treasurer (Chief Financial Officer) EX-99 7 ex99a.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER Exhibit 99 (a) CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 In connection with the Form 10-K of National Bankshares, Inc. for the year ended December 31, 2002, I, James G. Rakes, President and Chief Executive Officer of National Bankshares, Inc., hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to the best of my knowledge and belief, that: (1) such Form 10-K for the year ended December 31, 2002, fully complies with the requirements of section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and (2)the information contained in such Form 10-K for the year ended December 31, 2002, fairly presents, in all material respects, the financial condition and results of operations of National Bankshares, Inc. /s/ James G. Rakes - --------------------------- James G. Rakes Chairman President and Chief Executive Officer EX-10 8 ex10denardo.txt CHANGE IN CONTROL AGREEMENT DENARDO CHANGE IN CONTROL AGREEMENT THIS CHANGE IN CONTROL AGREEMENT (the "Agreement") is entered into as of the 8th day of January, 2003 (the "Effective Date"), by and between National Bankshares, Inc. ("NBI") and F. Brad Denardo ("Employee"). W I T N E S S E T H: WHEREAS, Employee heretofore has been employed as Corporate Officer of NBI and Executive Vice President and Chief Operating Officer of its wholly owned subsidiary, the National Bank of Blacksburg (the "Employer"), and in such position he or she has provided leadership and guidance in the growth and development of the business of NBI and its subsidiaries; and, WHEREAS, Employee's experience and knowledge of Employer's operations, customers and affairs is a benefit to the continuation and growth of Employer's business; and, for that reason, NBI desires to retain Employee's services as an employee of the Employer; and, WHEREAS, as an inducement to Employee's continued employment, NBI has agreed to provide for certain payments to Employee in the event of a termination of Employee's employment with the Employer under certain circumstances in conjunction with a change in control of NBI, and, to set forth the terms and conditions of that arrangement, NBI and Employee desire to enter into this Agreement. NOW, THEREFORE, in consideration of the premises and mutual promises, covenants and conditions hereinafter set forth, and for other good and valuable considerations, the receipt and sufficiency of which hereby are acknowledged, NBI and Employee hereby agree as follows: 1. Effective Date of Agreement. This Agreement shall be effective on the Effective Date set out above and shall remain in effect until terminated as provided herein. 2. Payment in Certain Events. If at the effective time of a "Change in Control" (as defined below) or any time within two years and 60 days following a Change in Control (A) Employer terminates Employee's employment other than for "Cause" (as defined below), or, (B) a "Termination Event" (as defined below) occurs and, thereafter, Employee voluntarily terminates his or her own employment with Employer in the manner described below, then (subject to the limitations set forth herein) Employee shall be entitled to receive from NBI, and NBI shall be obligated to pay or cause to be paid to Employee, an amount equal to two times the Employee's average annual compensation includable in the 58 Employee's annual gross income for federal income tax purposes for the five (5) most recent taxable years ending before the date on which the Change in Control occurs. If Employee's employment is terminated by Employer Without Cause (as defined below) prior to the effective time of a Change in Control but following the date on which NBI's board of directors takes action to approve an agreement (including any definitive agreement or an agreement in principle) relating to a Change in Control, then for purposes of this Agreement, such termination of employment shall be deemed to occur at the effective time of the Change in Control. Otherwise, if Employee's employment is terminated prior to the effective time of a Change in Control, Employee shall have no rights hereunder. Amounts payable under this Section 2 shall be paid, at Employee's option, either in (a) a lump sum within 45 days following the Termination Date (as defined below) or (b) up to six (6) equal monthly installments without interest which shall commence on the 45th day following the Termination Date and on the same day of each consecutive month thereafter, until fully paid. 3. Definitions. For purposes of this Agreement: (A) a "Change in Control" shall be deemed to have occurred and be effective at the time: (i) of the acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act') of beneficial ownership (within the meaning of Rule 13d-3 under the Exchange Act), of securities of NBI representing 20% or more of the combined voting power of the then outstanding securities; provided, however, that the following acquisitions shall not constitute a Change in Control: (a) any acquisition directly from NBI (excluding an acquisition by virtue of the exercise of a conversion privilege); (b) any acquisition by NBI; (c) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by NBI or any corporation controlled by NBI; or (d) any acquisition pursuant to a reorganization, merger or consolidation by any corporation owned or proposed to be owned, directly or indirectly, by NBI's shareholders if NBI's shareholders' ownership of securities of the corporation resulting from such transaction constitutes a majority of the ownership of securities of the resulting entity and at least a majority of the members of the board of directors of the corporation resulting from such transaction were members of the Incumbent Board as defined in this Agreement at the time of the execution of the initial agreement providing for such reorganization, merger or consolidation; or 59 (ii) when individuals who, as of the inception of this Agreement, constitute the board of directors of NBI (the "Incumbent Board") cease for any reason to constitute at least a majority of such board of directors; provided, however, that any individual becoming a director subsequent to the Effective Date whose election, or nomination for election by the shareholders was approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of either an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than a member of the NBI board of directors; or (iii) NBI consummates, (a) a merger, statutory share exchange, or consolidation of NBI with any other corporation, except as provided in Subsection 3(A)(i)(d), or (b) the sale or other disposition of all or substantially all of the assets of NBI. (B) All references to "NBI" shall include any "Successor" to NBI which shall have assumed and become liable for NBI's obligations hereunder (whether such assumption is by agreement, operation of law or otherwise). "Successor" refers to any person or entity (corporate or otherwise) into which NBI (or any such Successor) shall be merged or consolidated or to which all or substantially all of NBI's (or any such Successor's) assets shall be transferred in any manner. (C) For purposes of this Agreement, a "Termination Event" shall be deemed to have occurred if, within two years and 60 days following a Change in Control Employee terminates his or her employment with Employer for Good Reason (as defined below). (D) "Without Cause" shall mean the termination of Employee's employment which does not occur by virtue of Employee's death, Retirement or pursuant to a Determination of Long Term Incapacity, or by Employer With Cause or by Employee for Good Reason or for Other than Good Reason; (E) "Cause" or "with Cause" shall mean: (i) continual or deliberate neglect by Employee in the performance of his material duties and responsibilities or the Employee's willful failure to follow reasonable instructions or policies of Employer after 60 being notified of such failure and being given a reasonable opportunity and period (as determined by Employer) to remedy such failure; (ii) with respect to Employee, conviction of, indictment for (or its procedural equivalent), entering of a guilty plea or plea of no contest with respect to a felony, a crime of moral turpitude or any other crime with respect to which imprisonment is a possible punishment, or the commission of an act of embezzlement or fraud; (iii) any breach or violation by Employee in any material respect of any code or standard of behavior generally applicable to employees of Employer, after being advised in writing of such breach or violation and being given a reasonable opportunity and period (as determined by Employer) to remedy such breach or violation; (iv) dishonesty of Employee in any aspect of his or her employment, or breach of a fiduciary duty to Employer or to Employer's parent or any of its subsidiaries or affiliates; (v) the willful engaging by Employee in conduct that is reasonably likely to result, in the good faith judgment of Employer, in material injury to Employer or Employer's parent, or any of its subsidiaries or affiliates, monetarily or otherwise; (vi) the violation by Employee of any applicable federal or state law, or any applicable rule, regulation, order or statement of policy promulgated by any governmental agency or authority having jurisdiction over Employer, its parent or any of its affiliates or subsidiaries (a "Regulatory Authority," including without limitation the Federal Deposit Insurance Corporation, the Virginia Bureau of Financial Institutions, Office of the Comptroller of the Currency, the Federal Reserve Board, the Securities and Exchange Commission or any other regulatory agency), which results from Employee's negligence, willful misconduct or intentional disregard of such law, rule, regulation, order or policy statement and results in any substantial damage, monetary or otherwise, to Employer, its parent or any of its affiliates or subsidiaries or to their reputation; (vii) the conviction of Employee of any felony or any criminal offense involving dishonesty or breach of trust, or the occurrence of any event described in Section 19 of the Federal Deposit Insurance Act or any other event or circumstance which disqualifies Employee from serving as an employee or executive officer of, or a party affiliated with, Employer, its parent or any of its affiliates or subsidiaries; or, in the event Employee becomes unacceptableto, or is removed, suspended or prohibited from participating in the conduct of the affairs of Employer, its parent or any of its affiliates or subsidiaries (or if proceedings for that purpose are commenced) by, any Regulatory Authority; or 61 (viii) the exclusion of Employee by the carrier or underwriter from coverage under Employer's then current "blanket bond" or other fidelity bond or insurance policy covering its or their directors, officers or employees, or the occurrence of any event which Employer believes, in good faith, will result in Employee being excluded from such coverage, or having coverage limited as to Employee as compared to other covered officers or employees, pursuant to the terms and conditions of such "blanket bond" or other fidelity bond or insurance policy. (F) "Good Reason" shall mean the following occurrences after the effective time of a Change in Control: (i) the continued assignment to the Employee of duties inconsistent with the Employee's position, authority, duties or responsibilities immediately prior to the Change in Control; (ii) a substantial reduction in the status of the Employee, including a diminution in his position, authority, duties or responsibilities, excluding for this purpose an isolated, insubstantial and/or inadvertent action not taken in had faith and which is remedied by Employer promptly after receipt of notice thereof given by the Employee; (iii) the relocation of Employee to a principal place of employment located more than 50 miles from Employee's principal place of employment immediately preceding the Change in Control, without Employee's express written consent to such relocation; (iv) any failure by a Successor expressly to assume all of NBI's liabilities, duties and obligations hereunder; (v) a reduction in the Employee's annual base salary rate below the annual rate in effect immediately preceding the effective time of the Change in Control or as the same shall have been increased from time to time following such effective time; (vi) a reduction in the level, scope or coverage of Employee's life insurance, medical or hospitalization insurance, disability insurance or similar plans or benefits (including any retirement plan) from that being provided by Employer to Employee immediately preceding the effective time of the Change in Control or any such insurance, plans or benefits are eliminated without being replaced with substantially similar plans or benefits, unless such reduction or elimination applies proportionately to all salaried employees of Employer who participated in such plans or benefits immediately prior to such Change in Control; or 62 (vii) anything in this Agreement to the contrary notwithstanding, a termination by Employee for any reason during the thirty (30) day period immediately following the first anniversary of a Change in Control shall be deemed to be a termination for Good Reason for all purposes of this Agreement. Any good faith (meaning honesty-in-fact) determination of Good Reason, based on one or more of the foregoing, made by the Employee shall be conclusive. (G) "Other than Good Reason" shall mean any termination by the Employee which is not for Good Reason or Retirement shall be deemed a termination for Other than Good Reason. (H) "Retirement" shall mean the Employee's retirement on or after the Employee's normal retirement date under the terms of the National Bankshares Retirement Income Plan (or any successor or substitute plan or plans of NBI). (I) "Determination of Long Term Incapacity" shall mean a good faith determination by Employer that, as a result of mental or physical illness or injury the Employee has failed to perform his assigned duties with Employer on a full time basis for a period exceeding twelve (12) consecutive months. (J) "Termination Date" means the effective date as of which the Employee's employment with Employer is terminated, giving rise to a payment obligation under Section 2. 4. Possible Reduction in Payment and Benefits. Following any Change in Control, to the extent that any amount of pay or benefits provided under to Employee under this Agreement would cause Employee to be subject to excise tax under sections 280G and 4999 of the Internal Revenue Code of 1986, as amended (the "Code"), and after taking into consideration all other amounts payable to Employee under other NBI or Employer plans, programs, policies, and arrangements, then the amount of pay and benefits provided under this Agreement shall be reduced to the extent necessary to avoid imposition of any such excise taxes. Employee may select the payments and benefits to be limited or reduced, including an election not to have the vesting of certain benefits, including stock options, accelerate as a result of a Change in Control. 5. Legal Fees and Costs. Except as otherwise provided herein, NBI will pay or reimburse Employee for all costs and expenses, including without limitation court costs and reasonable attorneys' fees and expert witness fees and expenses, incurred by Employee in seeking to obtain or enforce by legal proceeding any right or benefit provided by this Agreement, in each case provided Employee's claim is substantially upheld by a court of competent jurisdiction. 63 6. Documents. All documents, record, tapes and other media of any kind or description relating to the business of NBI or any of its subsidiaries and affiliates (the "Documents"), whether or not prepared by Employee, shall be the sole and exclusive property of NBI. The Documents (and any copies) shall be returned to NBI upon Employee's termination of employment for any reason or at such earlier time or times as NBI may specify. 7. Regulatory Requirements. Notwithstanding anything contained in this Agreement to the contrary, it is understood and agreed that NBI (or any of its Successors) shall not be required to make any payment or take any action under this Agreement if: (A) NBI or Employer is declared by any Regulatory Authority to be insolvent, in default or operating in an unsafe or unsound manner, or if (B) in the opinion of counsel to NBI or Employer such payment or action (i) would be prohibited by or would violate any provision of state or federal law applicable to NBI or Employer, including without limitation the Federal Deposit Insurance Act, as now in effect or hereafter amended, (ii) would be prohibited by or would violate any applicable rules, regulations, orders or formal statements of policy, whether now existing or hereafter promulgated, of any Regulatory Authority, or (iii) otherwise is prohibited by any Regulatory Authority. 8. Termination of Agreement. This Agreement automatically shall terminate and become null and void upon any termination of Employee's employment with Employer other than a termination of employment which results in NBI's payment obligation provided for under Section 2 above. Following any such termination of this Agreement, it shall be of no further force or effect and Employee shall have no further rights hereunder. 9. Severability. If any provision of this Agreement, or part thereof, is determined to be unenforceable for any reason whatsoever, it shall be severable from the remainder of this Agreement and shall not invalidate or affect the other provisions of this Agreement, which shall remain in full force and effect arid shall be enforceable according to their terms. No covenant shall be dependent upon any other covenant or provision herein, each of which stands independently. 10. Modification. The parties expressly agree that should a court find any provision of this Agreement, or part thereof, to be unenforceable or unreasonable, the court may modify the provision, or part thereof, in a manner which renders that provision reasonable, enforceable, and in conformity with the public policy of Virginia. 64 11. Governing Law. This agreement shall be governed by and construed in accordance with the laws of the Commonwealth of Virginia. 12. Notices. All written notices required by this Agreement shall be deemed given when delivered personally or sent by registered or certified mail, return receipt requested, to the parties at their addresses set forth on the signature page of this Agreement. Each party may, from time to time, designate a different address to which notices should be sent by giving notice thereof in writing to the other party at least three days before the effective date of such change in address. 13. Amendment. This Agreement may not be varied, altered, modified or in any way amended except by an instrument in writing executed by the parties hereto or their legal representatives. 14. Binding Effect. This Agreement shall be binding upon Employee and on NBI, its Successors and assigns effective on the date first above written. 15. No Construction Against Any Party. This Agreement is the product of informed negotiations between the Employee and NBI. If any part of this Agreement is deemed to he unclear or ambiguous, it shall be construed as if it were drafted jointly by all parties. The Employee and NBI agree that neither party was in a superior bargaining position regarding the substantive terms of this Agreement. 16. Entire Agreement. This Agreement constitutes the complete, final and entire agreement of the parties with respect to the matters addressed herein and it supersedes all other prior agreements and understandings, both written and oral, express or implied, with respect to the subject matter of this Agreement. No promises, representations or warranties have been made by any party to or for the benefit of the other with respect to such matters which are not expressly set forth herein. 17. Exclusions. Notwithstanding anything contained herein to the contrary, it is expressly understood and agreed by Employee that: (a) Employee shall not be entitled to any payments under this Agreement if no Change in Control occurs or in the event (i) Employer terminates Employee's employment for Cause, or (ii) Employee voluntarily terminates his or employment with Employer for Other than Good Reason, or (iii) Employee's employment with Employer terminates or is terminated due to his death, Retirement or pursuant to a Determination of Long Term Disability, (b) Employee's employment with Employer is on an "at will" basis and this Agreement does not constitute an employment contract or an agreement by Employer to employ Employee for any particular period of time or in any particular capacity. Nothing in this Agreement is intended or should be 65 interpreted to confer upon Employee the right to continue in the employ of Employer or to interfere with or restrict in any way the right of Employer to discharge Employee or terminate his or her employment at any time or for any reason whatsoever, with or without Cause, and without any obligation or liability to Employee except as herein provided, it being the intent of the parties hereto only to provide for payment of the severance benefits specified herein in the event of the termination of Employee's employment with Employer under the circumstances described in Section 2. 18. Confidentiality. The Employee recognizes that as an employee of Employer, Employee will have access to and may participate in the origination of non-public, proprietary and confidential information and that Employee owes a fiduciary duty to the Employer. Confidential information may include, but is not limited to, trade secrets, customer lists and information, internal corporate planning, strategic plans, methods of marketing and operation, and other data or information of or concerning the Employer or its customers that is not generally known to the public or in the banking industry. The Employee agrees that he will never make a disclosure of confidential information to a third party or use confidential information other than for the exclusive benefit of the Employer and its affiliates. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written herein. National Bankshares, Inc. By: /s/ JAMES G. RAKES -------------------------------- President Address: 101 Hubbard Street P.O. Box 90002 Blacksburg, VA 24062-9002 /s/ F. BRAD DENARDO ------------------------------------ Employee Address: 3009 Lancaster Drive Blacksburg, VA 24060 66 EX-10 10 ex10buhyoff.txt CHANGE IN CONTROL AGREEMENT BUHYOFF CHANGE IN CONTROL AGREEMENT THIS CHANGE IN CONTROL AGREEMENT (the "Agreement") is entered into as of the 8th day of January, 2003 (the "Effective Date"), by and between National Bankshares, Inc. ("NBI") and Marilyn B. Buhyoff ("Employee"). W I T N E S S E T H: WHEREAS, Employee heretofore has been employed as Secretary and Counsel of NBI, Senior Vice President, Secretary & Counsel of its wholly owned subsidiary, the National Bank of Blacksburg, and Secretary of its wholly owned subsidiary, National Bankshares Financial Services, Inc. (the "Employer"), and in such position he or she has provided leadership and guidance in the growth and development of the business of NBI and its subsidiaries; and, WHEREAS, Employee's experience and knowledge of Employer's operations, customers and affairs is a benefit to the continuation and growth of Employer's business; and, for that reason, NBI desires to retain Employee's services as an employee of the Employer; and, WHEREAS, as an inducement to Employee's continued employment, NBI has agreed to provide for certain payments to Employee in the event of a termination of Employee's employment with the Employer under certain circumstances in conjunction with a change in control of NBI, and, to set forth the terms and conditions of that arrangement, NBI and Employee desire to enter into this Agreement. NOW, THEREFORE, in consideration of the premises and mutual promises, covenants and conditions hereinafter set forth, and for other good and valuable considerations, the receipt and sufficiency of which hereby are acknowledged, NBI and Employee hereby agree as follows: 1. Effective Date of Agreement. This Agreement shall be effective on the Effective Date set out above and shall remain in effect until terminated as provided herein. 2. Payment in Certain Events. If at the effective time of a "Change in Control" (as defined below) or any time within two years and 60 days following a Change in Control (A) Employer terminates Employee's employment other than for "Cause" (as defined below), or, (B) a "Termination Event" (as defined below) occurs and, thereafter, Employee voluntarily terminates his or her own employment with Employer in the manner described below, then (subject to the limitations set forth herein) Employee shall be entitled to receive from NBI, and NBI shall be obligated to pay or cause to be paid to Employee, an amount 49 equal to two times the Employee's average annual compensation includable in the Employee's annual gross income for federal income tax purposes for the five (5) most recent taxable years ending before the date on which the Change in Control occurs. If Employee's employment is terminated by Employer Without Cause (as defined below) prior to the effective time of a Change in Control but following the date on which NBI's board of directors takes action to approve an agreement (including any definitive agreement or an agreement in principle) relating to a Change in Control, then for purposes of this Agreement, such termination of employment shall be deemed to occur at the effective time of the Change in Control. Otherwise, if Employee's employment is terminated prior to the effective time of a Change in Control, Employee shall have no rights hereunder. Amounts payable under this Section 2 shall be paid, at Employee's option, either in (a) a lump sum within 45 days following the Termination Date (as defined below) or (b) up to six (6) equal monthly installments without interest which shall commence on the 45th day following the Termination Date and on the same day of each consecutive month thereafter, until fully paid. 3. Definitions. For purposes of this Agreement: (A) a "Change in Control" shall be deemed to have occurred and be effective at the time: (i) of the acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) and 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act') of beneficial ownership (within the meaning of Rule 13d-3 under the Exchange Act), of securities of NBI representing 20% or more of the combined voting power of the then outstanding securities; provided, however, that the following acquisitions shall not constitute a Change in Control: (a) any acquisition directly from NBI (excluding an acquisition by virtue of the exercise of a conversion privilege); (b) any acquisition by NBI; (c) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by NBI or any corporation controlled by NBI; or (d) any acquisition pursuant to a reorganization, merger or consolidation by any corporation owned or proposed to be owned, directly or indirectly, by NBI's shareholders if NBI's shareholders' ownership of securities of the corporation resulting from such transaction constitutes a majority of the ownership of securities of the resulting entity and at least a majority of the members of the board of directors of the corporation resulting from such transaction were members of the Incumbent Board as defined in this Agreement at the time of the execution of the initial agreement providing for such reorganization, merger or consolidation; or 50 (ii) when individuals who, as of the inception of this Agreement, constitute the board of directors of NBI (the "Incumbent Board") cease for any reason to constitute at least a majority of such board of directors; provided, however, that any individual becoming a director subsequent to the Effective Date whose election, or nomination for election by the shareholders was approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of either an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or other actual or threatened solicitation of proxies or consents by or on behalf of a person other than a member of the NBI board of directors; or (iii) NBI consummates, (a) a merger, statutory share exchange, or consolidation of NBI with any other corporation, except as provided in Subsection 3(A)(i)(d), or (b) the sale or other disposition of all or substantially all of the assets of NBI. (B) All references to "NBI" shall include any "Successor" to NBI which shall have assumed and become liable for NBI's obligations hereunder (whether such assumption is by agreement, operation of law or otherwise). "Successor" refers to any person or entity (corporate or otherwise) into which NBI (or any such Successor) shall be merged or consolidated or to which all or substantially all of NBI's (or any such Successor's) assets shall be transferred in any manner. (C) For purposes of this Agreement, a "Termination Event" shall be deemed to have occurred if, within two years and 60 days following a Change in Control Employee terminates his or her employment with Employer for Good Reason (as defined below). (D) "Without Cause" shall mean the termination of Employee's employment which does not occur by virtue of Employee's death, Retirement or pursuant to a Determination of Long Term Incapacity, or by Employer With Cause or by Employee for Good Reason or for Other than Good Reason; (E) "Cause" or "with Cause" shall mean: (i) continual or deliberate neglect by Employee in the performance of his material duties and responsibilities or the Employee's 51 willful failure to follow reasonable instructions or policies of Employer after being notified of such failure and being given a reasonable opportunity and period (as determined by Employer) to remedy such failure; (ii) with respect to Employee, conviction of, indictment for (or its procedural equivalent), entering of a guilty plea or plea of no contest with respect to a felony, a crime of moral turpitude or any other crime with respect to which imprisonment is a possible punishment, or the commission of an act of embezzlement or fraud; (iii) any breach or violation by Employee in any material respect of any code or standard of behavior generally applicable to employees of Employer, after being advised in writing of such breach or violation and being given a reasonable opportunity and period (as determined by Employer) to remedy such breach or violation; (iv) dishonesty of Employee in any aspect of his or her employment, or breach of a fiduciary duty to Employer or to Employer's parent or any of its subsidiaries or affiliates; (v) the willful engaging by Employee in conduct that is reasonably likely to result, in the good faith judgment of Employer, in material injury to Employer or Employer's parent, or any of its subsidiaries or affiliates, monetarily or otherwise; (vi) the violation by Employee of any applicable federal or state law, or any applicable rule, regulation, order or statement of policy promulgated by any governmental agency or authority having jurisdiction over Employer, its parent or any of its affiliates or subsidiaries (a "Regulatory Authority," including without limitation the Federal Deposit Insurance Corporation, the Virginia Bureau of Financial Institutions, Office of the Comptroller of the Currency, the Federal Reserve Board, the Securities and Exchange Commission or any other regulatory agency), which results from Employee's negligence, willful misconduct or intentional disregard of such law, rule, regulation, order or policy statement and results in any substantial damage, monetary or otherwise, to Employer, its parent or any of its affiliates or subsidiaries or to their reputation; (vii) the conviction of Employee of any felony or any criminal offense involving dishonesty or breach of trust, or the occurrence of any event described in Section 19 of the Federal Deposit Insurance Act or any other event or circumstance which disqualifies Employee from serving as an employee or executive officer of, or a party affiliated with, Employer, its parent or any of its affiliates or subsidiaries; or, in the event Employee becomes unacceptable to, or is removed, suspended or prohibited from participating in the conduct of the affairs of Employer, its parent or any of its affiliates or subsidiaries (or if proceedings for that purpose are commenced) by, any Regulatory Authority; or 52 (viii) the exclusion of Employee by the carrier or underwriter from coverage under Employer's then current "blanket bond" or other fidelity bond or insurance policy covering its or their directors, officers or employees, or the occurrence of any event which Employer believes, in good faith, will result in Employee being excluded from such coverage, or having coverage limited as to Employee as compared to other covered officers or employees, pursuant to the terms and conditions of such "blanket bond" or other fidelity bond or insurance policy. (F) "Good Reason" shall mean the following occurrences after the effective time of a Change in Control: (i) the continued assignment to the Employee of duties inconsistent with the Employee's position, authority, duties or responsibilities immediately prior to the Change in Control; (ii) a substantial reduction in the status of the Employee, including a diminution in his position, authority, duties or responsibilities, excluding for this purpose an isolated, insubstantial and/or inadvertent action not taken in had faith and which is remedied by Employer promptly after receipt of notice thereof given by the Employee; (iii) the relocation of Employee to a principal place of employment located more than 50 miles from Employee's principal place of employment immediately preceding the Change in Control, without Employee's express written consent to such relocation; (iv) any failure by a Successor expressly to assume all of NBI's liabilities, duties and obligations hereunder; (v) a reduction in the Employee's annual base salary rate below the annual rate in effect immediately preceding the effective time of the Change in Control or as the same shall have been increased from time to time following such effective time; (vi) a reduction in the level, scope or coverage of Employee's life insurance, medical or hospitalization insurance, disability insurance or similar plans or benefits (including any retirement plan) from that being provided by Employer to Employee immediately preceding the effective time of the Change in Control or any such insurance, plans or benefits are eliminated without being replaced with substantially similar plans or benefits, unless such reduction or elimination applies proportionately to all salaried employees of Employer who participated in such plans or benefits immediately prior to such Change in Control; or 53 (vii) anything in this Agreement to the contrary notwithstanding, a termination by Employee for any reason during the thirty (30) day period immediately following the first anniversary of a Change in Control shall be deemed to be a termination for Good Reason for all purposes of this Agreement. Any good faith (meaning honesty-in-fact) determination of Good Reason, based on one or more of the foregoing, made by the Employee shall be conclusive. (G) "Other than Good Reason" shall mean any termination by the Employee which is not for Good Reason or Retirement shall be deemed a termination for Other than Good Reason. (H) "Retirement" shall mean the Employee's retirement on or after the Employee's normal retirement date under the terms of the National Bankshares Retirement Income Plan (or any successor or substitute plan or plans of NBI). (I) "Determination of Long Term Incapacity" shall mean a good faith determination by Employer that, as a result of mental or physical illness or injury the Employee has failed to perform his assigned duties with Employer on a full time basis for a period exceeding twelve (12) consecutive months. (J) "Termination Date" means the effective date as of which the Employee's employment with Employer is terminated, giving rise to a payment obligation under Section 2. 4. Possible Reduction in Payment and Benefits. Following any Change in Control, to the extent that any amount of pay or benefits provided under to Employee under this Agreement would cause Employee to be subject to excise tax under sections 280G and 4999 of the Internal Revenue Code of 1986, as amended (the "Code"), and after taking into consideration all other amounts payable to Employee under other NBI or Employer plans, programs, policies, and arrangements, then the amount of pay and benefits provided under this Agreement shall be reduced to the extent necessary to avoid imposition of any such excise taxes. Employee may select the payments and benefits to be limited or reduced, including an election not to have the vesting of certain benefits, including stock options, accelerate as a result of a Change in Control. 5. Legal Fees and Costs. Except as otherwise provided herein, NBI will pay or reimburse Employee for all costs and expenses, including without limitation court costs and reasonable attorneys' fees and expert witness fees and expenses, incurred by Employee in seeking to obtain or enforce by legal proceeding any right or benefit provided by this Agreement, in each case 54 provided Employee's claim is substantially upheld by a court of competent jurisdiction. 6. Documents. All documents, record, tapes and other media of any kind or description relating to the business of NBI or any of its subsidiaries and affiliates (the "Documents"), whether or not prepared by Employee, shall be the sole and exclusive property of NBI. The Documents (and any copies) shall be returned to NBI upon Employee's termination of employment for any reason or at such earlier time or times as NBI may specify. 7. Regulatory Requirements. Notwithstanding anything contained in this Agreement to the contrary, it is understood and agreed that NBI (or any of its Successors) shall not be required to make any payment or take any action under this Agreement if: (A) NBI or Employer is declared by any Regulatory Authority to be insolvent, in default or operating in an unsafe or unsound manner, or if (B) in the opinion of counsel to NBI or Employer such payment or action (i) would be prohibited by or would violate any provision of state or federal law applicable to NBI or Employer, including without limitation the Federal Deposit Insurance Act, as now in effect or hereafter amended, (ii) would be prohibited by or would violate any applicable rules, regulations, orders or formal statements of policy, whether now existing or hereafter promulgated, of any Regulatory Authority, or (iii) otherwise is prohibited by any Regulatory Authority. 8. Termination of Agreement. This Agreement automatically shall terminate and become null and void upon any termination of Employee's employment with Employer other than a termination of employment which results in NBI's payment obligation provided for under Section 2 above. Following any such termination of this Agreement, it shall be of no further force or effect and Employee shall have no further rights hereunder. 9. Severability. If any provision of this Agreement, or part thereof, is determined to be unenforceable for any reason whatsoever, it shall be severable from the remainder of this Agreement and shall not invalidate or affect the other provisions of this Agreement, which shall remain in full force and effect arid shall be enforceable according to their terms. No covenant shall be dependent upon any other covenant or provision herein, each of which stands independently. 10. Modification. The parties expressly agree that should a court find any provision of this Agreement, or part thereof, to be unenforceable or unreasonable, the court may modify the provision, or part thereof, in a manner which renders that provision reasonable, enforceable, and in conformity with the public policy of Virginia. 55 11. Governing Law. This agreement shall be governed by and construed in accordance with the laws of the Commonwealth of Virginia. 12. Notices. All written notices required by this Agreement shall be deemed given when delivered personally or sent by registered or certified mail, return receipt requested, to the parties at their addresses set forth on the signature page of this Agreement. Each party may, from time to time, designate a different address to which notices should be sent by giving notice thereof in writing to the other party at least three days before the effective date of such change in address. 13. Amendment. This Agreement may not be varied, altered, modified or in any way amended except by an instrument in writing executed by the parties hereto or their legal representatives. 14. Binding Effect. This Agreement shall be binding upon Employee and on NBI, its Successors and assigns effective on the date first above written. 15. No Construction Against Any Party. This Agreement is the product of informed negotiations between the Employee and NBI. If any part of this Agreement is deemed to he unclear or ambiguous, it shall be construed as if it were drafted jointly by all parties. The Employee and NBI agree that neither party was in a superior bargaining position regarding the substantive terms of this Agreement. 16. Entire Agreement. This Agreement constitutes the complete, final and entire agreement of the parties with respect to the matters addressed herein and it supersedes all other prior agreements and understandings, both written and oral, express or implied, with respect to the subject matter of this Agreement. No promises, representations or warranties have been made by any party to or for the benefit of the other with respect to such matters which are not expressly set forth herein. 17. Exclusions. Notwithstanding anything contained herein to the contrary, it is expressly understood and agreed by Employee that: (a) Employee shall not be entitled to any payments under this Agreement if no Change in Control occurs or in the event (i) Employer terminates Employee's employment for Cause, or (ii) Employee voluntarily terminates his or employment with Employer for Other than Good Reason, or (iii) Employee's employment with Employer terminates or is terminated due to his death, Retirement or pursuant to a Determination of Long Term Disability, (b) Employee's employment with Employer is on an "at will" basis and this Agreement does not constitute an employment contract or an agreement by 56 Employer to employ Employee for any particular period of time or in any particular capacity. Nothing in this Agreement is intended or should be interpreted to confer upon Employee the right to continue in the employ of Employer or to interfere with or restrict in any way the right of Employer to discharge Employee or terminate his or her employment at any time or for any reason whatsoever, with or without Cause, and without any obligation or liability to Employee except as herein provided, it being the intent of the parties hereto only to provide for payment of the severance benefits specified herein in the event of the termination of Employee's employment with Employer under the circumstances described in Section 2. 18. Confidentiality. The Employee recognizes that as an employee of Employer, Employee will have access to and may participate in the origination of non-public, proprietary and confidential information and that Employee owes a fiduciary duty to the Employer. Confidential information may include, but is not limited to, trade secrets, customer lists and information, internal corporate planning, strategic plans, methods of marketing and operation, and other data or information of or concerning the Employer or its customers that is not generally known to the public or in the banking industry. The Employee agrees that he will never make a disclosure of confidential information to a third party or use confidential information other than for the exclusive benefit of the Employer and its affiliates. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first written herein. National Bankshares, Inc. By: /s/ JAMES G. RAKES -------------------------------- President Address: 101 Hubbard Street P.O. Box 90002 Blacksburg, VA 24062-9002 /s/ MARILYN B. BUHYOFF ------------------------------------ Employee Address: 1302 Greendale Drive Blacksburg, VA 24060 57 -----END PRIVACY-ENHANCED MESSAGE-----