10-Q 1 form10q.txt 10Q 3RD QUARTER 2004 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 ------------------ FORM 10-Q ------------------ Quarterly Report Pursuant to Section 13 or 15(d) Of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2004 Commission file number 0-15204 National Bankshares, Inc. (Exact name of registrant as specified in its charter) State or other jurisdiction of incorporation or organization - Virginia Internal Revenue Service - Employer Identification No. 54-1375874 101 Hubbard Street, P.O. Box 90002, Blacksburg, VA 24062-9002 (540) 951-6300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days. Yes _X_ No ___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b - 2 of the Exchange Act) Yes _X_ No ___ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at November 5, 2004 ------------------------------ -------------------------------- Common Stock, $2.50 Par Value 3,516,502 (This report contains 35 pages) =============================================================================== 18 NATIONAL BANKSHARES, INC. AND SUBSIDIARIES Form 10-Q Index Part I Financial Information ---------------------------- Page Item 1 Financial Statements Consolidated Balance Sheets, September 30, 2004 (Unaudited) and December 31, 2003 3 Consolidated Statements of Income for the Three Months 5 Ended September 30, 2004 and 2003 (Unaudited) Consolidated Statements of Income for the Nine Months Ended September 30, 2004 and 2003 (Unaudited) 7 Consolidated Statements of Changes in Stockholders' Equity, Nine Months Ended September 30, 2004 and 2003 (Unaudited) 9 Consolidated Statements of Cash Flows, Nine Months Ended September 30, 2004 and 2003 (Unaudited) 10 Notes to Consolidated Financial Statements 12 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 17 Item 3 Quantitative and Qualitative Disclosures about Market Risk 29 Item 4 Controls and Procedures 29 Part II Other Information -------------------------- Item 1 Legal Proceedings 30 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 30 Item 3 Defaults Upon Senior Securities 30 Item 4 Submission of Matters to a Vote of Security Holders 30 Item 5 Other Information 30 Item 6 Exhibits 30 Signatures 30 Index of Exhibits 30 2 Part I Financial Information Item 1. Financial Statements
National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets September 30, 2004 and December 31, 2003 (Unaudited) (Audited) September 30, December 31, ($ In thousands, except share and per share data) 2004 2003 ================== =================== Assets: Cash and due from banks $16,206 $11,733 Interest-bearing deposits 5,526 36,220 Securities available for sale 147,590 129,300 Securities held to maturity (fair value $111,712 in 2004 and $105,026 in 2003) 108,251 100,854 Mortgage loans held for sale 557 714 Loans: Real estate construction loans 24,209 28,055 Real estate mortgage loans 115,046 87,899 Commercial and industrial loans 241,038 208,997 Loans to individuals 92,665 82,742 ------------------ ------------------- Total loans 472,958 407,693 Less unearned income and deferred fees (867) (896) ------------------ ------------------- Loans, net of unearned income and deferred fees 472,091 406,797 Less allowance for loan losses (5,835) (5,369) ------------------ ------------------- Loans, net 466,256 401,428 ------------------ ------------------- Premises and equipment, net 11,738 10,094 Accrued interest receivable 5,153 4,610 Other real estate owned, net 1,010 1,663 Intangible assets and goodwill 17,565 9,958 Other assets 2,761 1,986 ------------------ ------------------- Total assets $782,613 $708,560 ================== =================== Liabilities and Stockholders' Equity Noninterest-bearing demand deposits $101,422 $83,671 Interest-bearing demand deposits 189,712 172,370 Savings deposits 64,199 53,084 Time deposits 334,958 316,253 ------------------ ------------------- Total deposits 690,291 625,378 ------------------ ------------------- Other borrowed funds 2,214 135 Accrued interest payable 483 489 Other liabilities 2,355 1,917 ------------------ ------------------- Total liabilities 695,343 627,919 ------------------ ------------------- 3 Stockholders' Equity Preferred stock of no par value. Authorized 5,000,000 shares; none issued and outstanding --- --- Common stock of $2.50 par value. Authorized 10,000,000 shares; issued and outstanding 3,516,502 shares in 2004 and 3,515,377 in 2003 8,791 8,788 Retained earnings 76,861 70,063 Accumulated other comprehensive income, net 1,618 1,790 ----------------- ------------------- Total stockholders' equity 87,270 80,641 ----------------- ------------------- Total liabilities and stockholders' equity $782,613 $708,560 ================= ===================
See accompanying notes to the consolidated financial statements. 4
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Three Months Ended September 30, 2004 and 2003 (Unaudited) September 30, September 30, ($ In thousands, except share and per share data) 2004 2003 ================== ================= Interest income: Interest and fees on loans $7,837 $7,495 Interest on interest-bearing deposits 23 43 Interest on federal funds sold 14 5 Interest on securities - taxable 1,654 1,377 Interest on securities - nontaxable 1,313 1,342 ------------------ ----------------- Total interest income 10,841 10,262 ------------------ ----------------- Interest expense: Interest on time deposits $100,000 or more 836 710 Interest on other deposits 2,053 2,130 Interest on borrowed funds 15 --- ------------------ ----------------- Total interest expense 2,904 2,840 ------------------ ----------------- Net interest income 7,937 7,422 Provision for loan losses 293 435 ------------------ ----------------- Net interest income after provision for loan losses 7,644 6,987 ------------------ ----------------- Noninterest income: Service charges on deposit accounts 824 704 Other service charges and fees 52 65 Credit card fees 480 416 Trust income 274 253 Other income 131 77 Realized securities gains, net 104 7 ------------------ ----------------- Total noninterest income 1,865 1,522 ------------------ ----------------- Noninterest expense: Salaries and employee benefits 2,723 2,396 Occupancy and furniture and fixtures 473 416 Data processing and ATM 349 310 Credit card processing 398 324 Intangibles amortization 233 238 Net costs of other real estate owned 37 19 Other operating expenses 1,062 1,001 ------------------ ----------------- Total noninterest expense 5,275 4,704 ------------------ ----------------- Income before income tax expense 4,234 3,805 Income tax expense 1,019 894 ------------------ ----------------- Net income $3,215 $2,911 ================== ================= 5 Net income per share - basic $0.91 $0.83 ================== ================= - diluted 0.91 0.82 ================== ================= Weighted average number of common shares outstanding - basic 3,519,491 3,512,877 ================== ================= - diluted 3,536,965 3,534,615 ================== ================= Dividends declared per share $--- $--- ================== =================
See accompanying notes to consolidated financial statements. 6
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Nine Months Ended September 30, 2004 and 2003 (Unaudited) September 30, September 30, ($ In thousands, except share and per share data) 2004 2003 ================== ================= Interest income: Interest and fees on loans $21,868 $22,766 Interest on interest-bearing deposits 137 180 Interest on federal funds sold 15 16 Interest on securities - taxable 4,648 4,177 Interest on securities - nontaxable 3,987 3,995 ------------------ ----------------- Total interest income 30,655 31,134 ------------------ ----------------- Interest expense: Interest on time deposits $100,000 or more 2,294 2,325 Interest on other deposits 5,852 7,248 Interest on borrowed funds 16 1 ------------------ ----------------- Total interest expense 8,162 9,574 ------------------ ----------------- Net interest income 22,493 21,560 Provision for loan losses 885 1,277 ------------------ ----------------- Net interest income after provision for loan losses 21,608 20,283 ------------------ ----------------- Noninterest income: Service charges on deposit accounts 2,234 1,877 Other service charges and fees 182 206 Credit card fees 1,362 1,210 Trust income 1,105 757 Other income 311 342 Realized securities gains, net 91 3 ------------------ ----------------- Total noninterest income 5,285 4,395 ------------------ ----------------- Noninterest expense: Salaries and employee benefits 7,815 7,161 Occupancy and furniture and fixtures 1,337 1,248 Data processing and ATM 913 851 Credit card processing 1,100 949 Intangibles amortization 699 715 Net costs of other real estate owned 149 38 Other operating expenses 2,997 2,878 ------------------ ----------------- Total noninterest expense 15,010 13,840 ------------------ ----------------- Income before income tax expense 11,883 10,838 Income tax expense 2,772 2,494 ------------------ ----------------- Net income $9,111 $8,344 ================== ================= 7 Net income per share - basic $2.59 $2.38 ================== ================== - diluted 2.57 2.36 ================== ================== Weighted average number of common shares outstanding - basic 3,517,923 3,512,262 ================== ================== - diluted 3,538,280 3,531,819 ================== ================== Dividends declared per share $0.63 $0.54 ================== ==================
See accompanying notes to consolidated financial statements. 8
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Nine Months Ended September 30, 2004 and 2003 (Unaudited) Accumulated Other ($ In thousands, except per Common Retained Comprehensive Comprehensive share data) Stock Earnings Income Income Total ============ ============== ================ ================ =========== Balances, December 31, 2002 $8,778 $62,525 $1,798 $73,101 Net income --- 8,344 --- $8,344 8,344 Dividend ($0.54 per share) --- (1,897) --- --- (1,897) Exercise of stock options 4 25 --- --- 29 Other comprehensive income, net of tax: Unrealized gains on securities available for sale, net of income tax $166 --- --- --- (307) --- Reclass adjustment net of tax $1 --- --- --- (2) --- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive income --- --- (309) (309) (309) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $8,035 --- ============ ============== ================ ================ =========== Balances, September 30, 2003 $8,782 $68,997 $1,489 $79,268 ============ ============== ================ ================ =========== Balances, December 31, 2003 $8,788 $70,063 $1,790 $80,641 Net income --- 9,111 --- $9,111 9,111 Dividends ($0.63 per share) --- (2,216) --- --- (2,216) Exercise of stock options 16 107 --- --- 123 Other comprehensive income, net of tax Unrealized losses on securities available for sale, net of income tax ($61) --- --- --- (113) --- Reclass adjustment net of income tax ($32) --- --- --- (59) --- ----- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive income --- --- (172) (172) (172) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $8,939 --- ============ ============== ================ ================ =========== Common Stock repurchase (13) (204) --- (217) Balances, September 30,2004 $8,791 $76,861 $1,618 $87,270 ============ ============== ================ ================ ===========
See accompanying notes to consolidated financial statements. 9
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows Nine Months Ended September 30, 2004 and 2003 (Unaudited) September 30, September 30, ($In thousands) 2004 2003 =================== ================= Cash flows from operating activities: Net income $9,111 $8,344 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 885 1,277 Depreciation of premises and equipment 727 687 Amortization of intangibles 699 715 Amortization of premiums and accretion of discount, net 200 383 (Gains) Losses on sales and calls of securities available for sale, net 27 (1) (Gains) on calls of securities held to maturity (118) (2) Losses and writedowns on other real estate owned 111 18 (Increase) decrease in: Mortgage loans held for sale 157 756 Accrued interest receivable (543) (759) Other assets 4,567 32 Increase (decrease) in: Accrued interest payable (6) (184) Other liabilities 438 (196) ------------------- ----------------- Net cash provided by operating activities 16,255 11,070 ------------------- ----------------- Cash flows from investing activities: Net increase in federal funds sold --- 1,591 Net decrease in interest-bearing deposits 30,694 488 Proceeds from calls, principal payments, sales and maturities of securities available for sale 19,982 19,825 Proceeds from calls, principal payments and maturities of securities held to maturity 6,933 14,493 Purchases of securities available for sale (20,221) (26,514) Purchases of securities held to maturity (14,288) (21,839) Purchases of loan participations (1,114) (2,051) Collections of loan participations 941 1,292 Net (increase) in loans to customers (26,269) (3,992) Acquisition of Community National Bank and First National Bank - Southeast (13,602) --- Proceeds from disposal of other real estate owned 970 81 Recoveries on loans charged off 174 192 Purchase of premises and equipment (687) (1,331) Proceeds from disposal of premises and equipment 2 449 ------------------- ----------------- Net cash (used in) investing activities (16,485) (17,316) ------------------- ----------------- 10 Cash flows from financing activities: Net increase (decrease) in other deposits 7,510 16,988 Net increase (decrease) in time deposits (2,576) (7,489) Net increase(decrease)in other borrowed funds 2,079 (656) Stock options exercised 123 29 Cash dividends (2,216) (1,897) Common Stock repurchased (217) --- ------------------- ----------------- Net cash provided by financing activities 4,703 6,975 ------------------- ----------------- Net increase in cash and due from banks 4,473 729 Cash and due from banks at beginning of period 11,733 12,316 ------------------- ----------------- Cash and due from banks at end of period $16,206 $13,045 =================== ================= Supplemental disclosure of cash flow information Cash paid for interest $8,168 $9,758 =================== ================= Cash paid for income taxes $2,576 $2,509 =================== ================= Loans charged to the allowance for loan losses $1,091 $1,059 =================== ================= Loans transferred to other real estate owned $327 $502 =================== ================= Unrealized (losses)on securities available for sale $(265) $(476) =================== ================= Transactions related to the acquisition of Community National Bank Increase in assets and liabilities: Investments $10,052 $--- Loans 40,371 --- Deposits 59,979 ---
See accompanying notes to consolidated financial statements. 11 National Bankshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements September 30, 2004 (Unaudited) Note (1) The consolidated financial statements 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, Inc. (NBFS), (the Company), conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments which are necessary for a fair presentation of the consolidated financial statements have been included. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of results of operations for the full year or any other interim period. The interim period consolidated financial statements and financial information included herein should be read in conjunction with the notes to consolidated financial statements included in the Company's 2003 Form 10-K. Note (2) Stock-Based Compensation At September 30, 2004, the Company had a stock-based employee compensation plan, which is described more fully in the Company's Form 10-K dated December 31, 2003. 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.
Nine months ended Three months ended September 30, September 30, ---------------------------- -------------------------- ($ In thousands, except per share data) 2004 2003 2004 2003 ---------------------------------------------------- -------------- ------------- ------------- ------------ Net income, as reported $9,111 $8,344 $3,215 $2,911 ---------------------------------------------------- Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (76) (30) (25) (10) ---------------------------------------------------- -------------- ------------- ------------- ------------ Pro forma net income $9,035 $8,314 $3,190 $2,901 ---------------------------------------------------- -------------- ------------- ------------- ------------ Earnings per share: Basic-as reported $2.59 $2.38 $0.91 $0.83 -------------- ------------- ------------- ------------ Basic-pro forma $2.57 $2.37 $0.91 $0.83 Diluted-as reported $2.57 $2.36 $0.91 $0.82 -------------- ------------- ------------- ------------ Diluted-pro forma $2.55 $2.35 $0.90 $0.82 ---------------------------------------------------- -------------- ------------- ------------- ------------
There were no stock options exercised during the third quarter. There were no stock options granted or forfeited during the period. For the quarter ended September 30, 2004, $16,500 options were excluded from the calculation of diluted earnings per share as the effect would have been anti-dilutive. 12 Note (3) Acquisitions On December 24, 2003, the Company's BTC subsidiary entered into an agreement to acquire the loans and assume the deposit liabilities of the Richlands, Virginia branch office of FNB Southeast of Reidsville, North Carolina (FNB-SE). BTC received approval for this transaction from its primary regulator, the Federal Reserve Bank, on February 18, 2004. The transaction, which did not include the purchase of fixed assets, was closed in the second quarter of 2004. The purchase and assumption added approximately $7.2 million in loans and approximately $15.0 million in deposits. The Company determined that the transaction did not constitute the acquisition of a business, and therefore it has been accounted for under the provisions of SFAS No. 147, Acquisitions of Certain Financial Institutions. The Company's NBB subsidiary entered into an agreement with The South Financial Group of Greenville, South Carolina on February 2, 2004. The contract provided that NBB would purchase substantially all of the assets and assume all of the liabilities of The South Financial Group's wholly-owned subsidiary, Community National Bank located in Pulaski, Virginia (CNB). This transaction closed in June of 2004 at a purchase price of $12.85 million. It added approximately $60 million in deposits and approximately $69 million in total assets. Any goodwill and intangible assets arising from the transaction have been accounted for under the provisions of SFAS No. 142 Goodwill and other Intangible Assets. The transaction resulted in the addition of approximately $6.2 in goodwill and $1.3 million in core deposit intangible. The results of operations are included in the financial statement from the date of acquisition. Note (4) Allowance for Loan Losses, Nonperforming Assets and Impaired Loans
For the periods ended September 30, December 31, 2004 2003 2003 ============== ============== ================= ($In thousands, except for % data) Balance at beginning of period $5,369 $5,092 $5,092 Provision for loan losses 885 1,277 1,691 Loans charged off (1,091) (1,059) (1,660) Acquisition of CNB 498 --- --- Recoveries 174 192 246 -------------- -------------- ----------------- Balance at the end of period $5,835 $5,502 $5,369 ============== ============== ================= Ratio of allowance for loan losses to the end of period loans net of unearned income and deferred fees 1.24% 1.33% 1.32% ============== ============== ================= Ratio of net charge-offs to average loans, net of unearned income and deferred fees(1) .28% .28% .34% ============== ============== ================= Ratio of allowance for loan losses to nonperforming loans(2) 1,220.71% 2,895.79% 1,516.67% ============== ============== =================
(1) Net charge-offs are on an annualized basis. (2) The Company defines nonperforming loans as total nonaccrual and restructured loans. Loans 90 days past due and still accruing are excluded. 13
September 30, December 31, 2004 2003 2003 ============= ============ ================ ($In thousands, except % data) Nonperforming Assets: Nonaccrual loans $478 $190 $354 Restructured loans --- --- --- ------------- ------------ ---------------- Total nonperforming loans 478 190 354 Foreclosed property 1,010 940 1,663 ------------- ------------ ---------------- Total nonperforming assets $1,488 $1,130 $2,017 ============= ============ ================ Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned .31% .27% .49% ============= ============ ================ Past due 90 days or more and still accruing $1,121 $2,207 $931 ============= ============ ================ Ratio of loans past due 90 days or more and still accruing to loans, net of unearned income and deferred fees .24% .53% .23% ============= ============ ================ Total impaired loans $478 $380 $871 ============= ============ ================ Impaired loans with a valuation allowance $64 --- $506 Valuation allowance (64) --- (135) ------------- ------------ ---------------- Impaired loans net of allowance $--- --- $371 ============= ============ ================ Impaired loans with no valuation allowance $414 $380 $365 ============= ============ ================ Average recorded investment in impaired loans $663 $224 $353 ============= ============ ================ Income recognized on impaired loans $--- $19 $66 ============= ============ ================ Amount of income recognized on a cash basis $--- --- --- ============= ============ ================
14 Note (5) Securities The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for the sale by major security type as of September 30, 2004 are as follows:
Gross Gross Amortized Unrealized Unrealized Fair ($ In thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ U.S. Treasury $4,041 $51 $21 $4,071 U.S. Government agencies and corporations 7,836 90 1 7,925 State and political subdivisions 78,329 2,463 296 80,496 Mortgage-backed securities 15,859 371 10 16,220 Corporate debt securities 34,889 674 424 35,139 Federal Reserve Bank stock- restricted 209 --- --- 209 Federal Home Loan Bank stock-restricted 1,553 --- --- 1,553 Other securities 1,834 143 --- 1,977 ----------------- ----------------- ----------------- ------------------ Total securities available for sale $144,550 $3,792 $752 $147,590 ================= ================= ================= ==================
The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type as of September 30, 2004 are as follows:
Gross Gross Amortized Unrealized Unrealized Fair Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ U.S. Government agencies and corporations $15,975 $84 $93 $15,966 State and political subdivisions 56,660 2,107 18 58,749 Mortgage-backed securities 3,525 147 1 3,671 Corporate securities 32,091 1,462 227 33,326 ----------------- ----------------- ----------------- ------------------ Total securities held to maturity $108,251 $3,800 $339 $111,712 ================= ================= ================= ==================
15 Note (6) Defined Benefit Plan
Components of Net Periodic Benefit Cost ($ in Thousands) Nine Months Ended Three Months Ended September 30, September 30, 2004 2003 2004 2003 ---- ---- ---- ---- Service cost $372 $321 $124 $107 Interest cost 402 375 134 125 Expected return on plan assets (375) (315) (125) (105) Amortization of prior service cost 6 6 2 2 Recognized net actuarial loss 90 84 30 28 Amortization of transition cost (9) (9) (3) (3) ---------- ---------- ------------ ---------- ---------- ---------- ------------ ---------- Net periodic benefit cost $486 $462 $162 $154 ========== ========== ============ ==========
Employer Contributions Bankshares previously disclosed in its financial statements for the year ended December 31, 2003, an estimated minimum contribution of $623,000 to its pension plan in 2004. That estimate has since been revised and Bankshares now expects to contribute $522,000 to the pension plan for 2004. As of September 30, 2004, the Company has made contributions totaling $334,000. Bankshares anticipates making all required contributions prior to the end of 2004. Note (7) Recent Accounting Announcements On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments" ("SAB 105"). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments ("IRLC"), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, "Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133." Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either the Company's consolidated financial position or consolidated results of operations. Emerging Issues Task Force Issue No. 03-1 "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1") was issued and is effective March 31, 2004. The EITF 03-1 provides guidance for determining the meaning of "other -than-temporarily impaired" and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115") and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired. On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1. This delay does not suspend the requirement to 16 recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in Issue 03-1 was not delayed. EITF No. 03-16, "Accounting for Investments in Limited Liability Companies was ratified by the Board and is effective for reporting periods beginning after June 15, 2004." APB Opinion No. 18, "The Equity Method of Accounting Investments in Common Stock," prescribes the accounting for investments in common stock of corporations that are not consolidated. AICPA Accounting Interpretation 2, "Investments in Partnerships Ventures," of Opinion 18, indicates that "many of the provisions of the Opinion would be appropriate in accounting" for partnerships. In EITF Abstracts, Topic No. D-46, "Accounting for Limited Partnership Investments," the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (LLCs) have characteristics of both characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs. The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting. National Bankshares, Inc. and Subsidiaries (In thousands, except per share data) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The purpose of this discussion is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly owned subsidiaries (the Company), which are not otherwise apparent from the consolidated financial statements and other information included in this report. Reference should be made to the financial statements and other information included in this report as well as the 2003 Annual Report on Form 10-K for an understanding of the following discussion and analysis. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements. 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 when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. 17 Allowance for 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 and estimable 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. Our 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 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 is 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 in either the formula or specific allowance. Core deposit intangibles 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. An outside evaluation of the intangible assets associated with the recent CNB acquisition has been conducted. The evaluation recognized as core deposit intangible approximately $1,354. Overview National Bankshares, Inc. (NBI) is a financial holding company located in Southwest Virginia. It conducts operations primarily through two full-service banking affiliates, the National Bank of Blacksburg and Bank of Tazewell County. It also has one nonbanking affiliate, National Bankshares Financial Services, Inc., which offers investment and insurance products. Net income derived from the nonbanking affiliate is not significant at this time or for the foreseeable future. NBI is primarily a community bank holding company. 18 Performance Summary The following table shows NBI's key performance ratios for the nine months ended September 30, 2004 and December 31, 2003 and 2002:
September 30, 2004 December 31, 2003 December 31, 2002 ------------------------------------------------- -------------------- -------------------- ---------------------- Return on average assets 1.64% 1.64% 1.53% ------------------------------------------------- -------------------- -------------------- ---------------------- Return on average equity 14.60% 14.77% 14.33% ------------------------------------------------- -------------------- -------------------- ---------------------- Net interest margin (1) 4.73% 4.82% 4.74% ------------------------------------------------- -------------------- -------------------- ---------------------- Noninterest margin (2) 1.77% 1.81% 1.84% ------------------------------------------------- -------------------- -------------------- ---------------------- Basic net earnings per share $2.59 $3.26 $2.85 ------------------------------------------------- -------------------- -------------------- ---------------------- Fully diluted net earnings per share $2.57 $3.24 $2.84 ------------------------------------------------- -------------------- -------------------- ----------------------
(1) Net Interest Margin - Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets. (2) Noninterest Margin - Noninterest income (including securities gains and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets. Earnings for the period ending September 30, 2004 were $9,111 up $9.19% from the same period in 2003. As illustrated in the above table, the return on average assets continues at the previous year's level. The return on average equity has declined, in part, because of an increase in capital due to earnings. Since the Company pays semi-annual dividends, capital builds in the first and third quarters, which reduces the return on average equity. In the second and fourth quarters the payout of capital for dividends has a positive effect. Unrealized gains and losses on securities available for sale, which can fluctuate by a substantial amount, can also affect the return on average equity. The interest margin and noninterest margin have remained relatively stable, declining 9 basis points and 4 basis points, respectively. The yield on earning assets declined by 47 basis points while the cost to fund the earning assets declined by 38 points. Basic earnings per share were $2.59 for the period ending September 30, 2004 and $2.38 for the period ending September 30, 2003. Overall profitability indicators remain stable or improving. Management believes that the current trend will continue in the short term, providing that interest rates remain stable. Rising interest rates may have an adverse affect on profitability in the short to intermediate term, especially if such rate increases move to substantially higher levels in a short period of time. Based on current information, rate increases are not expected to rise sharply. (See the discussion on "Net Interest Income" for more information.) Growth The following table shows NBI's key growth indicators: September 30, 2004 December 31, 2003 December 31, 2002 ------------------ -------------------- ------------------ -------------------- Securities $255,841 $230,154 $219,294 ------------------ -------------------- ------------------ -------------------- Loans, net 466,256 401,428 404,247 ------------------ -------------------- ------------------ -------------------- Deposits 690,291 625,378 608,271 ------------------ -------------------- ------------------ -------------------- Total assets 782,613 708,560 684,935 ------------------ -------------------- ------------------ -------------------- Bank-owned securities have increased by $25,687 in 2004. Approximately $10,100 was due to the purchase of substantially all of the assets of the Community National Bank, Pulaski, VA (CNB) in the latter part of the second quarter. Net loans increased by $64,828 in 2004. Loans assumed in the CNB transaction totaled approximately $40,400 and $7,200 in the purchase and assumption of certain assets and liabilities of the Richlands, Virginia office of FNB Southeast (FNB-SE). (See the discussion on "Net Interest Income" for more details.) 19 Deposits increased in 2004 by $64,913. Deposits acquired in the CNB transaction were approximately $60,000 and $15,000 in the FNB-SE branch purchase. Total assets increased $74,053 in the first nine months of 2004, mostly because of the CNB and FNB-SE transactions. Asset Quality Key asset quality indicators are shown below:
September 30, 2004 December 31,2003 December 31, 2002 --------------------------------------------- ------------------- ------------------- ------------------- Nonperforming loans $478 $354 $288 --------------------------------------------- ------------------- ------------------- ------------------- Loans past due over 90 days 1,121 931 977 --------------------------------------------- ------------------- ------------------- ------------------- Other real estate owned 1,010 1,663 537 --------------------------------------------- ------------------- ------------------- ------------------- Allowance for loan losses to loans 1.24% 1.32% 1.24% --------------------------------------------- ------------------- ------------------- ------------------- Net charge-off ratio .28% .34% .35% --------------------------------------------- ------------------- ------------------- -------------------
Asset quality remains good, with only the nonperforming loans category showing a $12 increase. Management works intensively with delinquent borrowers to attempt to bring nonperforming loans back to performing status. When these efforts are unsuccessful, management is moving quickly to liquidate loan collateral and to institute legal collection activities. The net charge-off ratio has declined from levels at year-end 2003. Loans past due ninety days or more were $1,121 at September 30, 2004, up slightly from the $931 at December 2003 and the $977 at December 31,2002. Net Interest Income Net interest income for the period ended September 30, 2004 was $22,493, an increase of $933 or 4.33%. The net interest margin was 4.73% for the period ended September 30, 2004 and 4.83% for the period ended September 30, 2003. During the past two years the Company has benefited from a relatively long period of low interest rates, which has no recent precedent. The trend continued into the first half of 2004. In June of 2004, the Federal Reserve Board raised the federal funds rates 25 basis points, signaling the start of a higher interest rate environment. Since then additional rate increases have occurred, with more expected. Many forecasters agree that interest rates will trend upward in small increments over the next several quarters. However, the impact of world events, such as but not limited to, oil prices, problems in the Middle East and terrorist related activities, could negatively impact the national economy and alter plans for future interest rate increases. If such events were to occur the Company, together with the entire banking industry, could be affected to some extent. The general impact of a rising interest rate scenario on the Company's balance sheet follows. Federal Funds Sold and Interest-bearing Deposits - These are overnight funds used primarily for liquidity purposes. They mature daily and, accordingly, interest rates change daily, which is advantageous in a period of rising interest rates. However these funds yield low interest, making other investments more attractive from an earnings standpoint. Securities Available for Sale - This category provides a higher level of earnings than overnight funds and can under certain circumstances be a source of liquidity and also demonstrate the ability to re-price. While these securities can be sold to provide liquidity and for interest rate sensitivity purposes, temporary declines in fair market value due to rising interest rates may make it unprofitable to sell the securities. In addition, embedded call features may not be activated during periods of high rates, leaving the Company with a "hold" or "sell" decision. See page 26 of the Company's 2003 Form 10-K for re-pricing data. 20 Securities Held to Maturity - Because of its nature, this category of investments is not necessarily structured to be a source of liquidity or to moderate interest rate sensitivity. These securities must be held to maturity except under extenuating circumstances. In a rising rate environment, the difference in the amount of interest income earned and the cost to fund the securities decreases. In other words, net interest income from these investments declines. Embedded call features may not be activated during periods of high rates. See the Company's 2003 Form 10-K for re-pricing data. Mortgage Loans Held for Sale - This category is primarily driven by volume. In periods of low interest rates, mortgage refinancing activity and home sales tend to accelerate and generate higher revenue levels than are experienced in times of high interest rates. In the last two years, re-financing activity has been significant. Recently, however, despite the continuing low rate environment, activity has declined. This may signal the end to what many have characterized as a refinancing boom. Loans - While the low rate environment of the recent past is more conducive to loan production than periods of extremely high interest rates, interest rates that are unusually low are a sign of a weak or a recovering economy. Ideal volumes may in fact be achieved in a more robust economy in which more moderate rate levels exist. If the economy continues to recover as forecast, higher loan volumes would have a positive impact on net interest income. Of particular concern is the area of loans to individuals, which has been in a downward trend for several quarters, with the only growth coming from loans acquired in purchase and assumption transactions. Management believes the decline is due to several reasons. o General economic conditions and the lack of employment in portions of the Company's market area. o A decline in consumer requests for new car financing because of special incentives offered by automobile companies. o Consumers' use of credit cards and home equity lines with higher credit limits. o Consumers taking advantage of low mortgage rates to refinance home mortgages to obtain funds that might otherwise have been borrowed through a consumer loan. A reversal of this trend may occur to some extent as economic conditions change and higher interest rates make mortgage refinancing less appealing. However, management believes that the automotive related financing offers and competition from the credit card sector will remain. Since loans to individuals are generally higher yielding, this trend will not have a favorable effect on net interest income. Interest Expense During periods of rising interest rates, interest-bearing demand deposits, and to a lesser degree savings deposits, migrate to higher rate, longer-term time deposits. Generally, as rates climb, more migration occurs. Given their re-pricing characteristics, interest-bearing demand deposits readily respond to any interest rate movement. In other words, increases or decreases in interest expense can occur quite quickly. With a definite bias towards higher interest rates in the future, it is expected that the net interest margin will decline, at least temporarily, in response to rising interest rates. As previously stated, the ultimate impact of rising interest rates is dependent upon the number of rate increases, the amount of such and the level to which they ultimately rise is a matter of uncertainty. Provision and Allowance for Loan Losses The provision for loan losses for the period ended September 30, 2004 was $885, a decrease of $392 from the September 30, 2003 provision expense of $1,277. 21 Nonperforming assets at September 30, 2004 were $1,488 and $2,017 at December 31, 2003. Of the nonperforming assets outstanding at September 30, 2004, $478 was in nonaccrual loans and $1,010 was in foreclosed properties. Efforts specifically designed to focus on and work intensively with delinquent borrowers have been undertaken. When these efforts have been unsuccessful, other more stringent legal collection measures and foreclosures have been initiated. Depending on the type of property and/or the circumstances surrounding a particular credit, the time to deal with each situation may vary widely. Hence, management cannot predict with any degree of certainty at what point in the future problems associated with these credits will be resolved. Based on current information, management believes that the volume of problem credits are at or near their peak. Loans ninety days past due and still accruing were $1,121 at September 30, 2004 and $931 at December 31, 2003. The ratio of the allowance for loan losses to loans net of unearned income and deferred fees was 1.24% at September 30, 2004, which compares to 1.32% at December 31, 2003. The annualized ratio of net charge-offs to loans net of unearned income was .28% at September 30, 2004 and .34% at December 31, 2003. Noninterest Income
September 30, 2004 September 30, 2003 September 30, 2002 ----------------------------------- ----------------------- ------------------------ --------------------------- Service charges on deposits $2,234 $1,877 $1,678 ----------------------------------- ----------------------- ------------------------ --------------------------- Other service charges and fees 182 206 202 ----------------------------------- ----------------------- ------------------------ --------------------------- Credit card fees 1,362 1,210 1,040 ----------------------------------- ----------------------- ------------------------ --------------------------- Trust fees 1,105 757 718 ----------------------------------- ----------------------- ------------------------ --------------------------- Other income 311 342 416 ----------------------------------- ----------------------- ------------------------ --------------------------- Realized securities gains/losses 91 3 343 ----------------------------------- ----------------------- ------------------------ ---------------------------
Noninterest income is comprised of several categories. Following is a description of each, as well as the factors that influence each. Service charges on deposit accounts consist of a variety of charges imposed on demand deposits, interest-bearing deposits and savings deposit accounts. These include, but are not limited to, the following: o Demand deposit monthly activity fees o Service charges for checks for which there are non-sufficient funds or overdraft charges o ATM transaction fees The principal factors affecting current or future income are: o Internally generated growth o Acquisitions of other banks/branches or de novo branches o Adjustments to service charge structures In 2003, the Company made certain changes to its service charge structure. These changes were not in effect in the first quarter of 2003. The remainder of the increase was due to volume, combined with routine charge-offs. Revenues are expected to continue to grow if, for no other reason, than the two recent acquisitions. See the comments under "Acquisitions." Other service charges and fees consist of several categories. The primary categories are listed below. o Fees for the issuance of official checks o Safe deposit box rent o Income from the sale of customer checks o Income from the sale of credit life and accident and health insurance 22 Levels of income derived from these categories vary. Fees for the issuance of official checks and customer check sales tend to grow as the existing franchise grows and as new offices are added. Fee schedules, while subject to change, generally do not alone yield a significant or discernable increase in income when adjusted. The most significant growth in safe deposit box rent also comes with an expansion of offices. Safe deposit box fee schedules, which are already at competitive levels, are occasionally adjusted. Income derived from the sale of credit life insurance and accident and health insurance varies with loan volumes. Credit card fees consist of three types of revenues as follows: o Credit card transaction fees o Debit card transaction fees o Merchant fees In all three cases, volume is critical to growth in income. For debit and credit cards the number of accounts, whether obtained from internal growth or by acquisition, is the key factor. Merchant fees also depend on the number of merchants in the Company's program, as well as the type of business and the level of transaction discounts associated with them. Trust income is somewhat dependent upon market conditions and the number of estate accounts being handled at any given point in time. Financial market conditions, which affect the value of trust assets managed, can vary, leading to fluctuations in the related income. Over the past few years and into 2004, the financial markets have experienced a significant degree of volatility. Of the $348 increase, approximately $229 was attributable to income from the settlement of estates. Improvement in market conditions accounts for the majority of the remaining increase. The other income category is used for types of income that cannot be classified with other forms of noninterest income. The category includes such things as: o Net gains on the sale of fixed assets o Rent on foreclosed property o Income from cash value life insurance o Other infrequent or minor forms of income o Revenue from investment and insurance sales Given the nature of the items included in this category, it is difficult to determine trends or patterns. Items warranting discussion are usually non-recurring in nature. Other income for the first three quarters of 2004 was down $31 when compared to the first three quarters of 2003. Two items unique to 2003 accounted for a large part of the decrease. The first was a $40 rebate received by an affiliate bank from a vendor. The second was a dividend paid to the Company's financial services affiliate. Net realized gains on securities at September 30, 2004 were $91 and were the results of called or sold securities offset by write downs in certain equity securties. Noninterest Expense
September 30, 2004 September 30, 2003 September 30, 2002 --------------------------------- ----------------------- -------------------------- --------------------------- Salaries and employee benefits $7,815 $7,161 $6,680 --------------------------------- ----------------------- -------------------------- --------------------------- Occupancy and furniture and fixtures 1,337 1,248 1,260 --------------------------------- ----------------------- -------------------------- --------------------------- Data processing and ATM 913 851 849 --------------------------------- ----------------------- -------------------------- --------------------------- Credit card processing 1,100 949 764 --------------------------------- ----------------------- -------------------------- --------------------------- Intangibles and goodwill amortization 699 715 716 --------------------------------- ----------------------- -------------------------- --------------------------- Net costs of other real estate owned 149 38 139 --------------------------------- ----------------------- -------------------------- --------------------------- Other operating expenses 2,997 2,878 2,709 --------------------------------- ----------------------- -------------------------- ---------------------------
23 Noninterest expense includes several categories. Following is a brief description of the factors that affect each. In addition to employee salaries, the salaries and benefits expense category includes the costs of employment taxes and employee fringe benefits. Certain of these are: o Health insurance o Employee life insurance o Dental insurance o Executive compensation plans (1) o Pension plans (1) o Employee stock option plan (1) o Employer FICA o Unemployment taxes (1) See the 2003 Form 10-K and the Proxy Statement for the 2004 Annual Stockholders meeting for further information. For the first three quarters of 2004, salary and benefits expense was up $654. Routine salary increases and health insurance cost increases contributed to the increase. Of more significance are the recent purchase and assumption transactions. While the FNB-SE branch acquisition added no employees to the payroll, the CNB purchase and assumption initially added twenty-one employees. Because the Company's NBB subsidiary is operating the former CNB office as a branch office, many former CNB employees were retained in their previous positions. Some former CNB employees hold jobs that are performed elsewhere at NBB and they have moved to those positions as the need arose. Occupancy costs include such items as depreciation expense, maintenance of the properties, repairs and real estate taxes. This category is most affected by new property acquisitions resulting from mergers, branch purchases or construction of new branch facilities. Conversely, expense can be lowered by branch office consolidations or closures, which though infrequent, have occurred. On occasion repairs and other expense items can rise to significant levels, though not frequently. This category increased $89 when the first nine months of 2004 and 2003 are compared. The CNB purchase and assumption transaction did not add significantly to this category because it was completed very near the end of the second quarter. The Company maintains its own data processing facility and has ATM's at twenty-two subsidiary bank offices and other locations. Costs to operate these are reflected in this category and include depreciation, maintenance, communication lines and certain supplies. Data processing costs were up $62 when the first half of 2004 is compared to the same period in 2003. While these cost increases are nominal, larger increases are expected because of the completion of the two previously mentioned purchase and assumption transactions. The first purchase and assumption transaction was quite small and has not greatly impacted data processing and ATM expense. The second acquisition involved the assets and liabilities of an existing bank, including assumption of its existing data processing contract, which will remain until mid 2005. Assumption of this contract increased monthly costs by approximately $12-$15. While the contract terminates in mid 2005, no substantial decreases in processing costs are expected, as the company's primary data processing contract allows for incremental increases. The Company also added three ATM's at its bank affiliates during the second quarter of 2004. Credit card processing includes costs associated with the processing of credit cards, debit cards and merchant transactions. These expenses are related to credit card income previously discussed in the "Noninterest Income" section, and the comments in that section are applicable. At September 30, 2004 the net cost of other real estate owned was $149. Expense has risen steadily for the past three years. The September 30, 2004 24 costs are not necessarily indicative of the full year for 2004. Other real estate owned at September 30, 2004 was $1,010, which compares to $1,663 at December 31, 2003 and $537 at December 31, 2002. Given the number of foreclosures, it is likely that higher costs could continue for 2004, possibly into 2005. Other operating expenses include all other forms of expense not classified elsewhere in the Company's statement of income. Included in this category are such items as stationery and supplies, franchise taxes, contributions, telephone, postage and other operating costs. Many of the expenses included in this category are relatively stable or moderately increase with inflation from year to year. However, there are some items included in the category, such as other losses and charge-offs and repossession expense, which can vary from time to time. While many of the items in this category have identifiable trends, others may have frequent nonrecurring items or items that occur at no particular frequency. This category was also affected by the recent acquisitions. Categories such as stationery and supplies, telephone, and postage all increase when new offices are acquired. Overall cost for this category increased 4.35%, when the periods ending September 30, 2004 and September 30, 2003 are compared. Income Taxes In 2003 the Company moved from the 34% tax rate to 35%. In addition to the actual taxes paid, this change affected other areas including the book tax provision, deferred taxes and tax equivalency calculations. Balance Sheet Year-to-date daily averages for the major balance sheet categories are as follows: Assets September 30, 2004 December 31, 2003 ---------------------------------------- ------------------- ----------------- Federal funds sold $351 $1,320 Interest-bearing deposits 17,792 21,958 Securities available for sale 141,575 125,042 Securities held to maturity 107,293 103,962 Mortgage loans held for sale 572 1,159 Real estate construction loans 22,447 29,575 Real estate mortgage loans 104,489 84,363 Commercial and industrial loans 222,008 207,855 Loans to individuals 85,999 90,365 Total Assets $741,743 $697,012 Liabilities and stockholders equity ---------------------------------------- Noninterest-bearing demand deposits $89,622 $79,760 Interest-bearing demand deposits 182,949 167,428 Savings deposits 57,459 51,646 Time deposits 324,784 317,989 All other borrowings 482 194 Shareholders' equity $83,372 $77,486 Securities available for sale increased by $16,533 from December 31, 2003, while securities held to maturity increased by $3,331. As shown in the statement of cash flow, of that increase $10,232 was attributable to the CNB transaction. During the first three quarters of 2004, $281 in securities held to maturity were sold. This represents the sale of one issue and was prompted by credit quality concerns. 25 The mix of loan categories at September 30, 2004 and December 31, 2003 is shown in the following table.
September 30, 2004 December 31, 2003 ------------------------------------------ ------------------------- --------------------------- Construction loans (1) $24,209 $28,055 ------------------------------------------ ------------------------- --------------------------- Real estate loans 115,046 87,899 ------------------------------------------ ------------------------- --------------------------- Commercial and industrial loans 241,038 208,997 ------------------------------------------ ------------------------- --------------------------- Loans to individuals 92,665 82,742 ------------------------------------------ ------------------------- ---------------------------
(1) All categories shown reflect gross loans at period-end. The volume of mortgage loans held for sale is directly related to interest rate levels. Activity generally peaks during periods of low interest rates, declining as interest rates rise. Period-end balances are not indicative of volume, as loans are constantly being originated and sold. The balance shown at period-end reflects only loans held by NBB for which there are purchase commitments from investors, but which have not yet been funded. At September 30, 2004 there were approximately $3,838 in commitments to extend mortgage loans outstanding. Construction loans were $24,209 at September 30, 2004 and $28,055 at December 31, 2003, a decrease of $3,846. This category tends to fluctuate because of demand and with the seasons. Demand may vary because of economic conditions. Completion of construction projects generally occurs within one year, at which time permanent financing through one of the Company's banking affiliates or another lender is obtained. Loans for which the Company retains permanent financing move into the commercial and industrial loan or mortgage loan categories. Real estate loans at September 30, 2004 were $115,046, which represents an increase of $27,147 from December 31, 2003. Loans in this category are for one-to-four family housing and are loans the banking affiliates elected to retain rather than sell on the secondary market. Of that increase, approximately $13.0 million were acquired from CNB and $2.6 million acquired from FNB-SE. Commercial and industrial loans were $241,038 at September 30, 2004, which represents an increase of $32,041 from December 31, 2003. Included in this category are loans for working capital, equipment, commercial real estate and other loans for legitimate business needs. The CNB transaction accounted for approximately $14.0 million of this growth and the FNB-SE acquisition $2.4 million. See Footnote 15 of the Company's 2003 Form 10-K for information related to "Concentrations of Credit". Historically, growth in this category has been satisfactory, and based on present knowledge, no adverse trends are anticipated. Loans to individuals increased by $9,923 when September 30, 2004 is compared to December 31, 2003. Growth attributable to the CNB transaction was approximately $5.3 million and $2.2 million from FNB-SE. Growth rates in this category have experienced a downward trend, with most growth observed in this area being the result of acquisitions. See the comments under the caption "Net Interest Income" in this report. At September 30, 2004 total deposits were $690,291 compared to $625,378 at December 31, 2004. Of the $64,913 net increase, approximately $60 million came from CNB and $15 million from FNB-SE, which were partially offset by deposit runoff. Liquidity and Capital Resources Net cash provided by operating activities was $16,255 for the period ended September 30, 2004, which compares to $11,070 for the same period the previous year. Net cash used in investing activities was $16,485 provided for the period ended September 30, 2004, and $17,316 used for the period ended September 30, 2003. The Company used approximately $13,602 in acquisitions, and it had no acquisitions in 2003. Net cash provided in financing activities was $4,703 for the period ending September 30, 2004. The substantial changes in cash used in investing activities and cash provided by financing activities are due to the CNB and FNB-SE transactions. Included in the supplemental cash flow data is interest paid on deposits, which declined substantially when the periods September 30, 2004 and 26 September 30, 2003 are compared. The decrease is due to a decline in interest expense due to the lower interest rate environment. The Company has other available sources of liquidity. They include lines of credit with a correspondent bank, advances from the Federal Home Loan Bank, and Federal Reserve Bank discount window borrowings. Management is unaware of any commitment that would have a material and adverse effect on liquidity at September 30, 2004. Total shareholders' equity grew by $6,629 from December 31, 2003 to September 30, 2004. Earnings net of the change in unrealized gains and losses for securities available for sale and dividends paid accounted for most of the increase. Stock options exercised provided $123. During the third quarter the Company repurchased 5,000 shares of the common stock for $217. The Tier I and Tier II risk-based capital ratios at September 30, 2004 were 11.96% and 12.99%, respectively. Derivatives The Company is not a party to derivative financial instruments with off-balance sheet risks such as futures, forwards, swaps and options. The Company is a party to financial instruments with off-balance sheet risks such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business to meet the financing needs of its customers. Management does not plan any future involvement in high- risk derivative products. The Company has investments in collateralized mortgage obligations, structured notes and other similar instruments that are included in securities available for sale and securities held to maturity. The fair value of these investments at September 30, 2004 was approximately $2,760. Amortized cost for these securities was approximately $2,655. Management Discussion and Analysis of the Financial Condition and results of operations for the three months ended September 30, 2004. Performance Summary The following table shows NBI's performance ratios for the three months ended September 30, 2004 and September 30, 2003 September September 30,2004 30,2003 ------------------------------------------ ----------------- ---------------- Return on Average Assets 1.63% 1.66% ------------------------------------------ ----------------- ---------------- Return on Average Equity 15.24% 14.78% ------------------------------------------ ----------------- ---------------- Net Interest Margin 4.70% 4.86% ------------------------------------------ ----------------- ---------------- Basic Net Earnings per Share $0.91 $0.83 ------------------------------------------ ----------------- ---------------- Fully diluted Net Earnings per Share $0.91 $0.82 ------------------------------------------ ----------------- ---------------- As can be seen by the above data, these key indicators have been relatively stable. The return on equity has increased slightly. Earnings per share data reflects the continued growth in net income. Following is a comparison of quarter-to-date daily averages for related categories. September September 30,2004 30,2003 ------------------- ---------------- ----------------- Securities $256,727 $228,794 ------------------- ---------------- ----------------- Loans, net 465,806 409,307 ------------------- ---------------- ----------------- Deposits 697,119 616,574 ------------------- ---------------- ----------------- Total Assets 786,220 697,216 ------------------- ---------------- ----------------- 27 As can be seen by the above data, the Company has experienced solid growth when the two quarters are compared. Much of the growth experienced was due to the acquisition of the FNB-SE branch loans and deposits by the Company's BTC affiliate that was completed in April of 2004. The CNB transaction that occurred in the second quarter also had a positive impact on those averages. Net Income Net income for the third quarter of 2004 was $3,215 compared to $2,911 for the same period in 2003. This result is a $.09 increase in Diluted Earnings per Share. While the FNB-SE transaction had a small unquantifiable effect upon net income in the third quarter of 2004, the CNB transaction has had a positive affect, though the exact amount can not be quantified. Net Interest Income Net interest income rose by $515 when the third quarters of 2004 and 2003 are compared. Overall interest income increased by $579, while interest expense increased by $64. The ongoing effect of the low interest rate environment is apparent. Previous comments in the discussion of year-to-date "Net Interest Income" section apply. Provision for Loan Losses The provision for loan losses was down $142 when the two periods are compared. Noninterest Income Overall noninterest income increased by $343 or 22.54%. Areas experiencing the greatest change are as follows: o Service charges on deposits increased $120 o Credit Card processing increased $ 64 o Trust income increased $ 21 General comments made in the year-to-date discussion apply. The increases in service charges on deposits are attributed in part to deposits acquired from CNB, which account for $82 of the $120 increase. There were no material non-routine items in the third quarter of 2004 in credit card processing or Trust income. Noninterest Expense Overall non-interest expense grew by $571 when September 30, 2004 and September 30, 2003 are compared. Three areas with the greatest increases follow: o Salaries and employee benefits increased $327 o Credit card processing increased $74 o OREO expense increased $18 General comments made pertaining to salaries and employee benefits made in the year-to-date discussion apply. In addition, the CNB purchase and assumption transaction affected this category. General comments related to credit card processing in the year-to-date discussion apply. There were no material reportable non-routine transactions. OREO expense is up. See the year-to-date discussion for additional comments. 28 Item 3. Quantitative and Qualitative Disclosures about Market Risk 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 to adverse movement in interest rates. Interest rate shock analyses provide management with an indication of potential economic loss due to future rate changes. The following table shows repricing opportunities for the major categories of assets and liabilities.
INTEREST EARNING ASSETS 1 YEAR 1-5 YEARS >5 YEARS TOTAL Interest-Bearing Deposits 5,705 --- --- 5,705 Securities AFS 16,646 51,716 76,010 144,372 Securities HTM 7,710 39,982 60,559 108,251 Mortgage Loans HFS 557 --- --- 557 Loans Net of U/E + RE/HFS 143,700 242,552 85,946 472,198 -------------- ------------- ------------ ------------- Total Interest Earning Assets 174,318 334,250 222,515 731,083 ============== ============= ============ ============= INTEREST BEARING LIABILITIES Interest Bearing Demand 191,530 --- --- 191,530 Savings Deposits 64,788 --- --- 64,788 Time Deposits 177,473 135,270 21,626 334,369 Other Borrowings 4,242 --- --- 4,242 -------------- ------------- ------------ ------------- Total Interest Bearing Liabilities 438,033 135,270 21,626 594,929 ============== ============= ============ ============= Gap (263,715) 198,980 200,889 136,154 ============== ============= ============ ============= ============== ============= ============ ============= Cumulative Gap (263,715) (64,735) 136,154 ============== ============= ============ ============= Cumulative Gap Ratio 0.40 0.89 1.23 1.23 ============== ============= ============ =============
Item 4. 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 as of the end of the period covered by this 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. 29 Part II Other Information Item 1. Legal Proceedings None for the nine months ended September 30, 2004. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds See Form 10-Q for the period ended June 30, 2004. Item 3. Defaults upon Senior Securities None for the nine months ended September 30, 2004. Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits See Index of Exhibits. Signatures National Bankshares, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DATE: November 8, 2004 NATIONAL BANKSHARES, INC. /s/JAMES G. RAKES --------------------- James G. Rakes Chief Executive Officer /s/J. ROBERT BUCHANAN --------------------- J. Robert Buchanan Chief Financial Officer
(1) Index of Exhibits Page No. in Exhibit No. Description Sequential System ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, of National (incorporated herein by Bankshares, Inc. reference to Exhibit 3(a) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 30 3(i) Articles of Amendment to Articles of Incorporation (incorporated herein by of National Bankshares, Inc., dated reference to exhibit 3(i) of April 8, 2003. The Annual Report on Form 10-K for the fiscal year ended December 31, 2003) 4(i) Specimen copy of certificate for National (incorporated herein by Bankshares, Inc. common stock, $2.50 par value reference to Exhibit 4(a) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 4(i) Article Fourth of the Articles of Incorporation (incorporated herein by of National Bankshares, Inc. included in reference to Exhibit 4(b) Exhibit No. of 3(a)) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated June 18, (incorporated herein by 1990, by and between Information Technology, Inc. reference to Exhibit 10(e) of and The National Bank of Blacksburg the Annual Report on Form 10-K for fiscal year ended December 31, 1992) *10(iii)(A) National Bankshares, Inc. 1999 Stock Option Plan (incorporated 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 between (incorporated herein by National Bankshares, Inc. and James G. Rakes reference to Exhibit 10(iii)(A) of Form 10-Q for the period ended June 30, 2002) *10(iii)(A) Employment Lease Agreement dated August 14, 2002, (incorporated herein by between National Bankshares, Inc. and The National reference to Exhibit Bank of Blacksburg 10(iii)(A)of form 10-Q for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January 5, 2003, (incorporated herein by between National Bankshares, Inc. and Marilyn B. reference to Exhibit 10 iii (A) Buhyoff of Form 10-K for the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated January 8, 2003, (incorporated herein by between National Bankshares, Inc. and F. Brad reference to Exhibit 10 iii (A) Denardo of Form 10-K for the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated June 1, 1998, (incorporated herein by between Bank of Tazewell County and Cameron L. reference to Exhibit 10 iii (A) Forester of Form 10-K for the period ended December 31, 2002) 31 31(i) Section 302 Certification of Chief Executive Officer Page 32 31(ii) Section 302 Certification of Chief Financial Officer Page 32 32(i) 18 U.S.C. Section 1350 Certification of Chief Executive Officer Page 34 32(ii) 18 U.S.C. Section 1350 Certification of Chief Financial Officer Page 34
* Indicates a management contract or compensatory plan required to be filed herein. 32