10-K 1 form10k2004.txt FORM 10-K -------------------------------------------------------------------------------- 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 December 31, 2004 Commission file number 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) (Zip Code) (540) 951-6300 (Registrant's telephone number, including area code) 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 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 as of June 30, 2004 was approximately $140,111,761. 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 February 15, 2005 Common Stock, $2.50 Par Value 3,519,002 DOCUMENTS INCORPORATED BY REFERENCE Selected information from the Registrant's Proxy Statement for the Annual Meeting to be held April 12, 2005 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 69 pages.) (The Index of Exhibits is on page 67.) Table of Contents Page Part I ------ Item 1. Business 3 Item 2. Properties 10 Item 3. Legal Proceedings 11 Item 4. Submission of Matters to a Vote of Security Holders 11 Part II ------- Item 5. Market for Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securties 11 Item 6. Selected Financial Data 12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 32 Item 8. Financial Statements and Supplementary Data 33 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 58 Item 9A. Controls and Procedures 58 Item 9B. Other Information 59 Part III -------- Item 10. Directors and Executive Officers of the Registrant 59 Item 11. Executive Compensation 59 Item 12. Security Ownership of Certain Beneficial Owners and Management 60 Item 13. Certain Relationships and Related Transactions 60 Item 14. Principal Accounting Fees and Services 60 Part IV ------- Item 15. Exhibits and Financial Statement Schedules 61 Signatures 62 Index of Exhibits 67 2 Part I $ In thousands, except per share data. Item 1. Business History and Business National Bankshares, Inc. (Bankshares or NBI) is a financial holding company organized under the laws of Virginia in 1986 and registered under the Bank Holding Company Act (BHCA). Bankshares conducts the majority of its business operations through its two wholly-owned bank subsidiaries, The National Bank of Blacksburg (NBB) and 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". Bankshares posts all reports required to be filed under the Securities Exchange Act of 1934 on its web site at www.nationalbankshares.com. 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 fourteen 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, 2004, NBB had total assets of $472,163. Total deposits at this date were $420,744. NBB's net income for 2004 was $8,665, which produced a return on average assets of 1.96% and a return on average stockholders' equity of 18.99%. Refer to Note 12, of the Notes to Consolidated Financial Statements 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 Farmers Bank of Clinch Valley. BTC merged with Bankshares in 1996. 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, 2004, BTC had total assets of $321,236. Total deposits at this same date were $285,328. BTC's net income for 2004 was $3,711, which produced a return on average assets of 1.20% and a return on average stockholders' equity of 10.83%. Refer to Note 12, of the Notes to Consolidated Financial Statements 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 the first quarter of 2004, NBFS ended its previous association with UVEST Financial Services Group, Inc. and began offering investment services through Bankers Investments, LLC. 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, marketability of collateral and the cash flow of the borrowers. 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 3 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 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, cash flow 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 the banks. 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) 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, 2004, 2003 and 2002, the percentage of total operating revenue contributed by each class of similar services which contributed 18% or more of total operating revenues of the Company during such periods. 4 Percentage of Period Class of Service Total Revenues ------ ---------------- -------------- December 31, 2004 Interest and Fees on Loans 61.30% Interest on Investments 23.60% December 31, 2003 Interest and Fees on Loans 68.59% Interest on Investments 23.35% December 31, 2002 Interest and Fees on Loans 66.90% Interest on Investments 20.65% Market Area The National Bank of Blacksburg Market Area NBB's primary market area consists of all 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, Narrows 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. Giles County's primary employer is the Celanese plant, a manufacturer of acetate fibers. Employment at this plant remained relatively stable until the 3rd quarter of 2004. At that time 300 employees, or approximately one tenth of its work force, were laid off. Pulaski County's major employer is the Volvo Heavy Trucks production facility. Employment trends at this facility have been positive over the past three years. The county also has several large furniture plants, most notably Pulaski Furniture. Furniture manufacturing has recently been negatively impacted by growing furniture imports. The City of Galax is located in the Virginia-North Carolina 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 recently furniture manufacturing has been negatively affected. 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. Montgomery County has developed into a regional retail center, with the construction of several large shopping areas. Two area hospitals, each of which is 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. 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. 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 5 loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions, insurance companies 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 for his service as a director of the Company. In 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, 2004, NBB employed 152 full time equivalent employees at its main office, operations center and branch offices. BTC at December 31, 2004 employed 97.5 full time equivalent employees in its various offices and operational areas. Bankshares had 17 and NBFS had 3 full time employees at December 31, 2004. 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 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 6 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 "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. The Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 was signed into law on July 30, 2002. It enacted sweeping reforms of the federal securities laws intended to protect investors by improving the accuracy and reliability of corporate disclosures. Compliance with this complex legislation and with subsequent Securities and Exchange Commission rules has since been a major focus of all public corporations in the United States, including Bankshares. Among the many significant provisions of the Sarbanes-Oxley Act, Section 404 and related Securities and Exchange Commission rules created increased security by internal and external auditors of Bankshares' systems of internal controls over financial reporting. These ongoing and extensive efforts are designed to insure that Bankshares' internal controls are effective in terms of both design and operation. 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 7 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. 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, including NBB and BTC, to 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. Both NBB and BTC have received "Satisfactory" CRA ratings in the last examination by bank regulators. 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. 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 8 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. 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. USA Patriot Act. The USA Patriot Act became effective in late 2001. It was passed to facilitate the sharing of information among government entities and financial institutions to combat terrorism and money laundering. The USA Patriot Act creates an obligation on banks to report customer activities that may involve terrorist activities or money laundering. 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 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 9 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 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. The Company makes 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. 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 thirteen branch offices: Three in the Town of Blacksburg; two in the Town of Christiansburg; three in the County of Giles; three in Pulaski County; one in the City of Radford; and one in the City of Galax. Bank of Tazewell County owns the land and buildings of seven of its ten offices. The bank leases the land and buildings for three offices. The Main Office is located at 309 East Main Street, Tazewell, Virginia. Three additional 10 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 Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities 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, 2004, there were 979 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 2004 and 2003.
Common Stock Market Prices -------------------------- ------------------------ ----------------------- ------------------------------ 2004 2003 Dividends per share -------------------------- ------------------------ ----------------------- ------------------------------ High Low High Low 2004 2003 -------------------------- ------------ ----------- ------------ ---------- ------------- ---------------- First Quarter $ 56.18 50.20 $ 39.48 29.52 --- --- -------------------------- ------------ ----------- ------------ ---------- ------------- ---------------- Second Quarter 50.44 37.43 44.97 37.86 0.63 0.54 -------------------------- ------------ ----------- ------------ ---------- ------------- ---------------- Third Quarter 44.44 41.56 47.75 38.00 --- --- -------------------------- ------------ ----------- ------------ ---------- ------------- ---------------- Fourth Quarter 53.98 43.40 51.19 41.75 0.65 0.59 -------------------------- ------------ ----------- ------------ ---------- ------------- ----------------
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. The following table provides information about our purchases during 2004 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act.
------------------------------- ----------------- --------------- ------------------- --------------------- Total Number of Approximate Dollar Shares Purchased Value of Shares Total Number as Part of That May Yet Be of Shares Average Price Publicly Purchased Under the Fiscal Period Purchased Paid per Announced Plans Plans or Programs(2) Share(1) or Programs(2) ------------------------------- ----------------- --------------- ------------------- --------------------- Total for First Quarter of --- --- --- --- 2004 ------------------------------- ----------------- --------------- ------------------- --------------------- Total for Second Quarter of --- --- --- $1,000,000 2004 ------------------------------- ----------------- --------------- ------------------- --------------------- Total for Third Quarter of 5,000 $ 43.35 5,000 $ 783,250 2004 (Purchased on August 25, 2004) ------------------------------- ----------------- --------------- ------------------- --------------------- Total for Fourth Quarter of --- --- --- $ 783,250 2004 ------------------------------- ----------------- --------------- ------------------- ---------------------
1) Average price per share includes commissions. 2) On May 12, 2004, the Board of Directors approved the repurchases by the Company of up to $1 million of our common stock pursuant to a stock repurchase program that expires on May 31, 2005. 11 Item 6. Selected Financial Data National Bankshares, Inc. and Subsidiaries Selected Consolidated Financial Data $ In thousands, except per share data.
Years ended December 31, ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- 2004 2003 2002 2001 2000 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Selected Interest income $ 41,492 $ 41,081 $ 42,747 $ 45,527 $ 38,358 Income ------------------------- ---------- ----------- ---------- ----------- ---------- Statement Interest expense 11,125 12,252 15,764 22,771 18,163 Data: ------------------------- ---------- ----------- ---------- ----------- ---------- Net interest income 30,367 28,829 26,983 22,756 20,195 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Provision for loan 1,189 1,691 2,251 1,408 1,329 losses ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Noninterest income 7,142 6,186 5,712 5,204 4,082 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Noninterest expense 20,336 18,646 17,427 16,953 12,876 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Income taxes 3,754 3,236 3,003 2,285 2,763 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Net income 12,230 11,442 10,014 7,314 7,309 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Per Share Basic net income 3.48 3.26 2.85 2.08 2.08 Data: ------------------------- ---------- ----------- ---------- ----------- ---------- Diluted net income 3.46 3.24 2.85 2.08 2.08 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Cash dividends declared 1.28 1.13 0.97 0.86 0.85 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Book value per share 24.75 22.94 20.82 18.59 17.04 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Selected Loans, net 472,199 401,428 404,247 394,042 355,795 Balance ------------------------- ---------- ----------- ---------- ----------- ---------- Sheet Data Total securities 250,708 230,154 219,294 191,476 156,344 at End of ------------------------- ---------- ----------- ---------- ----------- ---------- Year: Total assets 796,154 708,560 684,935 644,623 593,497 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Total deposits 705,932 625,378 608,271 576,618 530,648 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Stockholders' equity 87,088 80,641 73,101 65,261 59,834 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Selected Loans, net 438,761 405,696 404,717 380,970 310,624 Balance ------------------------- ---------- ----------- ---------- ----------- ---------- Sheet Daily Total securities 250,305 229,004 191,493 188,809 142,686 Averages: ------------------------- ---------- ----------- ---------- ----------- ---------- Total assets 753,730 697,012 655,783 635,692 500,381 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Total deposits 665,627 616,823 583,298 569,139 433,673 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Stockholders' equity 84,479 77,486 69,895 63,460 55,682 ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Selected Return on average assets 1.62% 1.64% 1.53% 1.15% 1.46% Ratios: ------------------------- ---------- ----------- ---------- ----------- ---------- Return on average equity 14.48% 14.77% 14.33% 11.53% 13.13% ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Dividend payout ratio 36.83% 34.71% 34.01% 41.29% 40.87% ---------------- ------------------------- ---------- ----------- ---------- ----------- ---------- Average equity to average assets 11.21% 11.12% 10.63% 9.98% 11.13% ---------------- ------------------------- ---------- ----------- ---------- ----------- ----------
12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations $ In thousands, except per share data. 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 and other information included in this report. This Annual Report on Form 10-K 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. The Company uses 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 one 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. 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 and are 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 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 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 either in the formula or in the specific allowance. Core deposit intangibles Effective January 1, 2002, the Company 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 amount of $9,958 and $10,912 at December 31, 2003 and 2002, respectively, did not constitute the acquisition of a business, and therefore will continue to be amortized. 13 Overview National Bankshares, Inc. (NBI) is a financial holding company, as defined in the Gramm-Leach-Bliley Act of 1999. Located in Southwest Virginia, it conducts operations primarily through two full service banking affiliates, the National Bank of Blacksburg (NBB) and Bank of Tazewell County (BTC). The banks are best characterized as community banks. It also has one nonbanking affiliate, National Bankshares Financial Services, Inc. (NBFS), which offers investment and insurance products. Revenues and net income derived from the nonbanking affiliate are not significant at this time, nor are they expected to be significant in the foreseeable future. Performance Summary The following table shows NBI's key performance ratios for the period ended December 31, 2004 and 2003: 12/31/04 12/31/03 --------------------------------------- ----------------- ----------------- Return on average assets 1.62% 1.64% --------------------------------------- ----------------- ----------------- Return on average equity 14.48% 14.77% --------------------------------------- ----------------- ----------------- Basic net earnings per share $ 3.48 $ 3.26 --------------------------------------- ----------------- ----------------- Fully diluted net earnings per share $ 3.46 $ 3.24 --------------------------------------- ----------------- ----------------- Net interest margin (1) 4.69% 4.82% --------------------------------------- ----------------- ----------------- Noninterest margin (2) 1.77% 1.81% --------------------------------------- ----------------- ----------------- (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 (excluding securities gain and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets. As can be seen from the above data, the Company's performance remains satisfactory. While the return on average assets and equity experienced slight declines, basic earnings per share enjoyed a $0.22, or 6.75%, increase. Growth The following table shows NBI's key growth indicators: For the period ending ---------------------- ------------ ------------- 12/31/04 12/31/03 ---------------------- ------------ ------------- Securities $250,708 $230,154 ---------------------- ------------ ------------- Loans, net 472,199 401,428 ---------------------- ------------ ------------- Deposits 705,932 625,378 ---------------------- ------------ ------------- Total assets 796,154 708,560 ---------------------- ------------ ------------- The above data reflects asset growth of 12.4%. Acquisition of the selected assets and liabilities of Community National Bank of Pulaski, Virginia (CNB) and the acquisition of branch deposits from one office of FNB Southeast (FNB-SE). The FNB-SE transaction added approximately $15,080 in deposits and $7,260 in loans. The CNB transaction added approximately $59,979 in deposits, $40,371 in loans and $10,052 in investments. Asset Quality Key asset quality indicators are shown below: 12/31/04 12/31/03 -------------------------------------------- ------------- ------------ Nonperforming loans $ 394 $ 354 -------------------------------------------- ------------- ------------ Loans past due over 90 days 754 931 -------------------------------------------- ------------- ------------ Other real estate owned 895 1,663 -------------------------------------------- ------------- ------------ Allowance for loan losses to loans 1.20% 1.32% -------------------------------------------- ------------- ------------ Net charge-off ratio .30% .34% -------------------------------------------- ------------- ------------ Asset quality remains satisfactory overall as shown by the above data. Other real estate owned, in particular, has declined substantially. 14 Net Interest Income 2004 vs 2003 Net interest income for the period ended December 31, 2004 was $30,367, an increase of $1,538 or 5.33% over 2003. The net interest margin was 4.69% for the period ended December 31, 2004 and 4.82% for the period ended December 31, 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 rate 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 other 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. It can, under certain circumstances, be a source of liquidity, and it also demonstrates 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. 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. 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. 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. Deposit 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. 15 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 the increases and the level to which interest rates ultimately rise. 2003 vs 2002 Net interest income for 2003 was $28,829, an increase of $1,846 over 2002. During 2003 interest income decreased $1,666 as assets repriced downward. Interest-bearing liabilities repriced downward at a faster pace, causing a decline in interest expense. The net result of these events was a slight increase in the net interest margin to 4.82% from 4.74% in 2002. The current trend is the result of an unusually long period of low interest rates. 16 Analysis of Net Interest Earnings The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the daily average balance outstanding, net interest income and net yield on average interest-earning assets for the years indicated.
-------------------------------------------------------------------------------------------------------- December 31, 2004 December 31, 2003 December 31, 2002 -------------------------------------------------------------------------------------------------------- Average Average Average Average Yield/ Average Yield/ Average Yield/ ($ in thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate -------------------------------------------------------------------------------------------------------- Interest-earning assets: Loans, net (1)(2)(3) $ 444,984 $29,898 6.72% $412,261 $29,915 7.26% $410,437 $32,556 7.93% Taxable securities 121,770 6,184 5.08% 101,426 5,668 5.59% 92,697 5,490 5.92% Nontaxable securities (1) 126,365 8,146 6.45% 124,274 8,263 6.65% 98,796 6,885 6.97% Federal funds sold 276 5 1.81% 1,320 16 1.21% 2,644 42 1.59% Interest bearing deposits 16,224 196 1.21% 21,958 230 1.05% 17,765 276 1.55% -------------------------------------------------------------------------------------------------------- Total interest- earning assets $ 709,619 $44,429 6.26% $661,239 $44,092 6.67% $622,339 $45,249 7.27% ======================================================================================================== Interest-bearing liabilities: Interest-bearing demand deposits $ 186,106 $ 1,556 .84% $167,428 $ 1,571 0.94% $147,749 $ 2,219 1.50% Savings deposits 58,899 255 .43% 51,646 323 0.63% 49,151 508 1.03% Time deposits 327,302 9,300 2.84% 317,989 10,356 3.26% 312,129 13,032 4.18% Short-term borrowings 531 14 2.64% 194 2 1.03% 311 5 1.61% -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- Total interest- bearing liabilities $ 572,838 $11,125 1.94% $537,257 $12,252 2.28% $509,340 $15,764 3.09% ======================================================================================================== Net interest income and interest rate spread $33,304 4.32% $31,840 4.39% $29,485 4.18% ======================================================================================================== Net yield on average interest-earning assets 4.69% 4.82% 4.74% ========================================================================================================
(1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 35% in 2004 and 35% for 2003 and 34% for 2002. (2) Loan fees of $473 in 2004, $716 in 2003 and $660 in 2002 are included in total interest income. (3) Nonaccrual loans are included in average balances for yield computations. 17 Analysis of Changes in Interest Income and Interest Expense The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).
============================================================================================ 2004 Over 2003 2003 Over 2002 -------------------------------------------------------------------------------------------- Changes Due To Changes Due To ------------------------------- ------------------------------- Net Dollar Net Dollar ($ in thousands) Rates(2) Volume(2) Change Rates(2) Volume(2) Change =================================================================================================================================== Interest income:(1) Loans $(2,301) $ 2,284 $ (17) $(2,785) $ 144 $ (2,641) Taxable securities (550) 1,066 516 (321) 499 178 Nontaxable securities (254) 138 (116) (328) 1,706 1,378 Federal funds sold 6 (17) (11) (8) (18) (26) Interest-bearing deposits 32 (66) (34) (102) 56 (46) ----------------------------------------------------------------------------------------------------------------------------------- Increase(decrease) in income on interest-earning assets $(3,067) $ 3,405 $ 338 $(3,544) $2,387 $ (1,157) ----------------------------------------------------------------------------------------------------------------------------------- Interest expense: Interest-bearing demand deposits $ (181) $ 166 $ (15) $ (915) $ 267 $ (648) Savings deposits (109) 41 (68) (210) 25 (185) Time deposits (1,352) 296 (1,056) (2,916) 240 (2,676) Short-term borrowings 6 6 12 (1) (2) (3) Long-Term Borrowings --- --- --- --- --- --- ----------------------------------------------------------------------------------------------------------------------------------- (Decrease) increase in expense of interest-bearing liabilities $(1,636) $ 509 $(1,127) $(4,042) $ 530 $ (3,512) ----------------------------------------------------------------------------------------------------------------------------------- Increase (decrease) in net interest income $(1,431) $ 2,896 $ 1,465 $ 498 $1,857 $ 2,355 ===================================================================================================================================
(1) Taxable equivalent basis using a Federal income tax rate of 35% in 2004, 35% for 2003 and 34% for 2002. (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. 18 Interest Rate Sensitivity 2004 vs 2003 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. 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, 2004. For purposes of this analysis noninterest income and expenses are assumed to be flat. ($ in thousands, except for percent data) ------------------------- ------------------------ ---------------------------- Rate Shift (bp) Return on Average Assets Return on Average Equity ------------------------- ------------------------ ---------------------------- 300 1.20% 10.45% ------------------------- ------------------------ ---------------------------- 200 1.49% 12.80% ------------------------- ------------------------ ---------------------------- 100 1.75% 14.95% ------------------------- ------------------------ ---------------------------- (-) 100 2.21% 18.54% ------------------------- ------------------------ ---------------------------- (-) 200 2.17% 18.27% ------------------------- ------------------------ ---------------------------- (-) 300 2.08% 17.53% ------------------------- ------------------------ ---------------------------- 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 somewhat 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. 2003 vs 2002 During 2003 the overall interest rate environment remained at a historically low level. While interest rates are expected to remain low for the first half of 2004, in the opinion of management rate increases are an inevitable consequence of the ongoing economic recovery. Any increase in interest rates would have, at a minimum, a temporarily negative impact on performance. Risk factors and forward-looking statements previously discussed under "Net Interest Income" apply. Noninterest Income 2004 vs 2003
December 31, 2004 December 31, 2003 December 31, 2002 Service charges on deposits $3,003 $2,597 $2,229 Other service charges and fees 252 267 260 Credit card fees 1,839 1,612 1,409 Trust fees 1,436 1,132 968 Other income 444 448 500 Realized securities gains/losses 168 130 346 --- --- --- Total noninterest income $7,142 $6,186 $5,712 ====== ====== ======
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 19 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 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 $304 increase, approximately $254 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. Net realized gains on securities at December 31, 2004 were $168 and were the results of called or sold securities, offset by write downs in certain equity securities. 2003 vs 2002 Noninterest income for 2003 was $6,186 an 8.30% increase from 2002. Service charges on deposits increased by $368. The increase was the result of changes in the terms of certain demand deposit products and the associated service charges. Credit card fees were up $203 over 2002 due to volume increases in merchant and interchange fees. Trust income increased by $164 when compared to 2002. Trust income is dependent upon market conditions as well as the type of account being handled at any given point in time. In 2003 market conditions improved, resulting in additional fees. The number of estates handled also increased. Net securities gains and losses were down $216 from 2002. In the second and third quarter of 2002 the Company sold certain investments owned by the parent company for a total gain of approximately $335. There were no similar sales in 2003. 20
Noninterest Expense 2004 vs 2003 December 31, 2002 December 31, 2004 December 31, 2003 Salaries and employee benefits $10,498 $9,568 $8,912 Occupancy and furniture and fixtures 1,797 1,655 1,692 Data processing and ATM 1,302 1,164 1,096 Credit card processing 1,502 1,244 1,036 Intangibles and goodwill amortization 967 954 954 Net costs of other real estate owned 201 178 145 Other operating expenses 4,069 3,883 3,592 $20,336 $18,646 $17,427 ======= ======= =======
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 Proxy Statement for the 2005 Annual Stockholders meeting for further information. For 2004, salary and benefits expense was up $930 or 9.72%. 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 $142 when 2004 and 2003 are compared. New branches, renovation and acquisitions also create increases in the area. The Company maintains its own data processing facility and has ATM's at twenty-four 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 $138 when 2004 is compared to 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 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 December 31, 2004 the net costs of other real estate owned was $201. Expense has risen steadily for the past three years. Other real estate owned at December 31, 2004 was $895, which compares to $1,663 at December 31, 2003 and $537 at December 31, 2002. 21 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 4.94%, when the periods ending December 31, 2004 and December 31, 2003 are compared. 2003 vs 2002 Noninterest expense for 2003 was $18,646, an increase of $1,219 or 6.99% over 2002. The most significant changes occurred in the salaries and employee benefits, credit card processing expenses and other operating expenses categories. Salaries and employee benefits increased by 7.36% or $656. Of that increase, approximately $254 was due to increased pension expense. During a period of low interest rates, rates used in actual forecasts are lower and result in higher net periodic pension expense. When interest rates rise, the amount of expense decreases. The remainder of the increase is due to normally expected increases in salaries and benefits. Credit card processing increased $208 over 2002. As previously mentioned in "Noninterest Income" above, credit card income increased because of a greater volume of merchant income. Credit card merchant expense moves in tandem with merchant income. Other operating expenses were up $291 or 8.10%. A major portion of this increase is $101 in additional Virginia bank franchise tax which was incurred because of an increase in Bank capital resulting from earnings. Also included is $39 in repossession expense and $36 related to a loss on the sale of a closed branch facility. Income Taxes 2004 vs 2003 Income tax expense for 2004 increased by $518 when compared to 2003. Tax exempt income continues to be the primary difference between the "expected" and reported tax expense. The Company's effective tax rates for 2004, 2003 and 2002 were 23.49%, 22.05% and 23.07%, respectively. The Company is subject to the 35% marginal tax rate. See Note 10 of the Notes to Consolidated Financial Statements for additional information relating to income taxes. 2003 vs 2002 Income tax expense for 2003 increased by $233 when compared to 2002. In 2003, the Company became subject to the 35% marginal tax rate because of higher income. This new rate resulted in a credit to tax expense of approximately $146 as the net deferred asset was adjusted to the new realization rate. Tax exempt income continues to be the primary difference between the "expected" and reported tax expense. 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. Historical dollar values used to determine depreciation expense do not reflect the effects of inflation on the market value of depreciable assets after their acquisition. Provision and Allowance for Loan Losses 2004 vs 2003 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 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 22 the Company's provision for loan losses is sufficient. Overall asset quality has shown some improvement in 2004. Reference is made to data shown in the performance summary. 2003 vs 2002 During 2003, the Company's BTC affiliate experienced a decline in asset quality. The result has been an increase in foreclosed properties, as shown by the following table. The problem has been recognized by management. Efforts specifically designed to focus on problem loans and to work intensively with delinquent borrowers have been undertaken. When these efforts are unsuccessful, management is moving more quickly to liquidate loan collateral and to institute legal collection activities. To date the net charge-off rate has remained stable. Loans past due ninety days or more were $931 at December 31, 2003, slightly lower than the $977 at December 31, 2002. 23 IV. Summary of Loan Loss Experience A. Analysis of the Allowance for Loan Losses The following tabulation shows average loan balances at the end of each period; changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off by loan category; and additions to the allowance which have been charged to operating expense:
============================================================================ December 31, ---------------------------------------------------------------------------- ($ in thousands) 2004 2003 2002 2001 2000 ============================================================================ Average net loans outstanding $438,761 $405,696 $404,717 $380,970 $310,624 ============================================================================ Balance at beginning of year $ 5,369 $ 5,092 $ 4,272 $ 3,886 $ 3,231 Charge-offs: Commercial and industrial loans 533 241 276 141 55 Real estate mortgage loans 120 299 61 32 --- Real estate construction loans 24 --- --- --- --- Loans to individuals 873 1,120 1,234 955 715 ---------------------------------------------------------------------------- Total loans charged off 1,550 1,660 1,571 1,128 770 ---------------------------------------------------------------------------- Recoveries: Commercial and industrial loans 46 104 13 8 3 Real estate mortgage loans 31 --- --- --- --- Real estate construction loans --- --- --- --- --- Loans to individuals 146 142 127 98 93 ---------------------------------------------------------------------------- Total recoveries 223 246 140 106 96 ---------------------------------------------------------------------------- Net loans charged off 1,327 1,414 1,431 1,022 674 ---------------------------------------------------------------------------- Additions charged to operations 1,189 1,691 2,251 1,408 1,329 ---------------------------------------------------------------------------- Acquisition of CNB 498 --- --- --- --- ---------------------------------------------------------------------------- Balance at end of year $ 5,729 $ 5,369 $ 5,092 $ 4,272 $ 3,886 ============================================================================ Net charge-offs to average net loans outstanding 0.30% 0.34% 0.35% 0.27% 0.21% =====================================================================================================================
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. 24 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, --------------------------------------------------------------------------------------------------------------------- 2004 2003 2002 2001 2000 --------------------------------------------------------------------------------------------------------------------- Percent of Percent of Percent of Percent of Percent of Loans in Loans in Loans in Loans in Loans in ($ in Allowance Each Allowance Each Allowance Each Allowance Each Allowance Each thousands) Amount Category to Amount Category to Amount Category to Amount Category to Amount Category to Total Loans Total Loans Total Loans Total Loans Total Loans ================================================================================================================================== Commercial and industrial loans $1,387 51.90% $1,239 51.26% $235 50.98% $557 47.43% $255 45.29% ---------------------------------------------------------------------------------------------------------------------------------- Real estate mortgage loans 990 24.10% 970 21.56% 911 20.01% 50 19.33% 120 19.66% ---------------------------------------------------------------------------------------------------------------------------------- Real estate construction loans 359 5.22% 125 6.88% --- 5.44% --- 4.89% --- 4.62% ---------------------------------------------------------------------------------------------------------------------------------- Loans to individuals 2,016 18.78% 2,257 20.30% 3,092 23.57% 2,909 28.35% 1,709 30.43% ---------------------------------------------------------------------------------------------------------------------------------- Unallocated 977 778 854 756 1,802 ---------------------------------------------------------------------------------------------------------------------------------- $5,729 100.00% $5,369 100.00% $5,092 100.00% $4,272 100.00% $3,886 100.00% =====================================================================================================================
25 Balance Sheet 2004 vs 2003 Total assets for Company at December 31, 2004 were $796,154, an increase of $87,594, or 12.36%, over December 31, 2003. The two acquisitions described in the performance summary account for much of the growth. In the fourth quarter of 2004, the Company announced plans to acquire two branches from Planters Bank and Trust Company of Virginia. This acquisition will add approximately $22 million in deposits. The transaction is scheduled to close in February 2005. 2003 vs 2002 Total assets for the Company increased by $23,625 or 3.45% in 2003. Total deposits increased by $17,107 or 2.81%. Growth was from development of the existing franchise, as there were no acquisitions in 2003. Loans 2004 vs 2003 The mix of loan categories at December 31, 2004 and December 31, 2003 is shown in the following table. December 31, 2004 December 31, 2003 Construction loans (1) $ 25,009 $ 28,055 Real estate loans 115,388 87,899 Commercial and industrial loans 248,523 208,997 Loans to individuals 89,889 82,742 ------ ------ Total loans $ 478,809 $ 407,693 ======= ======= (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 December 31, 2004 there were approximately $3,611 in commitments to extend mortgage loans outstanding and $1,717 at December 31, 2003. Construction loans were $25,009 at December 31, 2004 and $28,055 at December 31, 2003, a decrease of $3,046. This category tends to fluctuate because of demand. Demand may vary due to economic conditions and seasons. 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 December 31, 2004 were $115,388, which represents an increase of $27,489 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 $13,000 was acquired from CNB and $2,600 was acquired from FNB-SE. Commercial and industrial loans were $248,523 at December 31, 2004, which represents an increase of $39,526 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 $14,000 of this growth, and the FNB-SE acquisition contributed $2,400. Historically, growth in this category has been satisfactory, and based on present knowledge, no adverse trends are anticipated. Loans to individuals increased by $7,147 when December 31, 2004 is compared to December 31, 2003. Growth attributable to the CNB transaction was approximately $5,300, and $2,200 came from FNB-SE. Growth rates in this category have trended downward, with most growth being the result of acquisitions. See the comments under "Net Interest Income". 2003 vs 2002 Loans net of unearned income decreased by $2,542 or .62% in 2003. Real estate construction and real mortgage loans both showed increases of approximately $5,700, however this was offset by a slight decline in commercial loans and a $14,000 decline in loans to individuals. Management believes the decline in loans to individuals is due to several reasons. o General economic conditions and the lack of employment opportunity in portions of the Company's market area. o A decline in consumer requests for new car financing because of special financing incentives offered by automobile companies. o Consumers' use of credit cards 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. 26 Securities 2004 vs 2003 Securities available for sale increased by $16,023 from December 31, 2003, while securities held to maturity increased by $4,531. Of that increase, approximately $9,519 was attributable to the CNB transaction. During 2004, $1,310 in securities held to maturity were sold. Credit quality concerns prompted these sales. 2003 vs 2002 Securities in the available for sale portfolio increased $9,566 when December 31, 2003 and 2002 are compared. Securities held to maturity increased $1,294 when the same comparison is made. In order to maximize yields, securities are generally purchased with long term maturities. Many have call features. As set out in the "Statement of Cash Flows", the Company sold one bond classified as held to maturity because of credit quality concerns. It should be noted that over the past three years the Company has purchased approximately $135 million in securities classified as held to maturity. When the volume of securities purchased is considered, there have been few credit quality concerns in the investment portfolio. Credit quality will continue to be monitored and any necessary adjustments initiated to ensure that credit quality remains high and that it meets regulatory standards. A. Types of Loans
================================================================ December 31, ---------------------------------------------------------------- 2004 2003 2002 2001 2000 ===================================================================================================== Commercial and industrial loans $248,523 $208,997 $209,368 $189,764 $163,929 Real estate mortgage loans 115,388 87,899 82,193 77,339 71,163 Real estate construction loans 25,009 28,055 22,294 19,573 16,726 Loans to individuals 89,889 82,742 96,762 113,413 110,176 ---------------------------------------------------------------- Total loans $478,809 $407,693 $410,617 $400,089 $361,994 Less unearned income and deferred fees (881) (896) (1,278) (1,775) (2,313) ---------------------------------------------------------------- Total loans, net of unearned income $477,928 $406,797 $409,339 $398,314 $359,681 Less allowance for loans losses (5,729) (5,369) (5,092) (4,272) (3,886) ---------------------------------------------------------------- Total loans, net $472,199 $401,428 $404,247 $394,042 $355,795 =====================================================================================================
B. Maturities and Interest Rate Sensitivities
=================================================== December 31, 2004 --------------------------------------------------- 1 - 5 After < 1 Year Years 5 Years Total ======================================= ============== =========== ============ =========== Commercial and industrial $64,253 $140,664 $43,606 $248,523 Real estate construction 25,009 --- --- 25,009 --------------------------------------- -------------- ----------- ------------ ----------- 89,262 140,664 43,606 273,532 Less loans with predetermined interest rates 24,883 17,287 16,627 58,797 -------------- ----------- ------------ ----------- Loans with adjustable rates $64,379 $123,377 $26,979 $214,735 ======================================= ============== =========== ============ ===========
C. Risk Elements Nonaccrual, Past Due and Restructured Loans The following table presents aggregate amounts for nonaccrual loans, restructured loans, other real estate owned net, and 27 accruing loans which are contractually past due ninety days or more as to interest or principal payments.
======================================================= December 31, ------------------------------------------------------- 2004 2003 2002 2001 2000 ------------------------------------------------------------------------------------------------------ Nonaccrual loans: Commercial and industrial $354 $302 $102 $175 $ 65 Real estate mortgage 40 44 152 11 5 Loans to individuals --- 8 34 168 18 Total nonperforming loans $394 $354 $288 $354 $ 88 Other real estate owned, net 895 1,663 537 211 540 ------------------------------------------------------------------------------------------------------ Total nonperforming assets $1,289 $2,017 $825 $ 565 $628 ======================================================= ------------------------------------------------------------------------------------------------------ Accruing loans past due 90 days or more: Commercial and industrial $321 $98 $462 $303 $242 Real estate mortgage 258 619 119 277 664 Loans to individuals 175 214 396 400 415 ------------------------------------------------------------------------------------------------------ $754 $931 $977 $980 $1,321 ======================================================================================================
Loan loss and other industry indicators related to asset quality are presented in the Loan Loss Data table.
Loan Loss Data Table 2004 2003 2002 ------------------------------------------------- ------------------ ------------------ -------------- Provision for loan losses $ 1,189 $ 1,691 $ 2,251 ------------------------------------------------- ------------------ ------------------ -------------- Net charge-offs to average net loans 0.30% 0.34% 0.35% ------------------------------------------------- ------------------ ------------------ -------------- Allowance for loan losses to loans, net of unearned income and deferred fees 1.20% 1.32% 1.24% ------------------------------------------------- ------------------ ------------------ -------------- Allowance for loan losses to nonperforming loans 1,454.06% 1,516.67% 1,768.06% ------------------------------------------------- ------------------ ------------------ -------------- Allowance for loan losses to nonperforming assets 444.45% 266.19% 617.21% ------------------------------------------------- ------------------ ------------------ -------------- Nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned .27% .49% 0.20% ------------------------------------------------- ------------------ ------------------ -------------- Nonaccrual loans 394 354 288 ------------------------------------------------- ------------------ ------------------ -------------- Restructured loans --- --- --- ------------------------------------------------- ------------------ ------------------ -------------- Other real estate owned, net 895 1,663 537 ------------------------------------------------- ------------------ ------------------ -------------- Total nonperforming assets $ 1,289 $ 2,017 $ 825 ------------------------------------------------- ------------------ ------------------ -------------- Accruing loans past due 90 days or more $ 754 $ 931 $ 977 ------------------------------------------------- ------------------ ------------------ --------------
Note: Nonperforming loans include nonaccrual loans and restructured loans, but do not include accruing loans 90 days or more past due. 28 B. Maturities and Associated Yields The following table presents the maturities for securities available for sale and held to maturity as of December 31, 2004 and weighted average yield for each range of maturities.
======================================================================================= Maturities and Yields December 31, 2004 --------------------------------------------------------------------------------------- ($ in thousands except for % data) <1 Year 1-5 Years 5-10 Years >10 Years None Total ============================================================================================================================== Available for Sale ------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury $ --- $ 2,000 2,014 $ --- $ --- $ 4,014 --- 4.19% 3.97% --- --- 4.08% ----------------------------------------------------------------------------------------------------------------------------- U.S. Government agencies 2,029 2,854 1,992 --- --- 6,875 2.22% 4.05% 4.47% --- --- 3.63% ------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities --- 958 3,467 13,439 --- 17,864 --- 4.04% 4.05% 4.99% --- 4.76% ------------------------------------------------------------------------------------------------------------------------------ States and political --- 105 3,974 1,239 --- 5,318 subdivision - taxable --- 5.88% 4.86% 7.80% --- 5.56% ------------------------------------------------------------------------------------------------------------------------------ States and political subdivision 694 5,753 52,723 14,654 --- 73,824 - nontaxable(1) 7.94% 6.27% 6.27% 6.57% --- 6.35% ------------------------------------------------------------------------------------------------------------------------------ Corporate 2,767 10,409 20,672 --- --- 33,848 5.80% 3.77% 4.75% --- --- 4.54% ------------------------------------------------------------------------------------------------------------------------------ Federal Home Loan Bank stock --- --- --- --- 1,603 1,603 --- --- --- --- 3.75% 3.75% ------------------------------------------------------------------------------------------------------------------------------ Federal Reserve Bank stock --- --- --- --- 209 209 --- --- --- --- 6.00% 6.00% ------------------------------------------------------------------------------------------------------------------------------ Other securities --- --- --- --- 1,768 1,768 --- 22,079 --- 29,332 1.75% 1.75% ------------------------------------------------------------------------------------------------------------------------------ Total 5,490 22,079 84,842 28,332 3,580 145,323 4.60% 4.52% 5.65% 5.90% 2.99% 5.43% ------------------------------------------------------------------------------------------------------------------------------ Held to Maturity ------------------------------------------------------------------------------------------------------------------------------ U.S. Treasury --- --- --- --- --- --- --- --- --- --- --- --- ------------------------------------------------------------------------------------------------------------------------------ U.S. Government agencies 2,997 4,992 8,987 --- --- 16,976 4.24% 3.91% 4.52% --- --- 4.29% ------------------------------------------------------------------------------------------------------------------------------ Mortgage-backed securities 3 9 --- 3,042 --- 3,054 7.50% 7.63% --- 6.18% --- 6.19% ------------------------------------------------------------------------------------------------------------------------------ States and political --- --- 2,665 --- --- 2,665 subdivision - taxable --- --- 5.47% --- --- 5.47% ------------------------------------------------------------------------------------------------------------------------------ States and political 1,020 2,670 40,385 8,570 --- 52,645 subdivision - nontaxable 7.28% 6.26% 6.51% 6.32% --- 6.48% ------------------------------------------------------------------------------------------------------------------------------ Corporate 7,480 11,296 9,269 2,000 --- 30,045 5.93% 6.02% 5.26% 5.03% --- 5.70% ------------------------------------------------------------------------------------------------------------------------------ Other securities --- --- --- --- --- --- --- --- --- --- --- --- ------------------------------------------------------------------------------------------------------------------------------ Total $11,500 $18,967 $61,306 $13,612 --- $105,385 5.61% 5.50% 5.98% 6.10% --- 5.87% ==============================================================================================================================
(1) Rates shown represent weighted average yield on a fully taxable basis. The majority of mortgage-backed securities and collateralized mortgage obligations held at December 31, 2004 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 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. Except for U.S. Government securities, the Company has no securities with any issuer that exceeds 10% of stockholders' equity. 29 Deposits 2004 vs 2003 Total deposits grew $80,554 or 12.88% when December 31, 2004 and December 31, 2003 are compared. Of the nearly $80,000 in growth, approximately $60,000 was due to acquisitions. The decline in time deposits is a continuation of the trend of customers being unwilling to choose longer term deposit instruments. This trend is expected to reverse when interest rates move to higher levels, which will provide an incentive for customers to invest for longer periods. In addition to these acquisitions, the Company's BTC subsidiary has entered into an agreement to purchase two branch offices from Planters Bank and Trust Company of Virginia. This transaction, which is expected to close in February of 2005, added approximately $22,000 in deposits. 2003 vs 2002 Total deposits grew by $17,107 or 2.81% in 2003. All categories reflected increases except time deposits, which declined by 1.19%. In the interest-bearing deposit categories the largest dollar growth was in interest-bearing demand deposits, which grew by $7,154. This was followed by savings deposits, which grew by $4,128. A. Average Amounts of Deposits and Average Rates Paid Average amounts and average rates paid on deposit categories are presented below:
======================================================================= December 31, ----------------------------------------------------------------------- 2004 2003 2002 ----------------------------------------------------------------------- Average Average Average Average Rates Average Rates Average Rates ($ in thousands) Amounts Paid Amounts Paid Amounts Paid ----------------------------------------------------------------------------------------------------- Noninterest-bearing demand deposits $ 93,320 --- $ 79,760 --- $ 74,269 --- Interest-bearing demand deposits 186,106 0.84% 167,428 0.94% 147,749 1.50% Savings deposits 58,899 0.43% 51,646 0.63% 49,151 1.03% Time deposits 327,302 2.84% 317,989 3.26% 312,129 4.18% ----------------------------------------------------------------------------------------------------- Average total deposits $665,627 1.94% $616,823 2.28% $583,298 3.10% =====================================================================================================
B. Time Deposits of $100,000 or More The following table sets forth time certificates of deposit and other time deposits of $100,000 or more:
======================================================================= December 31, 2004 ======================================================================= 3 Months Over 3 Months Over 6 Months Over 12 Total or Less Through 6 Through 12 Months ($ in thousands) Months Months ------------------------------------------------------------------------------------------------------- Total time deposits of $100,000 or more $13,284 $20,189 $24,154 $47,709 $105,336 =======================================================================================================
30 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 and FNMA's, with a fair value of approximately $20,769, which includes $3,112 of structured notes, none of which is mortgage-backed. 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. The effects of changing interest rates are primarily managed through adjustments to the loan portfolio and deposit base, to the extent competitive factors allow. The investment portfolio is generally longer term. Adjustments for asset and liability management concerns are addressed when securities are called or mature and funds are subsequently reinvested. Historically, sales of securities have occurred for reasons related to credit quality or regulatory limitations. Few, if any, securities available for sale have been disposed of for the express purpose of managing interest rate risk. No trading activity for this purpose is planned for the foreseeable future, though it does remain an option. 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 2004 vs 2003 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 2004 and 2003. Net cash provided by operating activities was $20,863 for the period ended December 31, 2004, which compares to $14,793 for the same period the previous year. Net cash used in investing activities was $36,291 for the period ended December 31, 2004, and $27,976 used for the period ended December 31, 2003. The Company used approximately $13,602 in acquisitions, and it had no acquisitions in 2003. Net cash provided in financing activities was $16,188 for the period ending December 31, 2004 and $12,600 for the period ending December 31, 2003. 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 December 31, 2004 and December 31, 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 December 31, 2004. Total shareholders' equity grew by $6,447 from December 31, 2003 to December 31, 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 $172. 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 December 31, 2004 were 12.36% and 13.39%, respectively. 2003 vs 2002 Cash flows from operating activities for 2003 were $14,794. The principal source of cash was net income. Net cash used in investment activities was $27,976. Included in this account are $35,818 in purchases of securities available for sale, $23,185 in securities held to maturity and $17,402 in interest-bearing deposits. 31 Cash provided by financing activities was $12,599 compared to $28,792 in 2002. Time deposits decreased by $3,814 in 2003 and $1,743 in 2002. Other deposits increased $20,921 in 2003. Comments made under "Deposits" apply. Recent Accounting Pronouncements See Note 1, of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements. Capital Resources Total shareholders' equity at December 31, 2004 was $87,088, an increase of $6,447 or 7.99%. Total average capital to total average assets was 11.21% for 2004, which compares to 11.12% in 2003. Of the increase, net income accounted for $12,230, offset by dividends to shareholders in the amount of $4,504. Stock repurchased during the year cost $217, while stock options exercised resulted in an addition to capital of $172. Off-Balance Sheet Arrangements The Company's off-balance sheet arrangements are detailed in the table below.
Payments Due by Period Total Less Than 1-3 Years 3-5 More Than 1 Year Years 5 Years -------------------------------------------------------------------------------------------------- Commitments to extend credit $ 103,816 103,816 --- --- --- Standby Letters of Credit 4,365 4,365 --- --- --- Mortgage Loans with Potential Recourse 17,649 17,649 --- --- --- Commitments to invest in LLC's 912 912 --- --- --- Operating Leases 475 112 158 135 70 -------------------------------------------------------------------------------------------------- Total $ 127,217 127,217 158 135 70 ============================================================
In the normal course of business the Company's banking affiliates extend lines of credit to their customers. Amounts drawn upon these lines vary at any given time depending on the business needs of the customers. Standby letters of credit are also issued to the banks' customers. There are two types of standby letters of credit. The first is a guarantee of payment to facilitate customer purchases. The second type is a performance letter of credit that guarantees a payment if the customer fails to perform a specific obligation. Revenue from these letters was approximately $19 in 2004. While it would be possible for customers to draw in full on approved lines of credit and letters of credit, historically this has not occurred. In the event of a sudden and substantial draw on these lines, the Company has its own lines of credit on which it could draw funds. Sale of the loans would also be an option. The Company also sells mortgages on the secondary market for which there are recourse agreements should the borrower default. Operating leases are for buildings used in the day-to-day operations of the Company. Item 7A. Quantitative and Qualitative Disclosures About Market Risk See "Analysis of Interest Rate Sensitivity" set forth below. Additional information is set forth in the "Interest Rate Sensitivity" and "Derivatives and Market Risk Exposure" sections. 32 Item 8. Financial Statements and Supplementary Data CONSOLIDATED BALANCE SHEETS
$ In thousands, except share data. December 31, -------------- ----------- 2004 2003 -------------- ----------- Assets: -------- Cash and due from banks $ 12,493 $ 11,733 ----------------------------------------------------------- -------------- ----------- Interest-bearing deposits 22,463 36,220 ----------------------------------------------------------- -------------- ----------- Securities available for sale, at fair value 145,323 129,300 ----------------------------------------------------------- -------------- ----------- Securities held to maturity (fair value approximates $107,697 at December 31, 2004 and $105,026 at December 31, 2003) 105,385 100,854 ----------------------------------------------------------- -------------- ----------- Mortgage loans held for sale 1,003 714 ----------------------------------------------------------- -------------- ----------- Loans: ----------------------------------------------------------- -------------- ----------- Real estate construction loans 25,009 28,055 ----------------------------------------------------------- -------------- ----------- Real estate mortgage loans 115,388 87,899 ----------------------------------------------------------- -------------- ----------- Commercial and industrial loans 248,523 208,997 ----------------------------------------------------------- -------------- ----------- Loans to individuals 89,889 82,742 ----------------------------------------------------------- -------------- ----------- Total loans 478,809 407,693 ----------------------------------------------------------- -------------- ----------- Less unearned income and deferred fees (881) (896) ----------------------------------------------------------- -------------- ----------- Loans, net of unearned income and deferred fees 477,928 406,797 ----------------------------------------------------------- -------------- ----------- Less allowance for loan losses (5,729) (5,369) ----------------------------------------------------------- -------------- ----------- Loans, net 472,199 401,428 ----------------------------------------------------------- -------------- ----------- Premises and equipment, net 12,104 10,094 ----------------------------------------------------------- -------------- ----------- Accrued interest receivable 4,870 4,610 ----------------------------------------------------------- -------------- ----------- Other real estate owned, net 895 1,663 ----------------------------------------------------------- -------------- ----------- Intangible assets and goodwill 16,924 9,958 ----------------------------------------------------------- -------------- ----------- Other assets 2,495 1,986 ----------------------------------------------------------- -------------- ----------- Total assets $ 796,154 $708,560 ============== =========== Liabilities and Stockholders' Equity: ------------------------------------- Noninterest-bearing demand deposits $ 106,189 $ 83,671 ----------------------------------------------------------- -------------- ----------- Interest-bearing demand deposits 198,897 172,370 ----------------------------------------------------------- -------------- ----------- Saving deposits 62,817 53,084 ----------------------------------------------------------- -------------- ----------- Time deposits 338,029 316,253 ----------------------------------------------------------- -------------- ----------- Total deposits 705,932 625,378 ----------------------------------------------------------- -------------- ----------- Other borrowed funds 297 135 ----------------------------------------------------------- -------------- ----------- Accrued interest payable 483 489 ----------------------------------------------------------- -------------- ----------- Other liabilities 2,354 1,917 ----------------------------------------------------------- -------------- ----------- Total liabilities 709,066 627,919 ----------------------------------------------------------- -------------- ----------- 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 10,000,000 shares; issued and outstanding, 3,519,002 shares - 2004, and 3,515,377 - 2003 8,797 8,788 ----------------------------------------------------------- -------------- ----------- Retained earnings 77,735 70,063 ----------------------------------------------------------- -------------- ----------- Accumulated other comprehensive income, net 556 1,790 ----------------------------------------------------------- -------------- ----------- Total stockholders' equity 87,088 80,641 ----------------------------------------------------------- -------------- ----------- Total liabilities and stockholders' equity $ 796,154 $708,560 ----------------------------------------------------------- ============== ===========
The accompanying notes are an integral part of these consolidated financial statements. 33 CONSOLIDATED STATEMENTS OF INCOME
$ In thousands, except per share data. Years ended December 31, ---------- ---------- --------- 2004 2003 2002 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest Income Interest and fees on loans $ 29,812 $ 29,798 $32,420 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest on federal funds sold 5 16 42 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest on interest-bearing deposits 196 230 276 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest on securities - taxable 6,184 5,668 5,490 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest on securities - nontaxable 5,295 5,369 4,519 ---------------- -------------------------------------------------- ---------- ---------- --------- Total interest income 41,492 41,081 42,747 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest Interest on time deposits of $100,000 or more 3,138 3,016 3,470 Expense -------------------------------------------------- ---------- ---------- --------- Interest on other deposits 7,973 9,234 12,289 ---------------- -------------------------------------------------- ---------- ---------- --------- Interest on borrowed funds 14 2 5 ---------------- -------------------------------------------------- ---------- ---------- --------- Total interest expense 11,125 12,252 15,764 ---------------- -------------------------------------------------- ---------- ---------- --------- Net interest income 30,367 28,829 26,983 ---------------- -------------------------------------------------- ---------- ---------- --------- Provision for loan losses 1,189 1,691 2,251 ---------------- -------------------------------------------------- ---------- ---------- --------- Net interest income after provision for loan losses 29,178 27,138 24,732 ---------------- -------------------------------------------------- ---------- ---------- --------- Noninterest Service charges on deposit accounts 3,003 2,597 2,229 Income -------------------------------------------------- ---------- ---------- --------- Other service charges and fees 252 267 260 ---------------- -------------------------------------------------- ---------- ---------- --------- Credit card fees 1,839 1,612 1,409 ---------------- -------------------------------------------------- ---------- ---------- --------- Trust income 1,436 1,132 968 ---------------- -------------------------------------------------- ---------- ---------- --------- Other income 444 448 500 ---------------- -------------------------------------------------- ---------- ---------- --------- Realized securities gains, net 168 130 346 ---------------- -------------------------------------------------- ---------- ---------- --------- Total noninterest income 7,142 6,186 5,712 ---------------- -------------------------------------------------- ---------- ---------- --------- Noninterest Salaries and employee benefits 10,498 9,568 8,912 Expense -------------------------------------------------- ---------- ---------- --------- Occupancy and furniture and fixtures 1,797 1,655 1,692 ---------------- -------------------------------------------------- ---------- ---------- --------- Data processing and ATM 1,302 1,164 1,096 ---------------- -------------------------------------------------- ---------- ---------- --------- Credit card processing 1,502 1,244 1,036 ---------------- -------------------------------------------------- ---------- ---------- --------- Intangible assets and goodwill amortization 967 954 954 ---------------- -------------------------------------------------- ---------- ---------- --------- Net costs of other real estate owned 201 178 145 ---------------- -------------------------------------------------- ---------- ---------- --------- Other operating expenses 4,069 3,883 3,592 ---------------- -------------------------------------------------- ---------- ---------- --------- Total noninterest expense 20,336 18,646 17,427 ---------------- -------------------------------------------------- ---------- ---------- --------- Income before income taxes 15,984 14,678 13,017 ---------------- -------------------------------------------------- ---------- ---------- --------- Income tax expense 3,754 3,236 3,003 ---------------- -------------------------------------------------- ---------- ---------- --------- Net income $ 12,230 $ 11,442 $10,014 ======== ======== ======= Basic net income per share $ 3.48 $ 3.26 $2.85 ======== ======== ======= Fully diluted net income per share $ 3.46 $ 3.24 $2.85 ======== ======== =======
The accompanying notes are an integral part of these consolidated financial statements. 34 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
$ In thousands, except per share data. Common Retained Accumulated Other Comprehensive Total Stock Earnings Comprehensive Income Income ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- 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 dividends ($0.97 per share) --- (3,406) --- (3,406) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Balance at December 31, 2002 $ 8,778 $ 62,525 $ 1,798 $ 73,101 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Net income --- 11,442 --- $ 11,442 11,442 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Other comprehensive loss: Unrealized holding gains on available for sale securities net of deferred taxes of $28 --- --- --- 52 --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Less: reclassification adjustment, net of income taxes of $(46) --- --- --- (84) --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Minimum pension liability adjustment net of deferred taxes of $8 --- --- --- 24 --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Other comprehensive loss, net of tax of $(10) --- --- (8) (8) (8) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Total comprehensive income --- --- --- $ 11,434 --- ------------------------------------ ---------- ----------- ------------------------ ================= ---------- Cash dividends ($1.13 per share) --- (3,971) --- (3,971) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Exercise of stock options 10 67 --- 77 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Balance at December 31, 2003 $ 8,788 $ 70,063 $ 1,790 $ 80,641 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Net income --- 12,230 --- $ 12,230 12,230 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Other comprehensive loss: ------------------------- Unrealized holding losses on available for sale securities net of deferred taxes of $(516) --- --- --- (958) --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Less: reclassification adjustment, net of income taxes of $7 --- --- --- 12 --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Minimum pension liability adjustment, net of deferred taxes of $(155) --- --- --- (288) --- ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Other comprehensive loss, net of tax of $(664) --- --- (1,234) (1,234) (1,234) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Total comprehensive income --- --- --- $ 10,996 --- ------------------------------------ ---------- ----------- ------------------------ ================= ---------- Cash dividend ($1.28 per share) --- (4,504) --- (4,504) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Exercise of stock options 22 150 --- 172 ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Common stock repurchase (13) (204) --- (217) ------------------------------------ ---------- ----------- ------------------------ ----------------- ---------- Balance at December 31, 2004 $ 8,797 $ 77,735 $ 556 $ 87,088 ==================================== ========== =========== ======================== ================= ==========
The accompanying notes are an integral part of these consolidated financial statements. 35
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, $ In thousands. 2004 2003 2002 ------------ ----------- ---------- Cash Net income $12,230 $11,442 $ 10,014 Flows Adjustment to reconcile net income to net cash from provided by operating activities: Operating Provision for loan losses 1,189 1,691 2,251 Activities Deferred income tax (benefit) (18) (200) (551) Depreciation of premises and equipment 953 924 977 Amortization of intangibles 967 954 954 Amortization of premiums and accretion of discounts, net 335 359 392 (Gains) losses on sale and calls of securities available for sale, net 95 (79) (331) (Gains) losses on calls of securities held to maturity, net (263) (51) (15) Losses and writedowns on other real estate owned 139 94 87 Originations of mortgage loans held for sale (17,938) (37,039) (36,915) Sales of mortgage loans held for sale 17,649 37,171 37,214 (Gains) losses on sale and disposal of fixed assets --- 40 (11) Net change in: Accrued interest receivable (260) (320) 627 Other assets 8,253 216 (34) Accrued interest payable (6) (211) (401) Other liabilities 9 (198) (14) ------------ ----------- ---------- Net cash provided by operating activities 23,334 14,793 14,244 ------------ ----------- ---------- Cash Net change in federal funds sold --- 1,724 (644) Flows Net change in interest-bearing deposits 13,757 (17,402) (3,308) from Proceeds from repayments of mortgage-backed Investing securities 7,373 9,872 4,656 Activities Proceeds from sales of securities available for sale 94 1,193 813 Proceeds from calls, maturities, and principal repayments of securities available for sale 18,765 15,127 11,042 Proceeds from calls, maturities, and principal repayments of securities held to maturity 7,971 20,632 20,017 Proceeds from the sale of securities held to maturity 1,310 1,093 --- Purchases of securities available for sale (31,849) (35,818) (44,995) Purchases of securities held to maturity (15,788) (23,185) (16,953) Purchases of loan participations (1,668) (6,619) (19,440) Collections of loan participations 1,499 9,579 3,981 Acquisition of Community National Bank, net (8,022) --- --- Loan originations and principal collections, net (30,495) (3,592) 2,190 Proceeds from disposal of other real estate owned 1,031 294 255 Recoveries on loans charged off 223 246 145 Additions to premises and equipment (2,966) (1,527) (805) Proceeds from sale of premises and equipment 3 407 33 ------------ ----------- ---------- Net cash used by investing activities (38,762) (27,976) (43,013) ------------ ----------- ---------- Cash Net change in time deposits 495 (3,814) (1,743) Flows Net change in other deposits 20,080 20,921 33,396 from Net change in other borrowed funds 162 (613) 545 Financing Cash dividends paid (4,504) (3,971) (3,406) Activities Common stock repurchase (217) 77 --- Stock options exercised 172 --- --- ------------ ----------- ---------- Net cash provided by financing activities 16,188 12,600 28,792 ------------ ----------- ---------- Supplemental Net change in cash and due from banks 760 (583) 23 Disclosures Cash and due from banks at beginning of year 11,733 12,316 12,293 of Cash Flow ------------ ----------- ---------- Information Cash and due from banks at end of year $12,493 $11,733 $12,316 ------------ ----------- ---------- Interest paid on deposits and borrowed funds $11,131 $12,463 $16,165 Income taxes paid 3,578 3,338 3,414 Supplemental Loans charged against the allowance for loan Disclosures losses 1,550 1,660 1,576 of Noncash Loans transferred to other real estate owned 402 1,514 668 Activities Unrealized gain (loss) on securities available for sale (1,455) 3 2,444 Minimum pension liability adjustment 428 (41) 689 36 CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) Transactions related to the acquisition of Community National Bank: Increase in assets and liabilities: Investments 10,052 --- --- Loans 40,371 --- --- Deposits 59,979 --- ---
The accompanying notes are an integral part of these consolidated financial statements. 37 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, Inc. (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, 2004 or 2003. 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 held for sale are generally sold with the mortgage servicing rights released by the Company. 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 the 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 charged off 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. 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. The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as 38 impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent to the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. 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. Rate Lock Commitments The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 60 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, by committing to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. As a result, the Company is not exposed to losses nor will it realize significant gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitments and the best efforts contracts is very high due to their similarity. The market value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best effort contracts are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the changes in the value of the underlying assets while taking into consideration the probability that the rate lock commitments will close. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments. 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 3 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 $10,882 and $9,726 at December 31, 2004 and 2003, respectively, and goodwill of $6,042 and $232 at December 31, 2004 and 2003, respectively. Deposit intangibles are being amortized on a straight-line basis over a ten- or twelve-year period, and goodwill still being amortized on a straight-line basis is over a fifteen-year period. Goodwill from the CNB acquisition is not being amortized, but is subject to annual impairment testing. Stock-Based Compensation At December 31, 2004, 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. 39
Years Ended December 31, ---------------------------------------------- 2004 2003 2002 ------------- ---------------- --------------- (In thousands, except per share data) Net income as reported $ 12,230 $ 11,442 $ 10,014 Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards (102) (61) (35) ------------- ---------------- --------------- Pro forma net income $ 12,128 $ 11,381 $ 9,979 Earnings per share: ============= ================ =============== Basic-as reported $ 3.48 $ 3.26 $ 2.85 ============= ================ =============== Basic-pro forma $ 3.45 $ 3.24 $ 2.84 ============= ================ =============== Diluted-as reported $ 3.46 $ 3.24 $ 2.85 ============= ================ =============== Diluted-pro forma $ 3.43 $ 3.22 $ 2.84 ============= ================ ===============
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 that are 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 basis 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. 2004 2003 2002 ---- ---- ---- Average number of common shares outstanding 3,517,982 3,512,896 3,511,377 Effect of dilutive options 19,944 20,364 5,712 --------- --------- --------- Average number of common shares outstanding used to calculate diluted earnings per share 3,537,926 3,533,260 3,517,089 --------- --------- --------- In 2004 and 2002, stock options representing 13,125 and 9,750 shares, respectively, were not included in the computation of diluted net income per share because to do so would have been anti-dilutive. There were no anti-dilutive stock options excluded during 2003. 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. 40 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. Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). This Interpretation provides guidance with respect to the identification of variable interest entities when the assets, liabilities, non-controlling interests, and results of operations of a variable interest entity need to be included in a company's consolidated financial statements. An entity is deemed a variable interest entity, subject to the interpretation, if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or in cases in which the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity's activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. Due to significant implementation issues, the FASB modified the wording of FIN 46 and issued FIN 46R in December of 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities (SPEs) until financial statements issued for periods ending after March 15, 2004. SPEs were subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. The adoption of FIN 46 and FIN 46R did not have a material effect on the Company's consolidated financial position or consolidated results of operations. In December 2003, the Accounting Standards Executive Committee (AcSEC) of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer." The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The scope of the SOP applies to unhealthy "problem" loans that have been acquired, either individually in a portfolio, or in a business acquisition. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. The SOP does not apply to loans originated by the Company. The Company intends to adopt the provisions of SOP 03-3 effective January 1, 2005, and does not expect the initial implementation to have a significant effect on the Company's consolidated financial position or consolidated results of operations. 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 (EITF) Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" was issued and is effective March 31, 2004. 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 SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" 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 FASB 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 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 FASB 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 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. In December 2004, the FASB issued Statement of Financial Accounting 41 Standards No. 123 (revised 2004), "Share-Based Payment." This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires an entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period). The entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available). If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. This Statement is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. Under the transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures. For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123. 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, 2004 and 2003, the aggregate amounts of daily average required balances approximated $3,138 and $2,463, respectively. Note 3: Securities The amortized cost and fair value of securities available for sale, with gross unrealized gains and losses, follows:
December 31, 2004 Gross Gross Available for sale: Amortized Unrealized Unrealized Cost Gains Losses Fair Value -------------------------------------------- -------------- ------------- -------------- -------------- U.S. Treasury $ 4,041 $ 32 $ 59 $ 4,014 -------------------------------------------- U.S. Government agencies and corporations 6,831 55 11 6,875 States and political subdivisions 77,689 1,886 433 79,142 Mortgage-backed securities 17,609 284 29 17,142 Corporate debt securities 33,880 539 571 33,848 Federal Home Loan Bank stock-restricted 1,603 --- --- 1,603 Federal Reserve Bank stock-restricted 209 --- --- 209 Other securities 1,615 153 --- 1,768 ----- --- --- ----- Total securities available for sale $ 143,477 $ 2,949 $ 1,103 $ 145,323 ========= ======= ======= =========
December 31, 2003 Gross Gross Available for sale: Amortized Unrealized Unrealized Cost Gains Losses Fair Value ------------- -------------- ------------- ------------- U.S. Treasury $ 2,249 $ 91 $ --- $ 2,340 ---------------------------------------------- U.S. Government agencies and corporations 4,639 12 2 4,649 States and political subdivisions 80,872 2,524 282 83,114 Mortgage-backed securities 10,518 365 3 10,880 Corporate debt securities 24,609 773 319 25,063 Federal Home Loan Bank stock-restricted 1,646 --- --- 1,646 Federal Reserve Bank stock-restricted 209 --- --- 209 Other securities 1,257 142 --- 1,399 ----- --- --- ----- Total securities available for sale $ 125,999 $ 3,907 $ 606 $ 129,300 ========= ======= ===== =========
42 The amortized cost and fair value of single maturity securities available for sale at December 31, 2004, 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, 2004. December 31, 2004 Amortized Cost Fair Value -------------------- ------------------- Due in one year or less $ 5,460 $ 5,490 Due after one year through five years 21,988 22,079 Due after five years through ten years 83,834 84,842 Due after ten years 28,768 29,332 No maturity 3,427 3,580 -------------------- ------------------- $ 143,477 $ 145,323 ======= ======= The amortized cost and fair value of securities held to maturity, with gross unrealized gains and losses, follows:
December 31, 2004 Gross Gross Held to maturity: Amortized Unrealized Unrealized Cost Gains Losses Fair Value ------------- ------------ ------------ ----------- ------------- ------------ ------------ ----------- U.S. Government agencies and corporations $ 16,976 $ 40 $ 143 $ 16,873 States and political subdivisions 55,310 1,687 44 56,953 Mortgage-backed securities 3,054 113 2 3,165 Corporate debt securities 30,045 1,002 341 30,706 ------ ----- --- ------ Total securities held to maturity $ 105,385 $2,842 $ 530 $ 107,697 ======= ===== === =======
December 31, 2003 Gross Gross Held to maturity: Amortized Unrealized Unrealized Cost Gains Losses Fair Value -------------- ----------- ------------ ------------- U.S. Government agencies and corporations $ 5,993 $ 73 $ 66 $ 6,000 States and political subdivisions 56,361 2,257 104 58,514 Mortgage-backed securities 4,291 207 --- 4,498 Corporate debt securities 34,209 2,099 294 36,014 ------ ----- --- ------ Total securities held to maturity $ 100,854 $ 4,636 $ 464 $105,026 ======= ===== === =======
The amortized cost and fair value of single maturity securities held to maturity at December 31, 2004, 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, 2004. December 31, 2004 Amortized Fair Cost Value ---------------- ------------- Due in one year or less $ 11,500 $ 11,654 Due after one year through five years 18,967 19,683 Due after five years through ten years 61,306 62,615 Due after ten years 13,612 13,745 ------ ------ $ 105,385 $107,697 ========= ======== 43 Information pertaining to securities with gross unrealized losses at December 31, 2004 and 2003, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
December 31, 2004 Less Than 12 Months 12 Months or More ------------------- ----------------- Fair Unrealized Fair Unrealized Value Loss Value Loss U. S. Government agencies and corporations $ 15,012 170 $ 3,862 43 State and political subdivisions 20,270 340 4,803 137 Mortgage-backed securities 5,173 31 --- --- Corporate debt securities 20,168 344 9,285 568 ------ --- ----- --- Total temporarily impaired securities $ 60,623 885 $ 17,950 748 ====== === ====== ===
December 31, 2003 Less Than 12 Months 12 Months or More ------------------- ----------------- Fair Unrealized Fair Unrealized Value Loss Value Loss U. S. Government agencies and corporations $ 2,934 68 $ --- --- State and political subdivisions 14,191 365 1,173 21 Mortgage-backed securities 704 3 --- --- Corporate debt securities 14,217 613 --- --- ------ --- --- --- Total temporarily impaired securities $ 32,046 1,049 $ 1,173 21 ====== ===== ===== ==
The Company had 111 securities with a fair value of $78,573 which were temporarily impaired at December 31, 2004. The total unrealized loss on these securities was $1,633. Losses are attributed to interest rate movements. Credit quality of the securities portfolio is continuously monitored by management. The Company has the ability and intent to hold these securities until maturity. Therefore, the losses associated with these securities are not considered other than temporary at December 31, 2004. At December 31, 2004 and 2003, securities with a carrying value of $49,206 and $31,309, 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 $103,230, and NBB and BTC's capital stock investment in the FHLB. 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 $2,526 at December 31, 2004 and $5,037 at December 31, 2003. During the year ended December 31, 2004 total principal additions were $2,374 and principal payments were $4,885. Note 5: Allowance for Loan Losses An analysis of the allowance for loan losses follows:
Years ended December 31, 2004 2003 2002 ------------ ------------ ------------ Balance at beginning of year $ 5,369 $ 5,092 $ 4,272 Provision for loan losses 1,189 1,691 2,251 Loans charged off (1,550) (1,660) (1,571) Recoveries of loans previously charged off 223 246 140 Acquisition of bank 498 --- --- ------------ ------------ ------------ Balance at end of year $ 5,729 $ 5,369 $ 5,092 ============ ============ ============
44 The following is a summary of information pertaining to impaired loans: December 31, 2004 2003 2002 ---------- ---------- --------- Impaired loans without a valuation allowance $ 275 $ 365 $ 46 Impaired loans with a valuation allowance 79 506 93 ---------- ---------- --------- Total impaired loans $ 354 $ 871 $ 139 ========== =========== ======== Valuation allowance related to impaired loans $ 55 $ 135 $ 33 ========== =========== ======== Years ended December 31, 2004 2003 2002 --------- --------- -------- Average investment in impaired loans $601 $353 $397 Interest income recognized on impaired loans --- 66 11 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, 2004 and 2003 were $40 and $8, respectively. If interest on these loans had been accrued, such income would have been $2 and $0 respectively. Loans past due greater than 90 days which continue to accrue interest totaled $754 and $931 at December 31, 2004 and 2003, respectively. Note 6: Premises and Equipment A summary of the cost and accumulated depreciation of premises and equipment follows: December 31, 2004 2003 -------------------------------------- ------------- -------------- Premises $ 12,985 $ 11,419 Furniture and equipment 9,618 8,835 Construction-in-progress 564 10 ------------- -------------- $ 23,167 $ 20,264 Accumulated depreciation (11,063) (10,170) ------------- -------------- $ 12,104 $ 10,094 ============= ============== Depreciation expense for the years ended December 2004, 2003 and 2002 amounted to $953, $924 and $977, 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, 2004 are as follows: $108 in 2005, $88 in 2006, $72 in 2007, $66 in 2008, $68 in 2009, and $70 thereafter. Note 7: Deposits The aggregate amounts of time deposits in denominations of $100 or more at December 31, 2004 and 2003 were $105,336 and $95,216, respectively. At December 31, 2004 the scheduled maturities of time deposits are as follows: 2005 $ 176,157 2006 35,466 2007 43,098 2008 33,158 2009 29,684 Thereafter 20,466 --------- $ 338,029 ========= At December 31, 2004 and 2003, overdraft demand deposits reclassified to loans totaled $581 and $1,276, respectively. Note 8: Employee Benefit Plans 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 may 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, 2004, 2003 and 2002, NBB and BTC contributed $260, $231 and $227, respectively, to the plan. 45 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 $410, $389 and $227 in the years ended December 31, 2004, 2003 and 2002, respectively. Dividends on ESOP shares are charged to retained earnings. As of December 31, 2004, the number of allocated shares held by the ESOP was 106,745 and the number of unallocated shares was 4,860. 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, is 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. Defined Benefit Plan 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. Information pertaining to activity in the plans is as follows:
December 31, 2004 2003 2002 ----------------- ----------------- --------------- Change in benefit obligation: Benefit obligation at beginning of year $ 8,477 $ 7,078 $ 6,014 Service cost 497 427 353 Interest cost 538 501 429 Actuarial loss 900 938 593 (Gain) due to plan amendment --- --- (89) Benefits paid (192) (467) (222) ----------------- ----------------- --------------- Benefit obligation at end of year 10,220 8,477 7,078 ----------------- ----------------- --------------- Change in plan assets: Fair value of plan assets at beginning of year 5,415 4,504 4,650 Actual return on plan assets 424 729 (239) Employer contribution 745 649 315 Benefits paid (192) (467) (222) ----------------- ----------------- --------------- Fair value of plan assets at end of 6,392 5,415 4,504 ----------------- ----------------- --------------- Funded status (3,828) (3,062) (2,574) Unrecognized net actuarial loss 3,561 2,693 2,177 Unrecognized prior service cost 55 64 73 Unrecognized transition asset (76) (88) (100) ----------------- ----------------- --------------- Net accrued pension cost $ (288) $ (393) $ (424) ================= ================= ===============
The accumulated benefit obligations at December 31, 2004, 2003 and 2002 were $7,756, $6,456 and $5,618, respectively. Amounts recognized in the consolidated balance sheets:
December 31, 2004 2003 2002 ----------------- --------------- ------------- Accrued benefit liabilities $ (1,364) $(1,041) $ (1,113) Intangible asset 55 64 73 Deferred tax asset 376 227 235 Accumulated other comprehensive income 645 357 381 ----------------- --------------- ------------- Net amount recognized $ (288) $ (393) $ (424) ================= =============== =============
46 The components of net periodic cost are as follows:
Years ended December 31, 2004 2003 2002 --------------- ------------------- ----------------- Service cost $ 498 $ 427 $ 353 Interest cost 538 501 429 Expected return on plan assets (512) (418) (427) Amortization of prior service cost 9 9 9 Recognized net actuarial loss 120 111 12 Amortization of transition asset (13) (13) (13) --------------- ------------------- ----------------- Net periodic benefit cost $ 640 $ 617 $ 363 =============== =================== =================
The weighted average assumptions used to determine benefit obligations are as follows:
2004 2003 2002 --------------- ------------------- ----------------- Weighted assumptions as of December 31, Weighted average discount rate 6.00% 6.50% 7.00% Expected return on plan assets 9.00% 9.00% 9.00% Rate of compensation increases 4.00% 4.00% 4.00%
The weighted average assumptions used to determine net periodic benefit cost are as follows:
2004 2003 2002 --------------- ----------------- --------------- Weighted average assumptions as of December 31, Weighted average discount rate 6.50% 7.00% 7.50% Expected return on plan assets 9.00% 9.00% 9.00% Rate of compensation increase 4.00% 4.00% 5.00%
Long Term Rate of Return The Company, as plan sponsor, selects the expected long-term rate-of-return-on-assets assumption in consultation with its investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience, which may not continue over the measurement period, but other higher significance is placed on current forecasts of future long-term economic conditions. Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, and solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost). The Company, as plan sponsor, has adopted a Pension Administrative Committee Policy (the Policy) for monitoring the investment management of its qualified plans. The Policy includes a statement of general investment principles and a listing of specific investment guidelines, to which the committee may make documented exceptions. The guidelines state that, unless otherwise indicated, all investments that are permitted under the Prudent Investor Rule shall be permissible investments for the pension plan. All plan assets are to be invested in marketable securities. Certain investments are prohibited, including commodities and future contracts, private placements, repurchase agreements, options, and derivatives and stocks and ADR's of non-U.S. companies. The Policy establishes quality standards for fixed income investments and mutual funds included in the pension plan trust. The Policy also outlines diversification and asset allocation standards. The pension plan's weighted average asset allocations at October 31, 2004 and 2003 are as follows: Asset Allocation 2004 2003 ----------------------------------- ----------------- ------------------- U. S. Government obligations 13% 12% Mutual funds - equity 39% 40% Corporate bonds 14% 17% Equity securities 31% 27% Other 3% 4% ----------------- ------------------- 100% 100% ================= =================== 47 The Company expects to contribute $124 to the plan in 2005. Estimated future benefit payments, which reflect expected future service, as appropriate, are as follows: 2005 $ 26 2006 26 2007 25 2008 26 2009 26 2010 -2014 170 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 the NBI Board of Directors' Compensation Committee, made up entirely of independent 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, 2004, there were 162,500 additional shares available for grant under the Plan. A summary of the status of the Company's stock option plan is presented below:
2004 2003 2002 ----------------------- ------------------------- ----------------------- Number of Weighted Number of Weighted Number Weighted Shares Average Shares Average of Shares Average Exercise Exercise Exercise Price Price Price ----------- ----------- ------------- ----------- ---------- ------------ Outstanding, beginning of year 64,000 $ 30.24 51,500 $ 24.06 34,000 $ 21.18 Granted 19,500 49.85 16,500 46.65 17,500 29.65 Exercised (8,625) 19.95 (4,000) 19.16 --- --- ----------- ----------- ----------- Outstanding, end of year 74,875 $ 36.53 64,000 $ 30.24 51,500 $ 24.06 =========== =========== =========== Options exercisable at year-end 30,500 $ 27.55 24,125 $ 22.74 14,375 $ 20.76 Weighted-average fair value of options granted during the year $ 11.62 $ 10.65 $ 5.97
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, ---------------------------------------------------- 2004 2003 2002 ----------------- ----------------- ---------------- Dividend yield 1.74% 1.73% 1.88% Expected life 10 years 10 years 10 years Expected volatility 23.54% 22.14% 22.14% Risk-free interest rate 4.60% 4.82% 4.31% 48 Information pertaining to options outstanding at December 31, 2004 is as follows:
Options Outstanding Options Exercisable ------------------------------------ ------------------------------------ Remaining Range of Number Weighted Number Weighted Average Contractual Life Exercise Price Outstanding Average Exercisable Exercise Price Exercise Price ------------------ ------------------ ------------------ ----------------- ----------------- ------------------ 9.83 years $49.85 19,500 $49.85 --- $ --- 8.83 years 46.65 16,500 46.65 4,125 46.65 7.83 years 29.65 17,500 29.65 8,750 29.65 6.83 years 23.00 15,000 23.00 11,250 23.00 5.83 years 18.75 3,250 18.75 3,250 18.75 4.83 years 22.00 3,125 22.00 3,125 22.00
Note 10: Income Taxes Allocation of income tax expense between current and deferred portions is as follows: Years ended December 31, 2004 2003 2002 ----------- ----------- ----------- Current $ 3,772 $ 3,436 $ 3,554 Deferred (18) (200) (551) ----------- ----------- ----------- Total income tax expense $ 3,754 $ 3,236 $ 3,003 =========== =========== =========== The following is a reconciliation of the "expected" income tax expense, computed by applying the U.S. Federal income tax rate of 35% in 2004 and 2003 and 34% in 2002 to income before income tax expense, with the reported income tax expense: Years ended December 31, 2004 2003 2002 ------------ ---------- ---------- Computed "expected" income tax expense $ 5,594 $ 5,137 $ 4,426 Tax-exempt interest income (1,943) (1,977) (1,652) Nondeductible interest expense 149 169 191 Other, net (46) (93) 38 ------------ ---------- ---------- Reported income tax expense $ 3,754 $ 3,236 $ 3,003 ============ ========== ========== The components of the net deferred tax asset, included in other assets, are as follows:
December 31, 2004 2003 --------- ---------- Deferred tax assets: Allowance for loan losses and unearned fee income $ 2,017 $ 1,760 Valuation allowance on other real estate owned 23 31 Deferred compensation and other liabilities 498 421 Deposit intangibles and goodwill 23 100 Community development corporation related tax credit --- 4 $ 2,561 $ 2,316 --------- ---------- Deferred tax liabilities: Net unrealized losses on securities available for sale $ (647) $ (1,154) Fixed assets (282) (222) Discount accretion on securities (80) (82) Other (116) (99) --------- ---------- (1,125) (1,557) --------- ---------- Net deferred tax asset $ 1,436 $ 759 ========= ==========
The Company has determined that a valuation allowance for the gross deferred tax assets is not necessary at December 31, 2004 and 2003 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. 49 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, 2004, 2003, and 2002, dividends received from subsidiary banks were $4,504, $5,377 and $3,406, 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, 2004, retained net income, which was free of such restriction, amounted to approximately $20,491. Note 12: Minimum Regulatory Capital Requirement The Company (on a consolidated basis) and the subsidiary 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, 2004 and 2003, that the Company and the banks meet all capital adequacy requirements to which they are subject. As of December 31, 2004, the most recent notifications from the appropriate regulatory authorities categorized 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 banks' category. The Company's and the banks' actual capital amounts and ratios as of December 31, 2004 and 2003 are also presented in the following tables.
Actual Minimum Capital Minimum To Be Well Requirement Capitalized Under Prompt Corrective Action Provisions ---------- ---------- ---------- --------- ------------ ---------- Amount Ratio Amount Ratio Amount Ratio ---------- ---------- ---------- --------- ------------ ---------- December 31, 2004 Total capital (to risk weighted assets) Bankshares consolidated $75,364 13.4% $45,018 8.00% N/A N/A NBB 39,990 11.4% 28,100 8.00% $ 35,125 10.00% BTC 30,877 14.9% 16,598 8.00% 20,748 10.00% Tier 1 capital (to risk weighted assets) Bankshares consolidated $69,574 12.4% $22,509 4.00% N/A N/A NBB 36,692 10.5% 14,050 4.00% $ 21,075 6.00% BTC 28,446 13.7% 8,299 4.00% 12,449 6.00% Tier 1 capital (to average assets) Bankshares consolidated $69,574 9.0% $30,918 4.00% N/A N/A NBB 36,692 8.1% 18,220 4.00% $ 22,775 5.00% BTC 28,446 9.3% 12,193 4.00% 15,241 5.00%
50
Actual Minimum Capital Minimum To Be Well Requirement Capitalized Under Prompt Corrective Action Provisions ---------------------- --------------------- ---------------------- Amount Ratio Amount Ratio Amount Ratio ----------- ---------- ---------- ---------- ----------- ---------- December 31, 2003 Total capital (to risk weighted assets) Bankshares consolidated $74,260 15.0% $39,567 8.00% N/A N/A NBB 41,084 14.1% 23,267 8.00% $ 29,084 10.00% BTC 28,510 14.3% 15,968 8.00% 19,961 10.00% Tier 1 capital (to risk weighted assets) Bankshares consolidated $68,891 13.9% $19,784 4.00% N/A N/A NBB 37,903 13.0% 11,634 4.00% $ 17,450 6.00% BTC 26,322 13.2% 7,984 4.00% 11,976 6.00% Tier 1 capital (to average assets) Bankshares consolidated $68,891 9.9% $27,687 4.00% N/A N/A NBB 37,903 9.7% 15,611 4.00% $ 19,514 5.00% BTC 26,322 8.9% 11,758 4.00% 14,697 5.00%
Note 13: Condensed Financial Statements of Parent Company Financial information pertaining only to Bankshares (Parent) is as follows:
Condensed Balance Sheets December 31, 2004 2003 ------------ ------------- Assets Cash due from subsidiaries $ 91 $ 621 Securities available for sale 3,729 3,454 Investments in subsidiaries, at equity 83,117 76,521 Refundable income taxes due from 107 111 subsidiaries Other assets 207 77 ------------ ------------- Total assets $87,251 $80,784 ============ ============= Liabilities Other liabilities $163 $143 And Stockholders' equity 87,088 80,641 ------------ ------------- Stockholders' Equity Total liabilities and stockholders' equity $87,251 $80,784 ============ =============
Condensed Statements of Income Years Ended December 31, 2004 2003 2002 ----------- ------------ ------------ Income Dividends from Subsidiaries $4,504 $5,377 $3,406 Interest on securities - taxable 13 13 27 Interest on securities - nontaxable 122 109 86 Other income 895 616 462 Securities gains (losses) 8 (1) 319 ----------- ------------ ------------ 5,542 6,114 4,300 Expenses Other expenses 1,214 970 798 ----------- ------------ ------------ Income before income tax benefit (expense) and equity in undistributed net income of subsidiaries 4,328 5,144 3,502 51 Applicable income tax benefit (expense) 102 120 (1) ---------- ------------ ------------ Income before equity in undistributed net income of subsidiaries 4,430 5,264 3,501 Equity in undistributed net income of subsidiaries 7,800 6,178 6,513 ---------- ------------ ------------ Net income $12,230 $11,442 $ 10,014 ========== ============ ============
Condensed Statements of Cash Flows Years ended December 31, 2004 2003 2002 ------------- -------------- ------------- Cash Flows Net income $12,230 $11,442 $10,014 From Adjustments to reconcile net income to net Operating cash provided by operating activities: Expenses Equity in undistributed net income of subsidiaries (7,800) (6,178) (6,513) Amortization of premiums and accretion of discounts, net 3 4 5 Depreciation expense 1 1 --- Securities (gains) losses (8) 1 (319) Net change in refundable income taxes due from subsidiaries 4 (111) --- Net change in other assets (133) (18) (29) Net change in other liabilities (17) (40) 12 ------------- -------------- ------------- Net cash provided by operating activities 4,280 5,101 3,170 ------------- -------------- ------------- Cash Flows Purchases of securities available for sale (1,396) (1,105) (730) from Proceeds from sales of securities available Investing for sale 1,135 406 827 Activities Calls of securities available for sale --- 73 103 ------------- -------------- ------------- Net cash provided by (used in) investing activities (261) (626) 200 ------------- -------------- ------------- Cash Flows Cash dividends paid (4,504) (3,971) (3,406) from Common stock repurchase (217) --- --- Financing Exercise of stock options 172 77 --- Activities ------------- -------------- ------------- Net cash used in financing activities (4,549) (3,894) (3,406) ------------- -------------- ------------- Net change in cash (530) 581 (36) Cash due from subsidiaries at beginning of year 621 40 76 ------------- -------------- ------------- Cash due from subsidiaries at end of year $ 91 $ 621 $ 40 ============= ============== =============
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; standby letters of credit and interest rate locks. 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, 2004, and 2003, financial instruments were outstanding whose contract amounts represent credit risk:
December 31, 2004 2003 --------------- --------------- Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 103,816 $ 85,903 Standby letters of credit 4,365 6,557 Mortgage loans sold with potential recourse 17,649 37,171
52 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 2004, the Company originated $17,938 and sold $17,649 to investors, compared to $37,039 originated and $37,171 sold in 2003. 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. At December 31, 2004, the Company had locked-rate commitments to originate mortgage loans amounting to approximately $2,359 and loans held for sale of $1,003. The Company has entered into commitments, on a best-effort basis, to sell loans of approximately $1,232. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Company does not expect any counterparty to fail to meet its obligations. The Company maintains cash accounts in other commercial banks. The amount on deposit with correspondent institutions at December 31, 2004 that exceeded the insurance limits of the Federal Deposit Insurance Corporation was $1,637. 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. 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, 2004 and 2003, approximately $236,464 and $203,646, respectively, of the loan portfolio was concentrated in commercial real estate. This represents approximately 49% and 50% of the loan portfolio at December 31, 2004 and 2003, respectively. Included in commercial loans at December 31, 2004 and 2003 was approximately $142,768 and $169,340, respectively, in loans for college housing and professional office buildings. This represents approximately 30% and 42% of the loan portfolio at December 31, 2004 and 2003, respectively. Loans secured by residential real estate were approximately $139,213 and $114,590 at December 31, 2004 and 2003, respectively. This represents approximately 29% of the loan portfolio at December 31, 2004 and 2003, respectively. Loans secured by automobiles were approximately $20,732 and $18,219 at December 31, 2004 and 2003, respectively. This represents approximately 4% of the loan portfolio at December 31, 2004 and 4% at December 31, 2003. 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 53 aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company. 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, excluding restricted stock, 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. The carrying value of restricted securities approximates fair value based upon the redemption provisions of the applicable entities. 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 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, 2004 and 2003, 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, 2004 2003 ----------------------------- ---------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------------- -------------- -------------- ------------- Financial assets: Cash and due from banks $ 12,493 $ 12,493 $ 11,733 $ 11,733 Interest-bearing deposits 22,463 22,463 36,220 36,220 Securities 250,708 253,020 230,154 234,326 Mortgage loans held for sale 1,003 1,003 714 714 Loans, net 472,199 471,993 401,428 405,304 Accrued interest receivable 4,870 4,870 4,610 4,610 54 Financial liabilities: Deposits $ 705,932 $ 710,503 $ 625,378 $ 628,415 Other borrowed funds 297 297 135 135 Accrued interest payable 483 483 489 489
Note 17: Selected Quarterly Data (Unaudited) The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2004 and 2003:
2004 First Second Quarter Third Fourth Quarter Quarter Quarter --------------- --------------- -------------- ------------- Income Statement Data: Interest income $ 9,797 $ 10,017 $ 10,841 $ 10,837 Interest expense 2,599 2,659 2,904 2,963 --------------- --------------- -------------- ------------- Net interest income 7,198 7,358 7,937 7,874 Provision for loan losses 288 304 293 304 Noninterest income 1,739 1,681 1,865 1,857 Noninterest expense 4,820 4,915 5,275 5,326 Income taxes 869 884 1,019 982 --------------- --------------- -------------- ------------- Net income $ 2,960 $ 2,936 $ 3,215 $ 3,119 =============== =============== ============== ============= Per Share Data: -------------- Basic net income per share $ 0.84 $ 0.84 $ 0.91 $ 0.89 Fully diluted net income per share 0.84 0.83 0.91 0.88 Cash dividends per share --- 0.63 --- 0.65 Book value per share 24.11 23.12 24.82 24.75
2003 First Second Third Fourth Quarter Quarter Quarter Quarter --------------- --------------- -------------- ------------- Income Statement Data: Interest income $ 10,476 $ 10,396 $ 10,262 $ 9,947 Interest expense 3,478 3,256 2,840 2,678 --------------- --------------- -------------- ------------- Net interest income 6,998 7,140 7,422 7,269 Provision for loan losses 440 402 435 414 Noninterest income 1,369 1,504 1,522 1,791 Noninterest expense 4,567 4,569 4,704 4,806 Income taxes 728 872 894 742 --------------- --------------- -------------- ------------- Net income $ 2,632 $ 2,801 $ 2,911 $ 3,098 =============== =============== ============== ============= Per Share Data: -------------- Basic net income per share $ 0.75 $ 0.80 $ 0.83 $ 0.88 Fully diluted net income per share 0.75 0.79 0.82 0.88 Cash dividends per share --- 0.54 --- 0.59 Book value per share 21.57 22.34 22.56 22.94
Note 18: Proposed Acquisitions In the fourth quarter of 2004 the Company announced it had entered into agreement to purchase two branches from Planters Bank and Trust Company of Virginia. The transaction is expected to add approximately $21,996 in deposits and $8,902 in loans. The transaction is expected to close in February of 2005. 55 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 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, 2004 and 2003, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2004. We also have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting appearing under Item 9A, that National Bankshares, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). National Bankshares, Inc. and subsidiaries' management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the company's internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. 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, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that National Bankshares, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, National Bankshares, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, 56 based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). [GRAPHIC OMITTED][Yount, Hyde & Barbour, P.C. Signature] Winchester, Virginia February 23, 2005 57 Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure None Item 9A. Controls and Procedures Disclosure 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 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. Internal Control Over Financial Reporting Management's Report on Internal Control Over Financial Reporting. To the Stockholders National Bankshares, Inc. Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management's judgments and estimates concerning effects of events and transactions that are accounted for or disclosed. Management is also responsible for establishing and maintaining effective internal control over financial reporting. The Company's internal control over financial reporting includes those policies and procedures that pertain to the Company's ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time. In order to ensure that the Company's internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2004. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management believes the Company maintained effective internal control over financial reporting as of December 31, 2004. The Board of Directors, acting through its Audit committee, is responsible for the oversight of the Company's accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent auditor and approves decisions regarding the appointment or removal of the Company Auditor. It meets periodically with management, the independent auditors and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company in addition to reviewing the Company's financial reports. The independent auditors and the internal auditors have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee. Yount, Hyde & Barbour, P.C., independent auditors of the Company's financial statements, has reported on management's assertion with respect to the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. /s/ JAMES G. RAKES /s/ J. ROBERT BUCHANAN ---------------------- ------------------------- Chairman, President and Treasurer and Chief Executive Officer Chief Financial Officer 58 Item 9B. Other Information Not Applicable Part III Item 10. Directors and Executive Officers of the Registrant Information with respect to the directors of Bankshares is set out under the caption "Election of Directors" on pages 2 through 3 of Bankshares' Proxy Statement dated March 11, 2005 which information is incorporated herein by reference. The Board of Directors of Bankshares has a standing audit committee made up entirely of independent directors, as that term is defined in the Nasdaq Stock Market Rules. Dr. J.R. Stewart chairs the Audit Committee and its members are Mr. J.A. Deskins, Mr. P. A. Duncan and Dr. J. M. Lewis. Each member of the Audit Committee has extensive business experience; however, the Committee has identified Dr. Lewis as its financial expert, since he has a professional background which involves financial oversight responsibilities. Dr. Lewis currently oversees the preparation of financial statements in his role as President of New River Community College. He previously served as the College's Chief Financial Officer. The Company and each of its subsidiaries have adopted Codes of Ethics for directors, officers and employees, specifically including the Chief Executive Officer and Chief Financial Officer of Bankshares. These Codes of Ethics are available on the Company's web site at www.nationalbankshares.com. 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 60 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 53 Treasurer, National Bankshares, Inc.; 1998 Executive Vice President/Chief Operating Officer and Secretary of Bank of Tazewell County since 2003; prior thereto Cashier and Senior Vice President/Chief Financial Officer of The National Bank of Blacksburg since 1998. ----------------------------------------------------------------------------------------------------------- Marilyn B. Buhyoff 56 Secretary & Counsel, National Bankshares, 1989 Inc.; Counsel of The National Bank of Blacksburg since 1989, Trust Officer since 2004, and prior thereto Senior Vice President/ Administration, since 1992. Secretary of National Bankshares Financial Services, Inc. since 2001, and Executive Vice President since 2004. ----------------------------------------------------------------------------------------------------------- F. Brad Denardo 52 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. ===========================================================================================================
Item 11. Executive Compensation The information set forth under "Executive Compensation" on pages 5 through 6 of Bankshares' Proxy Statement dated March 11, 2005 is incorporated herein by reference. 59 The following table summarizes information concerning National Bankshares equity compensation plans at December 31, 2004:
--------------------------------------- --------------------- -------------------- --------------------- Number of Shares to Weighted Average Number of Shares be Issued upon Exercise Price of Remaining Available Exercise of Outstanding for Future Issuance Outstanding Options Options and Under Equity and Warrants Warrants Compensation Plans (Excluding Shares Plan Category Reflected in First Column) --------------------------------------- --------------------- -------------------- --------------------- Equity compensation plans approved by shareholders-1999 Stock Incentive Plan 74,875 $ 36.53 167,500 --------------------------------------- --------------------- -------------------- --------------------- Equity compensation plans not approved by shareholders --- --- --- --------------------------------------- --------------------- -------------------- --------------------- Total 74,875 $ 36.53 167,500 --------------------------------------- ===================== ==================== =====================
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 dated March 11, 2005 for the Annual Meeting of Stockholders to be held April 12, 2005. 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 11, 2005 is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The following fees were paid to Yount, Hyde & Barbour, P.C., Certified Public Accountants, for services provided to Bankshares for the years ended December 31, 2004 and 2003. The Audit Committee determined that the provision of non-audit services by Yount, Hyde & Barbour P.C. did not compromise the firm's ability to maintain its independence. Principal Accounting Fees and Services: 2004 2003 ---------------------- ---------------------- Fees Percentage Fees Percentage ---------- ----------- ---------- ----------- Audit fees $85,625 74% $53,000 71% Audit-related fees 25,956 22% 16,800 23% Tax fees 4,800 4% 4,550 6% ---------- ----------- ---------- ----------- $116,381 100% $74,350 100% ========== =========== ========== =========== Audit fees: Audit and review services (including Sarbanes-Oxley Rule 404) and review of documents filed with the SEC. Audit-related fees: Employee benefit plan audits, accounting assistance with acquisitions, and consultation concerning financial accounting and reporting standards. Tax fees: Preparation of federal and state tax returns, review of quarterly estimated tax payments, and consultation concerning tax compliance issues. The Audit Committee of the Board of Directors of Bankshares meets in advance and specifically approves of the provision of all services of Yount, Hyde & Barbour, P.C. 60 Part IV Item 15. Exhibits and Financial Statement Schedules 15 (a) Exhibits:
Page No. in Exhibit No. Description Sequential System ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, of (incorporated herein by National Bankshares, Inc. reference to Exhibit 3(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993) 3(i) Articles of Amendment to Articles of (incorporated herein by Incorporation of National Bankshares, Inc., reference to Exhibit 3(i) of the dated April 8, 2003. Annual Report on Form 10K for fiscal year ended December 31, 2003) 4(i) Specimen copy of certificate for National (incorporated herein by reference to Bankshares, Inc. common stock, $2.50 par value Exhibit 4(a) of the Annua Report on Form 10K for fiscal year ended December 31, 1993) 4(i) Article Four of the Articles of Incorporation (incorporated herein by of National Bankshares, Inc. included in reference to Exhibit 4(b) of the Annual Exhibit No. 3(a)) Report on Form 10K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated June (incorporated herein by 18, 1990, by and between Information Technology, reference to Exhibit 10(e) of the Annual. Inc and The National Bank of Blacksburg Report on Form 10K for fiscal year ended December 31, 1992) *10(iii)(A) National Bankshares, Inc. 1999 Stock Option (incorporated herein by reference to Plan 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 by reference between National Bankshares, Inc. and to Exhibit 10(iii)(A) of Form 10Q James G. Rakes for the period ended June 30, 2002) *10(iii)(A) Employee Lease Agreement dated August 14, 2002, (incorporated herein by reference between National Bankshares, Inc. and The to Exhibit 10 (iii) (A) of Form 10Q National Bank of Blacksburg for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January 5, (incorporated herein by reference to 2003, between National Bankshares, Inc. and Exhibit 10 (iii) (A) of Form 10K for Marilyn B. Buhyoff the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated January 8, (incorporated herein by reference to 2003, between National Bankshares, Inc. and F. Exhibit 10 (iii) (A) of Form 10K for Brad Denardo the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated June 1, 1998, (incorporated herein by reference between Bank of Tazewell County and Cameron L. to Exhibit 10 (iii) (A) of Form 10K Forester for the period ended December 31, 2002) 21(i) Subsidiaries of National Bankshares, Inc. Page 68 23 Consent of Yount, Hyde & Barbour, P.C. to Page 69 incorporation by reference of independent auditor's report included in this Form 10-K, into registrant's registration statement on Form S-8. 31(i) Section 906 Certification of Chief Executive Page 63 Officer 31(ii) Section 906 Certification of Chief Financial Page 64 Officer 32(i) 18 U.S.C. Section 1350 Certification of Chief Page 66 Executive Officer 32(ii) 18 U.S.C. Section 1350 Certification of Chief Page 66 Financial Officer
*Indicates a management contract or compensatory plan required to be filed herein. 61 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. /s/ JAMES G. RAKES ------------------------- James G. Rakes Chairman, President & Chief Executive Officer (Principal Executive Officer) /s/ J. ROBERT BUCHANAN ------------------------- J. Robert Buchanan Treasurer (Principal Financial Officer) 62 Exhibit No. 31(i) CERTIFICATIONS UNDER SECTION 906 OF THE SARBANES OXLEY ACT OF 2002 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 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15 (e) and 15d - 15 (e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a - 15(f) and 15d - 15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluations; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 9, 2005 /s/ JAMES G. RAKES ------------------------- James G. Rakes Chairman President and Chief Executive Officer (Principal Executive Officer) Exhibit 31(ii) 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 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15 (e) and 15d - 15 (e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a - 15(f) and 15d - 15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; and (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purpose in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluations; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 9, 2005 /s/ J. ROBERT BUCHANAN ------------------------------ J. Robert Buchanan Treasurer (Principal Financial Officer) 62 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 03/09/2005 Director ---------------------- ---------- L. A. Bowman /s/ J. A. DESKINS, SR. 03/09/2005 Director ----------------------------- ---------- J. A. Deskins, Sr. /s/ P. A. DUNCAN 03/09/2005 Director ---------------------- ---------- P. A. Duncan /s/ J. M. LEWIS 03/09/2005 Director ----------------------------- ---------- J. M. Lewis /s/ M. G. MILLER 03/09/2005 Director ---------------------- ---------- M. G. Miller /s/ W. T. PEERY 03/09/2005 Director ----------------------------- ---------- W. T. Peery Chairman of the Board /s/ J. G. RAKES 03/09/2005 President and Chief ----------------------------- ---------- Executive Officer - J. G. Rakes National Bankshares, Inc. /s/ J. M. SHULER 03/09/2005 Director ----------------------------- ---------- J. M. Shuler /s/ J. R. STEWART 03/09/2005 Director ---------------------- ---------- J. R. Stewart 65 Exhibit 32(i) CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO U.S.C. SECTION 1350 In connection with the Form 10-K of National Bankshares, Inc. for the year ended December 31, 2004, I, James G. Rakes, Chairman, 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, 2004, fully complies with the requirements of section 13(a) or 15(d) of the Securties Act of 1934; and (2) the information contained in such Form 10-K for the year ended December 31, 2004, 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 (Principal Executive Officer) Exhibit 32(ii) CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO U.S.C. SECTION 1350 In connection with the Form 10-K of National Bankshares, Inc. for the year ended December 31, 2004, I, J. Robert Buchanan, Treasurer 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, 2004, fully complies with the requirements of section 13(a) or 15(d) of the Securties Act of 1934; and (2) the information contained in such Form 10-K for the year ended December 31, 2004, 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 (Principal Financial Officer) 66
Index of Exhibits Page No. in Exhibit No. Description Sequential System ----------- ----------- ----------------- 3(i) Articles of Incorporation, as amended, of (incorporated herein by reference National Bankshares, Inc. to Exhibit 3(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993)\ 3(i) Articles of Amendment to Articles of (incorporated herein by reference Incorporation of National Bankshares, Inc., to Exhibit 3(i) of the Annual Report dated April 8, 2003. on Form 10K for fiscal year ended December 31, 2003) 4(i) Specimen copy of certificate for National (incorporated herein by reference Bankshares, Inc. common stock, $2.50 par value 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 Incorporation (incorporated herein by reference of National Bankshares, Inc. included in Exhibit to Exhibit 4(b) of the Annual No. 3(a)) Report on Form 10K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated June (incorporated herein by reference 18, 1990, by and between Information Technology, to Exhibit 10(e) of the Annual Inc. and The National Bank of Blacksburg Report on Form 10K 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 reference National Bankshares, Inc. and James G. Rakes to Exhibit 10(iii)(A) of For 10Q for the period ended June 30, 2002) *10(iii)(A) Employment Lease Agreement dated August 14, 2002, (incorporated herein by reference between National Bankshares, Inc. and The National to Exhibit 10(iii)(A) for the period Bank of Blacksburg ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January 5, 2003, (incorporated herein by reference between National Bankshares, Inc. and Marilyn B. to Exhibit 10 iii (A) of Form 10K Buhyoff for the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated January 8, 2003, (incorporated herein by reference between National Bankshares, Inc. and F. Brad to Exhibit 10 iii (A) of Form 10K Denardo for the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated June 1, 1998, (incorporated herein by reference between Bank of Tazewell County and Cameron L. to Exhibit 10 iii (A) of Form 10K Forester for the period ended December 31, 2002) 21(i) Subsidiaries of National Bankshares, Inc. Page 68 23 Consent of Yount, Hyde & Barbour, P.C. to Page 69 incorporation by reference of independent auditor's report included in this Form 10-K, into registrant's registration statement on Form S-8. 31(i) Section 906 Certification of Chief Executive Page 63 Officer 31(ii) Section 906 Certification of Chief Financial Page 64 Officer 32(i) 18 U.S.C. Section 1350 Certification of Chief Page 66 Executive Officer 32(ii) 18 U.S.C. Section 1350 Certification of Chief Page 66 Financial Officer
* Indicates a management contract or compensatory plan required to be filed herein. 67 Exhibit No. 21(i) SUBSIDIARIES OF NATIONAL BANKSHARES, INC. -------------------------- National Bankshares, Inc. -------------------------- | | ----------------------------|---------------------------- | | | | | | -------------------- -------------------- ------------------------ The National Bank Bank of Tazewell National Bankshares of Blacksburg County Financial Services, Inc. -------------------- -------------------- ------------------------ 68