- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 Form 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 Commission file number 0-15204 NATIONAL BANKSHARES, INC. (Exact name of registrant as specified in its charter) State or other jurisdiction of incorporation or organization - Virginia Internal Revenue Service - Employer Identification No. 54-1375874 101 Hubbard Street, P.O. Box 90002, Blacksburg, VA 24062-9002 (540) 951-6300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b - 2 of the Exchange Act). Yes |X| No |_| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b - 2 of the Exchange Act). Yes |_| No |X| Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at November 7, 2005 Common Stock, $2.50 Par Value 3,510,977 (This report contains 35 pages)
NATIONAL BANKSHARES, INC. AND SUBSIDIARIES Form 10-Q Index <TABLE> <CAPTION> Part I Financial Information Page ---------------------------- <S> <C> <C> <C> Item 1 Financial Statements Consolidated Balance Sheets, September 30, 2005 (Unaudited) 3-4 and December 31, 2004 Consolidated Statements of Income for the Three Months Ended September 5-6 30, 2005 and 2004 (Unaudited) Consolidated Statements of Income for the Nine Months Ended September 30, 7-8 2005 and 2004 (Unaudited) Consolidated Statements of Changes in 9 Stockholders' Equity, Nine Months Ended September 30, 2005 and 2004 (Unaudited) Consolidated Statements of Cash Flows, 10-11 Nine Months Ended September 30, 2005 and 2004 (Unaudited) Notes to Consolidated Financial Statements 12-17 Item 2 Management's Discussion and Analysis of 18-29 Financial Condition and Results of Operations Item 3 Quantitative and Qualitative Disclosures about 29 Market Risk Item 4 Controls and Procedures 29 Part II Other Information Item 1 Legal Proceedings 30 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 30 Item 3 Defaults Upon Senior Securities 30 Item 4 Submission of Matters to a Vote of Security Holders 30 Item 5 Other Information 30 Item 6 Exhibits 30 Signatures 31 Index of Exhibits 31-32 </TABLE> 2
Part I Financial Information Item 1. Financial Statements <TABLE> <CAPTION> National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets September 30, 2005 and December 31, 2004 (Unaudited) September 30, December 31, ($ In thousands, except share and per share data) 2005 2004 ================== =================== <S> <C> <C> Assets Cash and due from banks $17,114 $12,493 Interest-bearing deposits 15,836 22,463 Securities available for sale, at fair value 151,685 145,323 Securities held to maturity (fair value $113,668 in 2005 and $107,697 in 2004) 112,258 105,385 Mortgage loans held for sale 196 1,003 Loans: Real estate construction loans 27,639 25,009 Real estate mortgage loans 120,240 115,388 Commercial and industrial loans 263,729 248,523 Loans to individuals 88,179 89,889 ------------------ ------------------- Total loans 499,787 478,809 Less unearned income and deferred fees (927) (881) ------------------ ------------------- Loans, net of unearned income and deferred fees 498,860 477,928 Less: allowance for loan losses (5,620) (5,729) ------------------ ------------------- Loans, net 493,240 472,199 ------------------ ------------------- Bank premises and equipment, net 12,609 12,104 Accrued interest receivable 5,145 4,870 Other real estate owned, net 429 895 Intangible assets and goodwill, net 17,397 16,924 Other assets 2,998 2,495 ------------------ ------------------- Total assets $828,907 $796,154 ================== =================== Liabilities and Stockholders' Equity Noninterest-bearing demand deposits $115,174 $106,189 Interest-bearing demand deposits 209,107 198,897 Savings deposits 55,685 62,817 Time deposits 352,211 338,029 ------------------ ------------------- Total deposits 732,177 705,932 ------------------ ------------------- Other borrowed funds 623 297 Accrued interest payable 630 483 Other liabilities 2,807 2,354 ------------------ ------------------- Total liabilities 736,237 709,066 ------------------ ------------------- 3
Stockholders' Equity Preferred stock of no par value. Authorized 5,000,000 shares; none issued and outstanding --- --- Common stock of $2.50 par value. Authorized 10,000,000 shares; issued and outstanding 3,511,977 shares in 2005 and 3,519,002 in 2004 8,780 8,797 Retained earnings 84,060 77,735 Accumulated other comprehensive income (loss), net (170) 556 ----------------- ------------------- Total stockholders' equity 92,670 87,088 ----------------- ------------------- Total liabilities and stockholders' equity $828,907 $796,154 ================= =================== </TABLE> See accompanying notes to the consolidated financial statements. 4
<TABLE> <CAPTION> National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Three Months Ended September 30, 2005 and 2004 (Unaudited) September 30, September 30, ($ In thousands, except share and per share data) 2005 2004 ================== ================= <S> <C> <C> Interest income Interest and fees on loans $8,451 $7,837 Interest on interest-bearing deposits 141 23 Interest on federal funds sold --- 14 Interest on securities - taxable 1,607 1,654 Interest on securities - nontaxable 1,284 1,313 ------------------ ----------------- Total interest income 11,483 10,841 ------------------ ----------------- Interest expense Interest on time deposits $100,000 or more 1,032 836 Interest on other deposits 2,781 2,053 Interest on borrowed funds 3 15 ------------------ ----------------- Total interest expense 3,816 2,904 ------------------ ----------------- Net interest income 7,667 7,937 Provision for loan losses 169 293 ------------------ ----------------- Net interest income after provision for loan losses 7,498 7,644 ------------------ ----------------- Noninterest income Service charges on deposit accounts 797 824 Other service charges and fees 68 52 Credit card fees 553 480 Trust income 326 274 Other income 149 131 Realized securities gains(losses), net (1) 104 ------------------ ----------------- Total noninterest income 1,892 1,865 ------------------ ----------------- Noninterest expense Salaries and employee benefits 2,822 2,723 Occupancy, furniture and fixtures 491 473 Data processing and ATM 270 349 Credit card processing 431 398 Intangibles amortization 283 233 Net costs of other real estate owned 63 37 Other operating expenses 1,019 1,062 ------------------ ----------------- Total noninterest expense 5,379 5,275 ------------------ ----------------- Income before income tax expense 4,011 4,234 Income tax expense 957 1,019 ------------------ ----------------- Net income $3,054 $3,215 ================== ================= 5
Net income per share - basic $0.87 $0.91 - diluted $0.86 $0.91 ================= =================== Weighted average number of common shares outstanding - basic 3,511,977 3,519,491 ================= =================== - diluted 3,526,936 3,536,965 ================= =================== Dividends declared per share $--- $--- ================= =================== </TABLE> See accompanying notes to consolidated financial statements. 6
<TABLE> <CAPTION> National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Nine Months Ended September 30, 2005 and 2004 (Unaudited) September 30, September 30, ($ In thousands, except share and per share data) 2005 2004 ================== ================= <S> <C> <C> Interest income Interest and fees on loans $24,778 $21,868 Interest on interest-bearing deposits 286 137 Interest on federal funds sold 1 15 Interest on securities - taxable 4,858 4,648 Interest on securities - nontaxable 3,863 3,987 ------------------ ----------------- Total interest income 33,786 30,655 ------------------ ----------------- Interest expense Interest on time deposits $100,000 or more 2,836 2,294 Interest on other deposits 7,228 5,852 Interest on borrowed funds 21 16 ------------------ ----------------- Total interest expense 10,085 8,162 ------------------ ----------------- Net interest income 23,701 22,493 Provision for loan losses 557 885 ------------------ ----------------- Net interest income after provision for loan losses 23,144 21,608 ------------------ ----------------- Noninterest income Service charges on deposit accounts 2,273 2,234 Other service charges and fees 224 182 Credit card fees 1,625 1,362 Trust income 1,062 1,105 Other income 408 311 Realized securities gains(losses), net (5) 91 ------------------ ----------------- Total noninterest income 5,587 5,285 ------------------ ----------------- Noninterest expense Salaries and employee benefits 8,534 7,815 Occupancy, furniture and fixtures 1,450 1,337 Data processing and ATM 1,172 913 Credit card processing 1,270 1,100 Intangibles amortization 832 699 Net costs of other real estate owned 244 149 Other operating expenses 3,157 2,997 ------------------ ----------------- Total noninterest expense 16,659 15,010 ------------------ ----------------- Income before income tax expense 12,072 11,883 Income tax expense 2,873 2,772 ------------------ ----------------- Net income $9,199 $9,111 ================== ================= 7
Net income per share - basic $2.62 $2.59 ================= =================== - diluted $2.60 $2.57 ================= =================== Weighted average number of common shares outstanding - basic 3,515,855 3,517,923 ================= =================== - diluted 3,532,956 3,538,280 ================= =================== Dividends declared per share $0.70 $0.63 ================= =================== </TABLE> See accompanying notes to consolidated financial statements. 8
<TABLE> <CAPTION> National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Nine Months Ended September 30, 2005 and 2004 (Unaudited) Accumulated Other ($ In thousands) Common Retained Comprehensive Comprehensive Stock Earnings Income (Loss) Income Total ============ ============== ================ ================ =========== <S> <C> <C> <C> <C> <C> Balances, December 31, 2003 $8,788 $70,063 $1,790 $80,641 Net income --- 9,111 --- $9,111 9,111 Dividends ($0.63 per share) --- (2,216) --- --- (2,216) Exercise of stock options 16 107 --- --- 123 Other comprehensive loss, net of tax: Unrealized loss on securities available for sale, net of income tax $(61) --- --- --- (113) --- Reclass adjustment, net of tax $(32) --- --- --- (59) --- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive loss --- --- (172) (172) (172) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $8,939 --- ------------ -------------- ---------------- ---------------- ----------- Stock Repurchase (13) (204) --- (217) ------------ -------------- ---------------- ---------------- ----------- Balances, September 30, 2004 $8,791 $76,861 $1,618 $87,270 ============ ============== ================ ================ =========== Balances, December 31, 2004 $8,797 $77,735 $556 $87,088 Net income --- 9,199 --- $9,199 9,199 Dividends($0.70 per share) --- (2,464) --- --- (2,464) Other comprehensive loss, net of tax Unrealized losses on securities available for sale, net of income tax $(327) --- --- --- (607) --- Reclass adjustment, net of income tax $(64) --- --- --- (119) --- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive loss --- --- (726) (726) (726) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $8,473 --- ------------ -------------- ---------------- ---------------- ----------- Exercise of stock options 11 95 --- --- 106 ------------ -------------- ---------------- ---------------- ----------- Stock repurchase (28) (505) (533) ------------ -------------- ---------------- ---------------- ----------- Balances, September 30, 2005 $8,780 $84,060 $(170) $92,670 ============ ============== ================ ================ =========== </TABLE> See accompanying notes to consolidated financial statements. 9
<TABLE> <CAPTION> National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows Nine Months Ended September 30, 2005 and 2004 (Unaudited) September 30, September 30, ($In thousands) 2005 2004 ================ ================= <S> <C> <C> Cash flows from operating activities Net income $9,199 $9,111 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 557 885 Depreciation of bank premises and equipment 761 727 Amortization of intangibles 832 699 Amortization of premiums and accretion of discount, net 311 200 Losses on disposal of fixed assets 10 --- (Gains) Losses on sales and calls of securities available for sale, net (183) 27 (Gains) Losses on calls of securities held to maturity 188 (118) Losses and writedowns on other real estate owned 107 111 (Increase) decrease in: Mortgage loans held for sale 807 157 Accrued interest receivable (275) (543) Other assets (1,417) 4,567 Increase (decrease) in: Accrued interest payable 147 (6) Other liabilities 453 438 ----------------- ----------------- Net cash provided by operating activities $11,497 $16,255 ---------------- ----------------- Cash flows from investing activities Net decrease in interest-bearing deposits $6,627 $30,694 Proceeds from calls, principal payments, sales and maturities of securities available for sale 13,924 19,982 Proceeds from calls, principal payments and maturities of securities held to maturity 7,943 6,933 Proceeds from sale of securities held to maturity 3,312 --- Purchases of securities available for sale (21,442) (20,221) Purchases of securities held to maturity (18,405) (14,288) Purchases of loan participations (5,463) (1,114) Collections of loan participations 2,149 941 Net (increase) in loans to customers (9,750) (26,269) Acquisitions, net of cash received 13,178 (13,602) Proceeds from disposal of other real estate owned 510 970 Recoveries on loans charged off 146 174 Purchase of bank premises and equipment (1,352) (687) Proceeds from disposal of bank premises and equipment 76 2 ---------------- ----------------- Net cash (used in) investing activities $(8,547) $(16,485) ---------------- ----------------- 10
Cash flows from financing activities Net increase (decrease) in other deposits $(2,379) $7,510 Net increase (decrease) in time deposits 6,615 (2,576) Net increase in other borrowed funds 326 2,079 Stock options exercised 106 123 Cash dividends (2,464) (2,216) Stock Repurchased (533) (217) ---------------- ---------------- Net cash provided by financing activities 1,671 4,703 ---------------- ---------------- Net increase in cash and due from banks 4,621 4,473 Cash and due from banks at beginning of period 12,493 11,733 ---------------- ---------------- Cash and due from banks at end of period $17,114 $16,206 ================ ================ Supplemental disclosure of cash flow information Cash paid for interest $9,938 $8,168 ================ ================ Cash paid for income taxes $3,165 $2,576 ================ ================ Loans charged to the allowance for loan losses $812 $1,091 ================ ================ Loans transferred to other real estate owned $151 $327 ================ ================ Unrealized (losses) on securities available for sale ($1,117) $(265) ================ ================ Transactions related to acquisition of branches in 2005 and CNB in 2004 Increase in assets and liabilities: Investments --- $10,052 Loans $8,831 $40,371 Deposits $22,009 $59,979 </TABLE> See accompanying notes to consolidated financial statements. 11
National Bankshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements September 30, 2005 (Unaudited) ($ In thousands, except share and per share data) Note (1) The consolidated financial statements of National Bankshares, Inc. (Bankshares) and its wholly-owned subsidiaries, The National Bank of Blacksburg (NBB), Bank of Tazewell County (BTC) and National Bankshares Financial Services, Inc. (NBFS), (the Company), conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments, which are necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the nine months ended September 30, 2005 are not necessarily indicative of results of operations for the full year or any other interim period. The interim period consolidated financial statements and financial information included in this Form 10-Q should be read in conjunction with the notes to consolidated financial statements included in the Company's 2004 Form 10-K. The Company posts all reports required to be filed under the Securities and Exchange Act of 1934 on its web site at www.nationalbankshares.com. Note (2) Stock-Based Compensation At September 30, 2005, the Company had a stock-based employee compensation plan, which is described more fully in the Company's Form 10-K dated December 31, 2004. 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. <TABLE> <CAPTION> Nine months ended Three months ended September 30, September 30, -------------- ------------- ------------- ------------ ($ In thousands, except per share data) 2005 2004 2005 2004 -------------- ------------- ------------- ------------ <S> <C> <C> <C> <C> Net income, as reported $9,199 $9,111 $3,054 $3,215 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (110) (76) (37) (25) -------------- ------------- ------------- ------------ Pro forma net income $9,089 $9,035 $3,017 $3,190 -------------- ------------- ------------- ------------ Earnings per share: Basic - as reported $2.62 $2.59 $0.87 $0.91 -------------- ------------- ------------- ------------ Basic - pro forma $2.59 $2.57 $0.86 $0.91 -------------- ------------- ------------- ------------ Diluted - as reported $2.60 $2.57 $0.86 $0.91 -------------- ------------- ------------- ------------ Diluted - pro forma $2.57 $2.55 $0.85 $0.90 -------------- ------------- ------------- ------------ </TABLE> During the nine months ended September 30, 2005, there were no stock options granted and 1,250 stock options were forfeited. For the nine months ended September 30, 2005 and 2004, 24,000 shares and 11,000 shares, respectively, were excluded from the diluted earnings per share calculation, as their impact would have been anti-dilutive. For the three months ended September 30, 2005 and 2004, 36,000 shares and 16,500 shares were excluded. 12
Note (3) Allowance for Loan Losses, Nonperforming Assets and Impaired Loans <TABLE> <CAPTION> For the periods ended September 30, December 31, ------------- ------------ 2005 2004 2004 -------------- -------------- ----------------- <S> <C> <C> <C> ($ In thousands, except % data) Balance at beginning of period $5,729 $5,369 $5,369 Provision for loan losses 557 885 1,189 Loans charged off (812) (1,091) (1,550) Recoveries 146 174 223 Acquisition of bank - CNB --- 498 498 -------------- -------------- -------------- Balance at the end of period $5,620 $5,835 $5,729 ============== ============== ============== Ratio of allowance for loan losses to the end of period loans, net of unearned income and deferred fees 1.13% 1.24% 1.20% ============== ============== ============== Ratio of net charge-offs to average loans, net of unearned income and deferred fees(1) 0.18% 0.28% 0.30% ============== ============== =============== Ratio of allowance for loan losses to nonperforming loans(2) 2,239.04% 1,220.71% 1,454.06% ============== ============== =============== </TABLE> (1) Net charge-offs are on an annualized basis. (2) The Company defines nonperforming loans as total nonaccrual and restructured loans. Loans 90 days past due and still accruing are excluded. <TABLE> <CAPTION> September 30, December 31, ------------- ------------ 2005 2004 2004 ------------- ------------ -------------- ($ In thousands, except % data) <S> <C> <C> <C> Nonperforming Assets: Nonaccrual loans $251 $478 $394 Restructured loans --- --- --- ------------- ------------ -------------- Total nonperforming loans 251 478 394 Foreclosed property 429 1,010 895 ------------- ------------ -------------- Total nonperforming assets $680 $1,488 $1,289 ============= ============ ============== Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned 0.14% 0.31% 0.27% ============= ============ ============== </TABLE> 13
<TABLE> <CAPTION> September 30, December 31, ------------- ------------ 2005 2004 2004 ------------- ------------ --------------- <S> <C> <C> <C> Loans Past due 90 days or more and still accruing $563 $1,121 $754 ============= ============ ============= Ratio of loans past due 90 days or more and still accruing to loans, net of unearned income and deferred fees 0.11% 0.24% 0.16% ============= ============ ============= Impaired loans Total impaired loans $247 $478 $354 ============= ============ ============= Impaired loans with a valuation allowance --- $64 $79 Valuation allowance --- (64) (55) ------------- ------------ ------------- Impaired loans, net of allowance --- --- $24 ============= ============ ============= Impaired loans with no valuation allowance $247 $414 $275 ============= ============ ============= Average recorded investment in impaired loans $299 $663 $601 ============= ============ ============= Income recognized on impaired loans $1 --- --- ============= ============ ============= Amount of income recognized on a cash basis $1 --- --- ============= ============ ============= </TABLE> Nonaccrual loans excluded from impaired loan disclosure under FASB 114 at September 30, 2005 were $5. 14
Note (4) Securities The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for the sale by major security type as of September 30, 2005 are as follows: <TABLE> <CAPTION> September 30, 2005 Gross Gross Amortized Unrealized Unrealized Fair ($ In thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ---------------- <S> <C> <C> <C> <C> Available for sale: U.S. Treasury $4,037 $8 $66 $3,979 U.S. Government Agencies and Corporations 14,773 22 59 14,736 State and political subdivisions 73,997 1,677 455 75,219 Mortgage-backed securities 22,794 123 147 22,770 Corporate debt securities 31,564 218 764 31,018 Federal Reserve Bank stock- restricted 208 --- --- 208 Federal Home Loan Bank stock-restricted 1,613 --- --- 1,613 Other securities 1,973 169 --- 2,142 ------------- ----------------- ----------------- ---------------- Total securities available for sale $150,959 $2,217 $1,491 $151,685 ============= ================= ================= ================ </TABLE> The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type as of September 30, 2005 are as follows: <TABLE> <CAPTION> September 30, 2005 Gross Gross Amortized Unrealized Unrealized Fair ($ In thousands) Costs Gains Losses Values --------------- -------------- -------------- --------------- <S> <C> <C> <C> <C> Held to Maturity: U.S. Government Agencies and Corporations $25,600 $13 $244 $25,369 State and political subdivisions 58,128 1,518 67 59,579 Mortgage-backed securities 4,305 67 4 4,368 Corporate securities 24,225 471 344 24,352 --------------- -------------- -------------- --------------- Total securities held to maturity $112,258 $2,069 $659 $113,668 =============== ============== ============== =============== </TABLE> 15
Information pertaining to securities with gross unrealized losses and length of time that individual securities have been in a continuous loss position follows: <TABLE> <CAPTION> Less Than 12 Months 12 Months or More - --------------------------- ------------------- --------------------- --------------------- --------------------- Fair Value Unrealized Loss Fair Value Unrealized Loss - --------------------------- ------------------- --------------------- --------------------- --------------------- <S> <C> <C> <C> <C> December 31, 2004 $60,623 $885 $17,950 $748 - --------------------------- ------------------- --------------------- --------------------- --------------------- September 30, 2005 $74,085 $650 $44,274 $1,500 - --------------------------- ------------------- --------------------- --------------------- --------------------- </TABLE> Losses shown above are attributable to interest rate movements. The Company continuously monitors the credit quality of the securities portfolio. Since the Company has the ability and intent to hold the securities, the losses associated with those securities are considered temporary. Note (5) Recent Accounting Pronouncements In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3." The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented based on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a "restatement." The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Corporation does not anticipate this revision will have a material effect on its financial statements. On December 16, 2004, FASB issued SFAS No. 123R (revised 2004), "Share-Based Payment," that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company's equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic method and requires that such transactions be accounted for using a fair-value-based method and recognized as expense in the statement of income. The effective date of SFAS No. 123R (as amended by the SEC) is for annual periods beginning after June 15, 2005. The provisions of SFAS No. 123R do not have an impact on the Corporation's results of operations at the present time. In March 2005, the SEC issued Staff Accounting Bulleting No. 107 (SAB 107). SAB 107 expresses the views of the SEC staff regarding the interaction of FAS 123R and certain SEC rules and regulations and provides the SEC staff's view regarding the valuation of share-based payment arrangements for public companies. SAB 107 does not impact the Corporation's results of operations at the present time. In November 2004, the Emerging Issues Task Force (EITF) published Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. Generally Accepted Accounting Principles (GAAP) when developing its views. The Task Force also requested that the scope of the impairment issue be expanded to include equity investments and investments subject to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and that the issue be addressed by the Task Force as a separate EITF issue. At the EITF meeting, the Task Force reached a consensus on one issue that certain quantitative and qualitative disclosures should be required for securities accounted for under SFAS No. 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Board ratified the consensus on that one issue at its November 25, 2004 meeting. In September 2004, FASB directed its staff to issue two proposed FASB Staff Positions (FSP): Proposed FSP EITF Issue 03-1-a, which provides guidance for the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays the effective date of Issue 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. In June 2005, the FASB reached a decision whereby they declined to provide additional guidance on the meaning of other-than-temporary impairment. The Board directed the FASB staff to issue EITF 03-1a as final and to draft a new FSP that will replace EITF 03-01. The final FSP (retitled FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments"), would be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. The Corporation does not anticipate this revision will have a material effect on its financial statements. 16
Note (6) Defined Benefit Plan Components of Net Periodic Benefit Cost <TABLE> <CAPTION> Pension Benefits Nine Months Ended Three Months Ended September 30, September 30, --------------------- ----------------------- ($ in Thousands) <S> <C> <C> <C> <C> 2005 2004 2005 2004 ---- ---- ---- ---- Service cost $ 420 $ 372 $ 140 $ 124 Interest cost 459 402 153 134 Expected return on plan assets (435) (375) (145) (125) Amortization of prior service cost 6 6 2 2 Recognized net actuarial loss 138 90 46 30 Amortization of transition cost (9) (9) (3) (3) ---------- ---------- ----------- ----------- Net periodic benefit cost $ 579 $ 486 $ 193 $ 162 ========== ========== =========== =========== </TABLE> Employer Contributions Bankshares previously disclosed in its financial statements for the year ended December 31, 2004, an estimated quarterly minimum contribution of $124 to its pension plan in 2005. That estimate has since been revised and Bankshares now expects to contribute a total of $610, paid in quarterly installments, to the pension plan for 2005. As of September 30, 2005, the Company has contributed $317. Bankshares anticipates making all required contributions prior to the end of 2005. Note (7) Acquisitions In February of 2005, the Company acquired two branches from Planters Bank and Trust Company of Virginia. The transaction added approximately $8,831 in loans and approximately $22,009 in deposits. A deposit intangible of approximately $1,304 arose as a result of the transaction. This intangible will amortize over twelve years. Approximately $311 in fixed assets was also acquired. 17
National Bankshares, Inc. and Subsidiaries (In thousands, except per share data) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations for the Nine Months Ended September 30, 2005 The purpose of this discussion is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly-owned subsidiaries (the Company), which are not otherwise apparent from the consolidated financial statements and other information included in this report. Refer to the financial statements and other information included in this report as well as the 2004 Annual Report on Form 10-K for an understanding of the following discussion and analysis. This Quarterly Report on Form 10-Q contains forward-looking statements as described in the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in the forward-looking statements. Critical Accounting Policies General The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one element in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Allowance for Loan Losses The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Our allowance for loan losses has three basic components; the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when actual events occur. The formula allowance uses a historical loss view and certain qualitative factors 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. Expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors, whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. 18
Core deposit intangibles Effective January 1, 2002, the Corporation adopted Financial Accounting Standards Board Statement No. 142, Goodwill and Other Intangible Assets. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, Statement 142 requires that acquired intangible assets (such as core deposit intangibles) be separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged and amortized over its estimated useful life. Branch acquisition transactions were outside the scope of the Statement and therefore any intangible asset arising from such transactions remained subject to amortization over their estimated useful life. In October 2002, the Financial Accounting Standards Board issued Statement No. 147, Acquisitions of Certain Financial Institutions. The Statement amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, Business Combinations, and Statement No. 142 to branch acquisitions if such transactions meet the definition of a business combination. The provisions of the Statement do not apply to transactions between two or more mutual enterprises. In addition, the Statement amends Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. 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. Overview National Bankshares, Inc. (NBI) is a financial holding company located in Southwest Virginia. It conducts operations primarily through two full-service banking affiliates, the National Bank of Blacksburg and Bank of Tazewell County. It also has one nonbanking affiliate, National Bankshares Financial Services, Inc., which offers investment and insurance products. Net income derived from the nonbanking affiliate is not significant at this time or in the foreseeable future. NBI is a community bank operation. Performance Summary The following table shows NBI's key performance ratios for the period ended September 30, 2005 and December 31, 2004 and 2003: <TABLE> <CAPTION> September 30, December 31, December 31, 2005 2004 2003 - -------------------------------------------- ------------------- ---------------------- -------------------- <S> <C> <C> <C> Return on average assets 1.51% 1.62% 1.64% - -------------------------------------------- ------------------- ---------------------- -------------------- Return on average equity 13.69% 14.48% 14.77% - -------------------------------------------- ------------------- ---------------------- -------------------- Net interest margin (1) 4.53% 4.69% 4.82% - -------------------------------------------- ------------------- ---------------------- -------------------- Noninterest margin (2) 1.82% 1.77% 1.81% - -------------------------------------------- ------------------- ---------------------- -------------------- Basic net earnings per share $2.62 $3.48 $3.26 - -------------------------------------------- ------------------- ---------------------- -------------------- Fully diluted net earnings per share $2.60 $3.46 $3.24 - -------------------------------------------- ------------------- ---------------------- -------------------- </TABLE> (1) Net Interest Margin: Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets using a tax rate of 35%. (2) Noninterest Margin: Noninterest income (including securities gains and losses) less noninterest expense (excluding the provision for bad debts and income taxes) divided by average year-to-date assets. 19
The Company undertook three acquisitions during the period from the second quarter of 2004 through the first quarter of 2005. These acquisitions resulted in substantial growth, but did not have a material effect on the net interest margin. However, as interest rates have risen in the financial markets, there has been a compression in the net interest margin. The cost of funds has increased more rapidly than interest income and has impacted the level of net interest income. Net interest income at September 30, 2005 was $23,701, a 5.4% increase when compared to the prior year. Noninterest income for the nine month period ending September 30, 2005 was $5,587. This represents an increase of $302, or 5.7%, over the same period in 2004. An increase in credit card fees of $263 accounted for approximately 87.1% of the total change. Trust income declined by $43 when the two periods are compared. Growth The following table shows NBI's key growth indicators: <TABLE> <CAPTION> September 30, 2005 December 31, 2004 December 31, 2003 - ------------------- ---------------------------- --------------------- ---------------------- <S> <C> <C> <C> Securities $263,943 $250,708 $230,154 - ------------------- ---------------------------- --------------------- ---------------------- Loans, net 493,240 472,199 401,428 - ------------------- ---------------------------- --------------------- ---------------------- Deposits 732,177 705,932 625,378 - ------------------- ---------------------------- --------------------- ---------------------- Total assets 828,907 796,154 708,560 - ------------------- ---------------------------- --------------------- ---------------------- </TABLE> At September 30, 2005 total assets were $828,907, an increase of $32,753 from December 31, 2004. Reflected in the totals for the first nine months of 2005, is approximately $22,009 in deposits and $8,831 in loans that the Company acquired from Planters Bank and Trust Company of Virginia during the first quarter. This transaction accounted for the majority of the deposit growth and approximately 42% of the growth observed in loans. Surplus funds acquired in the transaction also contributed to growth in the investment portfolio. Asset Quality Key asset quality indicators are shown below: <TABLE> <CAPTION> September 30, 2005 December 31,2004 December 31, 2003 - --------------------------------------------- ----------------------- --------------------- ---------------------- <S> <C> <C> <C> Nonperforming loans $ 251 $ 394 $ 354 - --------------------------------------------- ----------------------- --------------------- ---------------------- Loans past due over 90 days 563 754 931 - --------------------------------------------- ----------------------- --------------------- ---------------------- Other real estate owned 429 895 1,663 - --------------------------------------------- ----------------------- --------------------- ---------------------- Allowance for loan losses to loans 1.13% 1.20% 1.32% - --------------------------------------------- ----------------------- --------------------- ---------------------- Net charge-off ratio 0.18% 0.30% 0.34% - --------------------------------------------- ----------------------- --------------------- ---------------------- </TABLE> This data indicates that the level of nonperforming loans has declined, as has the level of loans past due 90 days or more. Other real estate owned continues to decline as properties foreclosed upon are sold. Asset quality remains excellent at one of the Company's subsidiary banks, and it continues to improve at the Company's other banking affiliate. Net Interest Income Net interest income for the nine-month period ended September 30, 2005 was $23,701, an increase of $1,208, or 5.4%, over the same period in 2004. As previously mentioned, the Company has experienced a period of substantial growth largely through acquisitions, and this growth is the source of the increase in net interest income. Overall, the net interest margin has responded well to the acquisitions completed over the past year. However, the margin has narrowed as interest rates have increased. At September 30, 2005 the net interest margin was 4.53%, and it was 4.73% at September 30, 2004. With the assets from the past year's acquisitions, some fluctuation in the net interest margin was expected. It was also expected that the acquired assets and liabilities would not be optimal from an asset and liability management perspective, and that, going forward, some adjustments would be required. 20
Net Interest Income - Trends and Future Expectations During 2004, the Federal Reserve Board initiated a series of interest rate increases. These increases were designed to restore interest rates to historically more typical levels and to prevent inflation. Rate increases have occurred at regular intervals, each at 25 basis points to date. Management believes that interest rates will continue to rise for the foreseeable future. Rising energy costs coupled with high levels of government spending are viewed as inflationary. Government expenditures are expected to remain high as a result of natural disasters, conflict in the Middle East and new spending programs such as the prescription drug benefit for senior citizens. It is expected that the Federal Reserve Bank will continue to raise interest rates to combat inflationary pressures. The general impact of a rising interest rate scenario on the Company's balance sheet is described on page 15 of the Company's 2004 Form 10K, which is incorporated by reference in this report. Interest Expense Interest expense for the nine months ended September 30, 2005 was $10,085, an increase of $1,923, or 23.6%, from the same period the prior year. As previously discussed, the Company has experienced a period of growth which has contributed to the interest expense increase, as have rising interest rates. During periods of rising interest rates, interest-bearing demand deposits, and to a lesser degree savings deposits, migrate to higher rate, longer-term time deposits. Generally, as rates climb, more migration occurs. Given their re-pricing characteristics, interest-bearing demand deposits readily respond to any interest rate movement. In other words, increases or decreases in interest expense can occur quite quickly. With a definite bias towards higher interest rates in the future, it is expected that the net interest margin will continue to decline, at least temporarily, in response to rising interest rates. The ultimate impact of rising interest rates is dependent upon the number of rate increases, the amount of these rate increases and the level to which interest rates ultimately rise. Provision and Allowance for Loan Losses The provision for loan losses for the nine-month period ended September 30, 2005 was $557, a $328 decrease from the same period ended September 30, 2004. The ratio of the allowance for loan losses to total loans at the end of the first nine months of 2005 was 1.13%, which compares to 1.24% at the same period last year. The net charge-off ratio at September 30, 2005 was 0.18%, and it was 0.28% at September 30, 2004. The Company regularly reviews asset quality and re-evaluates the allowance for loan losses. Reviews are conducted for each of the two bank subsidiaries, and an appropriate provision and allowance for loan losses is established for each bank, depending upon factors that are unique to that bank and the quality of its loan portfolio. As noted above, the ratio of the allowance for loan losses to total loans is lower than at the end of the third quarter in 2004. The ratio has declined as total loans have grown from $478,809 at December 31, 2004 to $499,787 at September 30, 2005, while the level of the allowance has remained stable. Because of the continued excellent overall quality of the loan portfolio at one subsidiary bank and the improving quality of the loan portfolio at the second bank, it is management's judgment that the decrease in the provision for loan losses is justified and the allowance is appropriate and adequate. (See "Allowance for Loan Losses" under "Critical Accounting Policies".) 21
<TABLE> <CAPTION> Noninterest Income September 30, 2005 September 30, 2004 September 30, 2003 - ----------------------------------- ----------------------- ------------------------ ------------------------ <S> <C> <C> <C> Service charges on deposits $2,273 $2,234 $1,877 - ----------------------------------- ----------------------- ------------------------ ------------------------ Other service charges and fees 224 182 206 - ----------------------------------- ----------------------- ------------------------ ------------------------ Credit card fees 1,625 1,362 1,210 - ----------------------------------- ----------------------- ------------------------ ------------------------ Trust fees 1,062 1,105 757 - ----------------------------------- ----------------------- ------------------------ ------------------------ Other income 408 311 342 - ----------------------------------- ----------------------- ------------------------ ------------------------ Realized securities gains (losses) (5) 91 3 - ----------------------------------- ----------------------- ------------------------ ------------------------ </TABLE> Noninterest income is made up of several categories. Following is a description of each, as well as the factors that influence each. "Service charges on deposit accounts" consist of a variety of charges imposed on demand deposits, interest-bearing deposits and savings deposit accounts. These include, but are not limited to, the following: o Demand deposit monthly activity fees o Service charges for checks for which there are non-sufficient funds or overdraft charges o ATM transaction fees The principal factors affecting current or future levels of income from this category are: o Internally generated growth o Acquisitions of other banks/branches or de novo branches o Adjustments to service charge structures As the above table demonstrates, there was a 1.7% increase in service charges and deposit accounts between 2004 and 2005. Additional volume from acquisitions was the primary cause for the increase, as there have been no significant changes to service charge structures. "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 other service charges and fees 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 by themselves yield a significant increase in income when they change. 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 volume. The increase in this category is also largely the result of increased volume from acquisitions. "Credit card fees" consist of three types of revenues. 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. Recent acquisitions have had a positive impact on this category. 22
"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 2005, the financial markets have experienced a degree of volatility. Income from estates is also unpredictable, as the number of estates is impossible to predict. Trust income for the period ended September 30, 2005 was $1,062, down $43 from the same period in 2004. This decrease was caused by a decrease in estate income. "Other income" is used for types of income that cannot be classified with other categories 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, trends or patterns are not discernable. Realized net losses on securities were $(5). The net loss was due to write-downs in certain investments in limited liability companies (LLC's) of which the Company is part owner, as well as sales, maturities and calls of securities. <TABLE> <CAPTION> Noninterest Expense September 30, 2005 September 30, 2004 September 30, 2003 - ----------------------------- --------------------------- -------------------------- --------------------------- <S> <C> <C> <C> Salaries and employee benefits $8,534 $7,815 $7,161 - ----------------------------- --------------------------- -------------------------- --------------------------- Occupancy and furniture and fixtures 1,450 1,337 1,248 - ----------------------------- --------------------------- -------------------------- --------------------------- Data processing and ATM 1,172 913 851 - ----------------------------- --------------------------- -------------------------- --------------------------- Credit card processing 1,270 1,100 949 - ----------------------------- --------------------------- -------------------------- --------------------------- Intangibles and goodwill amortization 832 699 715 - ----------------------------- --------------------------- -------------------------- --------------------------- Net costs of other real estate owned 244 149 38 - ----------------------------- --------------------------- -------------------------- --------------------------- Other operating expenses 3,157 2,997 2,878 - ----------------------------- --------------------------- -------------------------- --------------------------- </TABLE> 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 Employer FICA o Unemployment taxes 23
(1) See the 2004 Form 10-K and the Proxy Statement for the 2005 Annual Stockholders meeting for further information For the first nine months of 2005, salary and benefits expense was $8,534, an increase of $719. A greater number of employees because of acquisitions, routine salary increases, pensions and health insurance cost increases contributed to the increase. At September 30, 2005 the Company employed 272 full time equivalent employees, and there were 242 full time equivalent employees at September 30, 2004. 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. Occasionally, but not frequently, repairs and other expense items may be significant. Included in the increase is depreciation of costs related to a new phone system and for fixed assets purchased in acquisitions. The Company maintains its own data processing facility and has ATM's at twenty-one of the branch offices of its subsidiary banks and at four off-site locations. Costs to operate ATM's are reflected in this category and include depreciation, maintenance, communication lines and certain supplies. For the period ended September 30, 2005, data processing and ATM expenses were up $259 when compared to the same period in 2004. A significant percentage of this increase is attributable to acquisitions. One-time conversion expenses were approximately $152. In addition, out-sourced data processing fees for Community National Bank (CNB) continued from the date of its purchase in the second quarter of 2004 until its computer systems were combined with NBB's in the first quarter of 2005. These fees totaled $47. Also included in the increased data processing expenses were the costs related to the operation of five additional ATM's. 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 "Noninterest Income", and the comments in that section are applicable. Intangibles offset by intangible amortization and goodwill increased by $133 due to acquisition activity. At September 30, 2005 the net cost of other real estate owned was $244, which consists of losses on disposal, write-downs and other foreclosure costs. As the Company's bank subsidiaries generally hold one or more parcels of foreclosed real estate, more losses are possible. The September 30, 2005 costs are not necessarily indicative of the full year for 2005. Other real estate owned at September 30, 2005 was $429, which compares to $895 at December 31, 2004. 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 increase moderately 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. Overall costs for this category increased by 5.4%, when the periods ended September 30, 2005 and September 30, 2004 are compared. Included in this category is postage, which rose approximately $22 when the periods ended September 30, 2005 and 2004 are compared. Increased mailings due to a larger deposit base and two computer conversions, which required additional mailings, contributed to the increase. 24
Stationery and supplies, which are also affected by the acquisitions, were up $13 when the two periods are compared. Franchise taxes, which banks pay in lieu of state income taxes, were up by $69. This tax is based on the banks' capital, and capital increased because of earnings retained. Balance Sheet Year-to-date daily averages for the major balance sheet categories are as follows: <TABLE> <CAPTION> Assets September 30, 2005 December 31, 2004 - ------------------------------------------------ -------------------------- ---------------------- <S> <C> <C> Federal funds sold $ 72 $ 276 Interest-bearing deposits 12,592 16,224 Securities available for sale 151,260 143,021 Securities held to maturity 109,773 107,284 Mortgage loans held for sale 690 626 Real estate construction loans 26,878 23,041 Real estate mortgage loans 118,000 107,189 Commercial and industrial loans 258,717 228,897 Loans to individuals 89,313 86,083 Total Assets $ 814,827 $ 753,730 Liabilities and stockholders equity - ------------------------------------------------ Noninterest-bearing demand deposits $ 114,086 $93,320 Interest-bearing demand deposits 201,510 186,106 Savings deposits 58,863 58,899 Time deposits 345,338 327,302 Other borrowings 967 531 Shareholders' equity $89,819 $84,479 </TABLE> Securities The Company sold approximately $3,312 in securities held to maturity during the first nine months of 2005. These sales were prompted by reductions in credit quality ratings, and therefore were not a violation of FAS 115. Loans During the first nine months of 2005, the Company completed an acquisition of two branches from Planters Bank and Trust Company of Virginia. The purchase of approximately $8,831 in loans was included in the transaction. The volume of mortgage loans held for sale is directly related to interest rate levels. Activity generally peaks during periods of low interest rates, declining as interest rates rise. Period-end balances are not indicative of volume, as loans are constantly being originated and sold. The balance shown at period-end reflects only loans held by NBB for which there are purchase commitments from investors, but which have not yet been funded. At September 30, 2005 there was approximately $3,487 in outstanding commitments to extend mortgage loans. Construction loans were $27,639 at September 30, 2005 and $25,009 at December 31, 2004, an increase of $2,630. This category tends to fluctuate because of demand and with the seasons. Demand also may vary because of economic conditions. Completion of construction projects generally occurs within one year, at which time permanent financing through one of the Company's banking affiliates or another lender is obtained. Loans for which the Company retains permanent financing move into the commercial and industrial loan or mortgage loan categories. Real estate loans at September 30, 2005 were $120,240, which represents an increase of $4,852 from December 31, 2004. Loans in this category are for one-to-four family housing and are loans the banking affiliates elected to retain rather than to sell on the secondary market. 25
Commercial and industrial loans were $263,729 at September 30, 2005, an increase of $15,206 from December 31, 2004. Included in this category are loans for working capital, equipment, commercial real estate and other loans for business needs. See Note 15 of the Company's 2004 Form 10-K for information related to "Concentrations of Credit". Loans to individuals decreased by $1,710 when September 30, 2005 is compared to December 31, 2004. For further comments on trends related to loans to individuals see "Loans" on page 15 in the Company's 2004 Form 10-K. Total deposits at September 30, 2005 increased by $26,245 from December 31, 2004. Noninterest-bearing demand deposits increased by $8,985 when September 30, 2005 is compared to December 31, 2004. During the same period, interest-bearing demand deposits increased by $10,210, and time deposits increased by $14,182. The majority of the growth in deposits came from the acquisition of the two Planters Bank and Trust branches in the first quarter of 2005. Liquidity and Capital Resources Net cash provided by operating activities was $11,497 for the period ended September 30, 2005, which compares to $16,255 for the same period the previous year. Net cash used in investing activities was $8,547 for the period ended September 30, 2005, and $16,485 used for the period ended September 30, 2004. Net cash provided by financing activities was $1,671 for the period ending September 30, 2005. Management is unaware of any commitment that would have a material and adverse effect on liquidity at September 30, 2005. Total shareholders' equity grew by $5,582 from December 31, 2004 to September 30, 2005. Earnings and the changes in unrealized gains and losses for securities available for sale accounted for the net increase. During the first three quarters of 2005, the Company repurchased 11,400 shares of its own stock for approximately $533 at an average price of $46.70 (excluding broker commission). During the second quarter, the Company declared a $0.70 per share dividend. The Tier I and Tier II risk-based capital ratios at September 30, 2005 were 13.12% and 14.11%, respectively. The Company's leverage capital ratio was 9.35% Interest Rate Sensitivity Following is a table showing repricing and maturity data for the Company's interest-earning assets and interest-bearing liabilities: <TABLE> <CAPTION> September 30, 2005 ----------------------------------------------- Assets <1 Year 1-5 Years > 5 Years - ------------------------------------------- -------------- ---------------- --------------- <S> <C> <C> <C> Federal funds sold --- --- --- Interest-bearing deposits 15,836 --- --- Securities available for sale 20,978 66,326 64,381 Securities held to maturity 15,718 44,834 51,706 Mortgage loans held for sale 196 --- --- Loans, net of unearned income and deferred fees 156,997 276,023 65,840 -------------- ---------------- --------------- Total assets repricing/maturing 209,725 387,183 181,927 ============== ================ =============== Cumulative 209,725 596,908 778,835 ============== ================ =============== Liabilities Interest-bearing demand deposits 209,107 --- --- Savings deposits 55,685 --- --- Time deposits 179,118 171,505 588 Other borrowings 623 --- --- -------------- ---------------- --------------- Total liabilities/maturing 444,533 172,505 588 ============== ================ =============== Gap (234,808) 214,678 181,339 ============== ================ =============== Cumulative repricing gap (234,808) (20,130) 161,209 ============== ================ =============== Cumulative gap ratio 0.47 0.97 1.26 ============== ================ =============== </TABLE> 26
As is noted under "Net Interest Income", the Company is liability-sensitive, as its deposits will re-price at a faster rate than its interest earning assets. In a period of rising interest rates, this can have a negative effect until assets can re-price higher. Management's Discussion and Analysis of Financial Condition and Results of Operations for the Three Months Ended September 30, 2005. The following table shows NBI's key performance ratios for the three months ended September 30, 2005 and 2004. <TABLE> <CAPTION> Three months ended September 30, September 30, 2005 2004 ---- ---- <S> <C> <C> Return on average assets 1.47% 1.63% Return on average equity 13.30% 15.24% Net interest margin 4.31% 4.70% Basic net earnings per share $0.87 $0.91 Fully diluted net earnings per share $0.86 $0.91 </TABLE> The return on average assets for the three months ended September 30, 2005 was 1.47%, a sixteen basis point decrease from the same period in 2004. The return on average equity also declined. The decline in the net interest margin was caused to a large extent by increased cost of funds. In addition, the third quarter of 2005 reflects the full effects of two acquisitions, one of which occurred in late June 2004 and another in February of 2005. Net Interest Income The following table shows information related to NBI's net interest margin for the three months ended September 30, 2005 and 2004. <TABLE> <CAPTION> Three months ended September 30, September 30, % change 2005 2004 <S> <C> <C> <C> Interest income $11,483 $10,841 5.92% Interest expense 3,816 2,904 31.40% ----- ----- ------ Net interest income $7,667 $7,937 (3.40)% ====== ====== ======= September 30, September 30, 2005 2004 Yield on earning assets 6.26% 6.27% Cost to fund earning assets 1.95% 1.57% Net interest margin 4.31% 4.70% </TABLE> When the two periods are compared, the yield on interest earning assets remained essentially the same. However, the cost to fund the earning assets rose by 38 basis points. This reflects the steady increase in interest rates affecting the Company and the entire banking industry. Forecasts suggest that the Federal Reserve will continue to increase interest rates in the near future. Considered as a whole, the Company is liability-sensitive, which means its deposit base will upwardly reprice at a faster rate than its interest earning assets. This will have a negative effect, at least in the short term, until the slower-responding asset side reprices upward. 27
Provision for Loan Losses The provision for loan losses for the three months ended September 30, 2005 was $169. This compares to $293 for the three months ended September 30, 2004 and represents a $124 decrease. Comments made in the year-to-date discussion for the "Provision and Allowance for Loan Losses" apply. Because asset quality directly impacts the level of the provision for loan losses, see also the "Asset Quality" section. Noninterest Income The following table compares NBI's noninterest income categories for the three months ended September 30, 2005 and 2004. <TABLE> <CAPTION> Three months ended September 30, 2005 September 30, 2004 % change <S> <C> <C> <C> Service charges on deposits $797 $824 (3.28)% Other service charges and fees 68 52 30.77% Credit card fees 553 480 15.21% Trust fees 326 274 18.98% Other income 149 131 13.74% Realized securities gains/losses (1) 104 (100.96)% </TABLE> Service charges on deposits for the third quarter of 2005 were $797, down 3.3% over the same quarter in 2004. There have been no material changes in the service charge structure. Credit card fees increased $73 when the third quarter of 2005 and 2004 are compared. These fees are almost exclusively driven by volume. Growth from acquisitions was again the major cause of the increase. Other income for the third quarter of 2005 was $149, up $18 from the third quarter of 2004. Comments in the year-to-date discussion apply. Noninterest Expenses The following table compares NBI's noninterest expense categories for the three months ended September 30, 2005 and 2004. <TABLE> <CAPTION> Three months ended September 30, September 30, 2005 2004 % change ---- ---- -------- <S> <C> <C> <C> Salaries and employee benefits $2,822 $2,723 3.64% Occupancy and furniture and fixtures 491 473 3.81% Data processing and ATM 270 349 (22.64)% Credit card processing 431 398 8.29% Intangible assets and goodwill amortization 283 233 21.46% Net costs of other real estate owned 63 37 70.27% Other operating expenses 1,019 1,062 (4.05)% </TABLE> Salaries and employee benefits for the three month period ending September 30, 2005 were $2,822, up $99 or 3.6%. In late June 2004, NBB acquired the Community National Bank of Pulaski, Virginia and substantially all of its employees became employees of that bank. In February of 2005, BTC completed an acquisition of certain branches. These acquisitions account for the majority of the increase in this category. Comments in the year-to-date discussion also apply. Occupancy and furniture and fixtures expense increased $18 when the third quarter of 2005 and 2004 expense are compared. Impacting this area was the acquisition of a new Company-wide phone system, as well as the previously mentioned acquisitions late in June 2004 and in the first quarter of 2005. Data processing and ATM expenses were $270 for the three month period ended September 30, 2005, compared to $349 for the same period in 2004. A large portion of the decrease is attributable to the termination in early 2005 of a contract for previously outsourced computer services at Community National Bank. Expenses related to the amortization of intangibles increased $50 when the third quarter of 2005 and 2004 are compared. Acquisitions accounted for this increase. There have been no write-downs due to impairment. The $63 in costs associated with other real estate is the result of efforts to liquidate foreclosed properties. The amount of foreclosed property has declined from $895 at December 31, 2004 to $429 at September 30, 2005. 28
Derivatives The Company is not a party to derivative financial instruments with off-balance sheet risks, such as futures, forwards, swaps and options. The Company is a party to financial instruments with off-balance sheet risks, such as commitments to extend credit, standby letters of credit, and recourse obligations in the normal course of business, to meet the financing needs of its customers. Management does not plan any future involvement in high- risk derivative products. The Company has investments in collateralized mortgage obligations, structured notes and other similar instruments that are included in securities available for sale and securities held to maturity. The fair value of these investments at September 30, 2005 was approximately $1,008. Amortized cost for these securities was approximately $1,003. The Company's banking affiliates extend lines of credit to their customers in the normal course of business. 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. 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. During the first nine months of 2005, there have been no significant or unusual changes in this area. Item 3. Quantitative and Qualitative Disclosures about Market Risk The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income to adverse movement in interest rates. Interest rate shock analyses provides management with an indication of potential economic loss due to future rate changes. There have not been any changes which would significantly alter the results disclosed as of December 31, 2004 in the Company's Form 10-K. (See "Interest Rate Sensitivity" above.) Item 4. Controls and Procedures Under the supervision and with the participation of management, including the Company's principal executive officer and principal financial officer, the Company has conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures as of September 30, 2005. Based on that evaluation, the Company's principal executive officer and principal financial officer have concluded that these controls and procedures are effective to give reasonable assurance in alerting them in a timely fashion to material information relating to the Company that is required to be included in the reports the Company files under the Act. There were no changes in the Company's internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Disclosure controls and procedures are the Company's controls and procedures that are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to allow timely decisions regarding its required disclosure. The Company believes that a controls system, no matter how well designed and operated, cannot provide absolute assurance that all control issues have been detected. 29
Part II Other Information Item 1. Legal Proceedings There were no material legal proceedings for the three months ended September 30, 2005. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds On May 12, 2004, the Board of Directors approved the repurchase of up to $1 million of the Company's common stock in a stock repurchase program that was set to expire on May 31, 2005. On May 11, 2005, the Board of Directors approved the renewal of the stock repurchase program and authorized the open market repurchase of up to $1 million in common stock between June 1, 2005 and May 31, 2006. At September 30, 2005, approximately $797,788 may yet be purchased under the new plan. No shares were purchased during the quarter ended September 30, 2005. Item 3. Defaults upon Senior Securities None for the three months ended September 30, 2005. Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits See Index of Exhibits. 30
Signatures Pursuant to the requirements 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. DATE: November 8, 2005 NATIONAL BANKSHARES, INC. /s/ JAMES G. RAKES ------------------------- James G. Rakes Chief Executive Officer /s/ J. ROBERT BUCHANAN ------------------------- J. Robert Buchanan Chief Financial Officer <TABLE> <CAPTION> (1) Index of Exhibits Page No. in Exhibit No. Description Sequential System ----------- ----------- ----------------- <S> <C> <C> 3(i) Articles of Incorporation, as amended, of National (incorporated herein by Bankshares, Inc. reference to Exhibit 3(a) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 3(i) Articles of Amendment to Articles of Incorporation (incorporated herein by of National Bankshares, Inc.,dated April 8, 2003. reference to exhibit 3(i) of The Annual Report on Form 10-K for the fiscal year ended December 31, 2003) 4(i) Specimen copy of certificate for National (incorporated herein by Bankshares, Inc. common stock, $2.50 par value reference to Exhibit 4(a) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 4(i) Article Four of the Articles of Incorporation of (incorporated herein by National Bankshares, Inc. included in Exhibit No. reference to Exhibit 4(b) 3(a) of the Annual Report on Form 10-K for fiscal year ended December 31, 1993) 10(ii)(B) Computer software license agreement dated June 18, (incorporated herein by 1990, by and between Information Technology, Inc. reference to Exhibit 10(e) and The National Bank of Blacksburg of the Annual Report on Form 10-K for fiscal year ended December 31, 1992) *10(iii)(A) National Bankshares, Inc. 1999 Stock Option Plan (incorporated herein by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on June 4, 1999) 31
*10(iii)(A) Employment Agreement dated January 2002 between (incorporated herein by National Bankshares, Inc. and James G. Rakes reference to Exhibit 10(iii)(A) of Form 10-Q for the period ended June 30, 2002) *10(iii)(A) Employment Lease Agreement dated August 14, 2002, (incorporated herein by between National Bankshares, Inc. and The National reference to Exhibit 10(iii)(A) Bank of Blacksburg of form 10-Q for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January 5, 2003, (incorporated herein by between National Bankshares, Inc. and Marilyn B. reference to Exhibit 10 iii Buhyoff (A) of Form 10-K for the period ended December 31, 2002) *10(iii)(A) Change in Control Agreement dated January 8, 2003, (incorporated herein by between National Bankshares, Inc. and F. Brad reference to Exhibit 10 iii (A) Denardo of Form 10-K for the period ended December 31, 2002) 31(i) Section 302 Certification of Chief Executive Officer Page 33 31(ii) Section 302 Certification of Chief Financial Officer Page 34 32(i) 18 U.S.C. Section 1350 Certification of Chief Executive Officer Page 35 32(ii) 18 U.S.C. Section 1350 Certification of Chief Financial Officer Page 35 * Indicates a management contract or compensatory plan required to be filed herein. </TABLE> 32
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 quarterly report on Form 10-Q 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: November 8, 2005 /s/ JAMES G. RAKES ------------------------- James G. Rakes Chairman President and Chief Executive Officer (Principal Executive Officer) 33
Exhibit 31(ii) I, J. Robert Buchanan, Treasurer (Chief Financial Officer) of National Bankshares, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q 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: November 8, 2005 /s/ J. ROBERT BUCHANAN ------------------------ J. Robert Buchanan Treasurer (Principal Financial Officer) 34
Exhibit 32 (i) CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 In connection with the Form 10-Q of National Bankshares, Inc. for the quarter ended September 30, 2005, I, James G. Rakes, President and Chief Executive Officer of National Bankshares, Inc. (Principal Executive Officer), 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-Q for the quarter ended September 30, 2005, fully complies with the requirements of section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and (2)the information contained in such Form 10-Q for the quarter ended September 30, 2005, 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 FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 In connection with the Form 10-Q of National Bankshares, Inc. for the quarter ended September 30, 2005, I, J. Robert Buchanan, Treasurer (Principal Financial Officer) of National Bankshares, Inc., hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to the best of my knowledge and belief, that: (1) such Form 10-Q for the quarter ended September 30, 2005, fully complies with the requirements of section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and (2)the information contained in such Form 10-Q for the quarter ended September 30, 2005, 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) 35