- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 2006. |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OR THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________. Commission file number 0-15204 NATIONAL BANKSHARES, INC. (Exact name of Registrant as specified in its Charter) Virginia 54-1375874 (State of incorporation) (I.R.S. Employer Identification No.) 101 Hubbard Street P.O. Box 90002 Blacksburg, VA 24062-9002 (540) 951-6300 (Address and telephone number of principal executive offices) 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 filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b - 2 of the Exchange Act. Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_| 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 April 30, 2006 ----- ----------------------------- Common Stock, $1.25 Par Value 7,013,784 (This report contains 31 pages)
NATIONAL BANKSHARES, INC. AND SUBSIDIARIES Form 10-Q Index <TABLE> <CAPTION> Part I Financial Information Page - ---------------------------- <S> <C> <C> Item 1 Financial Statements Consolidated Balance Sheets, March 31, 2006 (Unaudited) 3-4 and December 31, 2005 Consolidated Statements of Income for the Three Months Ended March 31, 5-6 2006 and 2005 (Unaudited) Consolidated Statements of Changes in 7 Stockholders' Equity, Three Months Ended March 31, 2006 and 2005 (Unaudited) Consolidated Statements of Cash Flows, 8-9 Three Months Ended March 31, 2006 and 2005 (Unaudited) Notes to Consolidated Financial Statements 10-16 Item 2 Management's Discussion and Analysis of 16-25 Financial Condition and Results of Operations Item 3 Quantitative and Qualitative Disclosures About 25 Market Risk Item 4 Controls and Procedures 25 Part II Other Information - -------------------------- Item 1 Legal Proceedings 26 Item 1A Risk Factors 26 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 26 Item 3 Defaults Upon Senior Securities 26 Item 4 Submission of Matters to a Vote of Security Holders 26 Item 5 Other Information 26 Item 6 Exhibits 26 Signatures 27 - ---------- Index of Exhibits 27-28 - ----------------- </TABLE> 2
Part I Financial Information Item 1. Financial Statements National Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets <TABLE> <CAPTION> (Unaudited) March 31, December 31, ($ In thousands, except share and per share data) 2006 2005 ================== =================== Assets <S> <C> <C> Cash and due from banks $18,270 $20,115 Interest-bearing deposits 17,253 10,279 Securities available for sale, at fair value 168,560 162,833 Securities held to maturity (fair value approximates $106,574 at March 31, 2006 and $109,513 at December 31, 2005) 107,268 109,708 Mortgage loans held for sale 493 --- Loans: Real estate construction loans 27,290 27,116 Real estate mortgage loans 117,326 117,421 Commercial and industrial loans 264,300 264,149 Loans to individuals 81,841 84,838 ------------------ ------------------- Total loans 490,757 493,524 Less unearned income and deferred fees (948) (913) ------------------ ------------------- Loans, net of unearned income and deferred fees 489,809 492,611 Less: allowance for loan losses (5,418) (5,449) ------------------ ------------------- Loans, net 484,391 487,162 ------------------ ------------------- Bank premises and equipment, net 12,757 12,808 Accrued interest receivable 5,498 5,145 Other real estate owned, net 390 376 Intangible assets and goodwill, net 16,829 17,113 Other assets 16,247 15,959 ------------------ ------------------- Total assets $847,956 $841,498 ================== =================== Liabilities and Stockholders' Equity Noninterest-bearing demand deposits $117,895 $112,445 Interest-bearing demand deposits 225,240 225,611 Savings deposits 55,210 54,505 Time deposits 350,877 353,088 ------------------ ------------------- Total deposits 749,222 745,649 ------------------ ------------------- Other borrowed funds 83 357 Accrued interest payable 724 725 Other liabilities 3,667 2,828 ------------------ ------------------- Total liabilities 753,696 749,559 ------------------ ------------------- 3
Stockholders' Equity Preferred stock of no par value. Authorized 5,000,000 shares; none issued and outstanding --- --- Common stock of $1.25 par value. Authorized 10,000,000 shares; issued and outstanding 7,013,174 shares in 2006 and 7,019,874 in 2005 8,767 8,775 Retained earnings 87,407 84,610 Accumulated other comprehensive income (loss), net (1,914) (1,446) ------------------ ------------------- Total stockholders' equity 94,260 91,939 ------------------ ------------------- Total liabilities and stockholders' equity $847,956 $841,498 ================== =================== </TABLE> See accompanying notes to the consolidated financial statements. 4
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Income Three Months Ended March 31, 2006 and 2005 (Unaudited) <TABLE> <CAPTION> March 31, March 31, ($ In thousands, except share and per share data) 2006 2005 ======================================================================= ================== ================= <S> <C> <C> Interest income: Interest and fees on loans $8,361 $8,067 Interest on interest-bearing deposits 158 81 Interest on securities - taxable 1,803 1,591 Interest on securities - nontaxable 1,261 1,296 ------------------ ----------------- Total interest income 11,583 11,035 ------------------ ----------------- Interest expense: Interest on time deposits $100,000 or more 1,088 873 Interest on other deposits 3,148 2,165 Interest on borrowed funds 2 5 ------------------ ----------------- Total interest expense 4,238 3,043 ------------------ ----------------- Net interest income 7,345 7,992 Provision for loan losses 17 190 ------------------ ----------------- Net interest income after provision for loan losses 7,328 7,802 ------------------ ----------------- Noninterest income: Service charges on deposit accounts 815 675 Other service charges and fees 109 87 Credit card fees 524 494 Trust income 380 408 Other income 267 137 Realized securities (losses), net (36) (33) ------------------ ----------------- Total noninterest income 2,059 1,768 ------------------ ----------------- Noninterest expense: Salaries and employee benefits 2,911 2,862 Occupancy, furniture and fixtures 533 479 Data processing and ATM 301 467 Credit card processing 413 376 Intangibles amortization 284 266 Net costs of other real estate owned 14 108 Other operating expenses 1,043 1,131 ------------------ ----------------- Total noninterest expense 5,499 5,689 ------------------ ----------------- Income before income tax expense 3,888 3,881 Income tax expense 885 888 ------------------ ----------------- Net income $3,003 $2,993 ================== ================= 5
Net income per share - basic $0.43 $0.43 ================= =================== - diluted $0.43 $0.43 ================= =================== Weighted average number of common shares outstanding - basic 7,015,061 7,038,120 ================= =================== - diluted 7,044,385 7,077,770 ================= =================== Dividends declared per share $--- $--- ================= =================== </TABLE> See accompanying notes to consolidated financial statements. 6
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Three Months Ended March 31, 2006 and 2005 (Unaudited) <TABLE> <CAPTION> Accumulated Other ($ In thousands) Common Retained Comprehensive Comprehensive Stock Earnings Income (Loss) Income Total ============ ============== ================ ================ =========== <S> <C> <C> <C> <C> <C> Balances, December 31, 2004 $8,797 $77,735 $556 $87,088 Net income --- 2,993 --- 2,993 $2,993 Other comprehensive loss, net of tax: Unrealized loss on securities available for sale, net of income tax $(730) --- --- --- (1,356) --- Reclass adjustment, net of tax $12 --- --- --- 21 --- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive loss --- --- (1,335) (1,335) (1,335) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $1,658 --- ------------ -------------- ---------------- ---------------- ----------- Exercise of stock options 5 42 --- --- 47 ------------ -------------- ---------------- ---------------- ----------- Balances, March 31, 2005 $8,802 $80,770 $(779) --- $88,793 ============ ============== ================ ================ =========== Balances, December 31, 2005 $8,775 $84,610 $(1,446) $91,939 Net income --- 3,003 --- 3,003 $3,003 Other comprehensive loss, net of tax: Unrealized losses on securities available for sale, net of income tax $(265) --- --- --- (491) --- Reclass adjustment, net of income tax $13 --- --- --- 23 --- ------------ -------------- ---------------- ---------------- ----------- Other comprehensive loss --- --- (468) (468) (468) ------------ -------------- ---------------- ---------------- ----------- Comprehensive income --- --- --- $2,535 --- ------------ -------------- ---------------- ---------------- ----------- Exercise of stock options 5 36 --- --- 41 ------------ -------------- ---------------- ---------------- ----------- Stock repurchase (13) (242) (255) ------------ -------------- ---------------- ---------------- ----------- Balances, March 31, 2006 $8,767 $87,407 $(1,914) $94,260 ============ ============== ================ ================ =========== </TABLE> See accompanying notes to consolidated financial statements. 7
National Bankshares, Inc. and Subsidiaries Consolidated Statements of Cash Flows Three Months Ended March 31, 2006 and 2005 (Unaudited) <TABLE> <CAPTION> March 31, March 31, ($In thousands) 2006 2005 =================== ================= <S> <C> <C> Cash flows from operating activities: Net income $3,003 $2,993 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 17 190 Depreciation of bank premises and equipment 246 247 Amortization of intangibles 284 266 Amortization of premiums and accretion of discount, net 61 125 (Gains) on disposal of fixed assets (2) (4) (Gains)losses on sales and calls of securities available for sale, net 36 (12) (Gains) on calls of securities held to maturity --- (2) Losses and writedowns on other real estate owned 10 43 (Increase) decrease in: Mortgage loans held for sale (493) 813 Accrued interest receivable (353) (481) Other assets (36) (1,439) Increase (decrease) in: Accrued interest payable (1) 74 Other liabilities 839 980 ------------------- ----------------- Net cash provided by operating activities $3,611 $3,793 ------------------- ----------------- Cash flows from investing activities Net (increase) decrease in interest-bearing deposits $(6,974) $10,860 Proceeds from calls, principal payments, sales and maturities of securities available for sale 4,156 4,880 Proceeds from calls, principal payments and maturities of securities held to maturity 3,880 1,964 Purchases of securities available for sale (10,682) (14,496) Purchases of securities held to maturity (1,458) (6,008) Purchases of loan participations --- (2,304) Collections of loan participations (1,398) 1,285 Net (increase)decrease in loans to customers 4,089 (15,773) Proceeds from disposal of other real estate owned --- 157 Recoveries on loans charged off 39 46 Purchase of bank premises and equipment (196) (981) Proceeds from disposal of bank premises and equipment 3 5 ------------------- ----------------- Net cash (used in) investing activities $(8,541) $(20,365) ------------------- ----------------- 8
Cash flows from financing activities: Net increase in other deposits $5,784 $10,429 Net increase (decrease) in time deposits (2,211) 7,512 Net increase (decrease) in other borrowed funds (274) 134 Stock options exercised 41 47 Stock repurchased (255) --- ------------------ ----------------- Net cash provided by financing activities $3,085 $18,122 ------------------ ----------------- Net increase (decrease) in cash and due from banks (1,845) 1,550 Cash and due from banks at beginning of period 20,115 12,493 ------------------ ----------------- Cash and due from banks at end of period $18,270 $14,043 ================== ================= Supplemental disclosure of cash flow information: Cash paid for interest $4,239 $2,969 ================== ================= Cash paid for income taxes $--- $180 ================== ================= Loans charged to the allowance for loan losses $87 $253 ================== ================= Loans transferred to other real estate owned $24 $20 ================== ================ Unrealized (losses) on securities available for sale $(720) $(2,053) ================== ================ Transactions related to acquisition of branches Increase in assets and liabilities: Loans $--- $8,831 Deposits $--- $22,009 Fixed Assets $--- $311 </TABLE> See accompanying notes to consolidated financial statements. 9
National Bankshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements March 31, 2006 (Unaudited) ($ 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 three months ended March 31, 2006 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 2005 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 The Company 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 generally vest 25% after one year, 50% after two years, 75% after three years and 100% after four years. On December 29, 2005, the Company's Board of Directors passed a resolution stating that all 142,000 previously granted, but unvested, stock options be immediately vested. The vesting was made subject to the provision that any shares of NBI common stock obtained by an option grantee by exercise of an option subject to accelerated vesting may not be sold or otherwise transferred prior to the expiration of the option's original vesting period. This action was taken to reduce the impact of the "Statement of Financial Accounting Standards No. 123R, Share-Based Payment" on the Company's earnings over the reminder vesting period of the stock options. 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 March 31, 2006, there were 286,000 additional shares available for grant under the plan. Compensation expense is calculated using the Black-Scholes model and is amortized over the requisite service period using the straight-line method. Please refer to the Company's Form 10-K dated December 31, 2005 for assumptions used. There have been no grants of stock options in 2006. 10
<TABLE> <CAPTION> Weighted- Weighted- Average Aggregate Average Remaining Intrinsic Exercise Contractual Value Options Shares(1) Price Term ($000) - ------------------------------------------- ------------ ------------ --------------- ------------ <S> <C> <C> <C> <C> Outstanding at January 1, 2006 172,500 $19.90 Granted --- Exercised (4,000) $10.45 Forfeited or expired --- --- Outstanding at March 31, 2006 168,500 $20.13 7.7 $824 ======= ====== === ==== Exercisable at March 31, 2006 168,500 $20.134 7.7 $824 ======= ======= === ==== </TABLE> 1. Outstanding shares at January 1, 2006 have been adjusted to reflect a 2-for-1 stock split effective March 31, 2006. Because no options were granted in 2006, there is no expense included in net income. Three months ended March 31, ----------------- ($ In thousands, except per share data) 2005 - ---------------------------------------------------- ----------------- Net income, as reported $2,993 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (36) ----------------- Pro forma net income $2,957 ----------------- Earnings per share: Basic - as reported $0.43 ----------------- Basic - pro forma $0.42 ----------------- Diluted - as reported $0.43 ----------------- Diluted - pro forma $0.42 - ---------------------------------------------------- ----------------- During the three months ended March 31, 2006, there were no stock options granted and 4,000 stock options were exercised with an intrinsic value of $54,000. For the three months ended March 31, 2005 there were no stock options granted and 1,750 options were exercised. For and 2004, 36,000 shares and 16,500 shares were excluded. 11
Note (3) Allowance for Loan Losses, Nonperforming Assets and Impaired Loans <TABLE> <CAPTION> For the periods ended March 31, December 31, --------- ------------ 2006 2005 2005 -------------- -------------- ----------------- ($ In thousands, except % data) <S> <C> <C> <C> Balance at beginning of period $5,449 $5,729 $5,729 Provision for loan losses 17 190 567 Loans charged off (87) (253) (1,101) Recoveries 39 46 254 -------------- -------------- ----------------- Balance at the end of period $5,418 $5,712 $5,449 ============== ============== ================= Ratio of allowance for loan losses to the end of period loans, net of unearned income and deferred fees 1.11% 1.16% 1.11% ============== ============== ================= Ratio of net charge-offs to average loans, net of unearned income and deferred fees(1.) 0.04% 0.17% 0.17% ============== ============== ================= Ratio of allowance for loan losses to nonperforming loans(2.) 5,889.13% 1,646.11% 3,061.24% ============== ============== ================= </TABLE> 1. Net charge-offs are on an annualized basis. 2. The Company defines nonperforming loans as total nonaccrual and restructured loans. Loans 90 days past due and still accruing are excluded. <TABLE> <CAPTION> March 31, December 31, --------- ------------ 2006 2005 2005 ------------- ------------ ---------------- ($ In thousands, except % data) Nonperforming Assets: <S> <C> <C> <C> Nonaccrual loans $92 $347 $178 Restructured loans --- --- --- ------------- ------------ ---------------- Total nonperforming loans 92 347 178 Foreclosed property 390 715 376 ------------- ------------ ---------------- Total nonperforming assets $482 $1,062 $554 ============= ============ ================ Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned 0.10% 0.21% 0.11% ============= ============ ================ </TABLE> 12
<TABLE> <CAPTION> March 31, December 31, --------- ------------ 2006 2005 2005 ------------- ------------ --------------- <S> <C> <C> <C> Loans Past due 90 days or more and still accruing $184 $763 $546 ============= ============ =============== Ratio of loans past due 90 days or more and still accruing to loans, net of unearned income and deferred fees 0.04% 0.15% 0.11% ============= ============ =============== Impaired loans: Total impaired loans $92 $341 $174 ============= ============ =============== Impaired loans with a valuation allowance --- --- --- Valuation allowance --- --- --- ------------- ------------ --------------- Impaired loans, net of allowance --- --- --- ============= ============ =============== Impaired loans with no valuation allowance $92 $341 $174 ============= ============ =============== Average recorded investment in impaired loans $133 $348 $274 ============= ============ =============== Income recognized on impaired loans $2 --- --- ============= ============ =============== Amount of income recognized on a cash basis $2 --- $11 ============= ============ =============== </TABLE> Nonaccrual loans excluded from impaired loan disclosure under FASB 114 at March 31, 2006 were $0. 13
Note (4) Securities The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for the sale by major security type as of March 31, 2006 are as follows: <TABLE> <CAPTION> March 31, 2006 Gross Gross Amortized Unrealized Unrealized Fair ($ In thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ <S> <C> <C> <C> <C> Available for sale: U.S. Treasury $3,036 --- $161 $2,875 U.S. Government Agencies and Corporations 28,767 --- 395 28,372 State and political subdivisions 72,739 965 726 72,978 Mortgage-backed securities 30,542 79 545 30,076 Corporate debt securities 32,071 72 1,441 30,702 Federal Reserve Bank stock- restricted 208 --- --- 208 Federal Home Loan Bank stock-restricted 1,759 --- --- 1,759 Other securities 1,433 157 --- 1,590 ----------------- ----------------- ----------------- ------------------ Total securities available for sale $170,555 $1,273 $3,268 $168,560 ================= ================= ================= ================== </TABLE> The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type as of March 31, 2006 are as follows: <TABLE> <CAPTION> March 31, 2006 Gross Gross Amortized Unrealized Unrealized Fair ($ In thousands) Costs Gains Losses Values ----------------- ----------------- ----------------- ------------------ <S> <C> <C> <C> <C> Held to Maturity: U.S. Government Agencies and Corporations $28,606 --- $825 $27,781 State and political subdivisions 54,674 832 293 55,213 Mortgage-backed securities 3,785 41 44 3,782 Corporate securities 20,203 236 641 19,798 ----------------- ----------------- ----------------- ------------------ Total securities held to maturity $107,268 $1,109 $1,803 $106,574 ================= ================= ================= ================== </TABLE> 14
Information pertaining to securities with gross unrealized losses at March 31, 2006 and December 31, 2005, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows: <TABLE> <CAPTION> March 31, 2006 Less Than 12 Months 12 Months or More Fair Value Unrealized Loss Fair Value Unrealized Loss <S> <C> <C> <C> <C> U.S. Government agencies and corporations $40,447 $587 $19,641 $794 State and political subdivisions 26,722 345 18,265 674 Mortgage-backed securities 18,301 252 10,437 337 Corporate debt securities 10,178 276 27,329 1,806 ------ --- ------ ----- Total temporarily impaired securities $95,648 $1,460 $75,672 $3,611 ======= ====== ======= ====== </TABLE> <TABLE> <CAPTION> December 31, 2005 Less Than 12 Months 12 Months or More Fair Value Unrealized Loss Fair Value Unrealized Loss <S> <C> <C> <C> <C> U.S. Government agencies and corporations $38,913 541 $11,698 485 State and political subdivisions 28,660 429 15,625 601 Mortgage-backed securities 22,169 333 3,132 76 Corporate debt securities 12,052 200 25,881 1,482 ------ --- ------ ----- Total temporarily impaired securities $101,794 $1,503 $56,336 $2,644 ======== ====== ======= ====== </TABLE> The Company had 260 securities with a fair value of $171,320 which were temporarily impaired at March 31, 2006. The total unrealized loss on these securities was $5,071. 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 considered temporary at March 31, 2006. All securities shown are above investment grade. Note (5) Recent Accounting Pronouncements In March 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 156, "Accounting for Servicing of Financial Assets an amendment of FASB Statement 140" (Statement 156). Statement 156 amends Statement 140 with respect to separately recognized servicing assets and liabilities. Statement 156 requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract and requires all servicing assets and liabilities to be initially measured at fair value, if practicable. Statement 156 also permits entities to subsequently measure servicing assets and liabilities using an amortization method or fair value measurement method. Under the amortization method, servicing assets and liabilities are amortized in proportion to and over the estimated period of servicing. Under the fair value measurement method, servicing assets are measured at fair value at each reporting date and changes in fair value are reported in net income for the period the change occurs. Adoption of Statement 156 is required as of the beginning of fiscal years beginning subsequent to September 15, 2006. Earlier adoption is permitted as of the beginning of an entity's fiscal year, provided the entity has not yet issued financial statements, including interim financial statements. 15
The Corporation does not expect the adoption of Statement 156 at the beginning of 2007 to have a material impact. Note (6) Defined Benefit Plan Components of Net Periodic Benefit Cost Pension Benefits Three Months Ended March 31, ----------------------- ($ in Thousands) 2006 2005 ---------- ------------ Service cost $ 143 $ 140 Interest cost 161 153 Expected return on plan assets (143) (145) Amortization of prior service cost (3) 2 Recognized net actuarial loss 53 46 Amortization of transition cost 2 (3) ---------- ------------ Net periodic benefit cost $ 213 $ 193 ========== ============ Employer Contributions Bankshares expects to contribute a total of $698, paid in quarterly installments, to the pension plan for 2006. Bankshares anticipates making all required contributions prior to the end of 2006. Note (7) Stock Split Bankshares' Board of Directors approved a 2-for-1 stock split of Bankshares' common stock. All per share information for all periods presented has been retroactively restated to reflect the stock split. 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 Three Months Ended March 31, 2006 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 2005 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, 16
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. 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. 17
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 March 31, 2006 and December 31, 2005 and 2004. Per share data has been adjusted to reflect the effects of the March 31, 2006 2-for-1 stock split. <TABLE> <CAPTION> March 31, December 31, December 31, 2006 2005 2004 - ----------------------------------------------- ------------------- ---------------------- ----------------------- <S> <C> <C> <C> Return on average assets 1.45% 1.52% 1.62% - ----------------------------------------------- ------------------- ---------------------- ----------------------- Return on average equity 13.04% 13.73% 14.48% - ----------------------------------------------- ------------------- ---------------------- ----------------------- Net interest margin (1) 4.22% 4.45% 4.69% - ----------------------------------------------- ------------------- ---------------------- ----------------------- Noninterest margin (2) 1.64% 1.74% 1.77% - ----------------------------------------------- ------------------- ---------------------- ----------------------- Basic net earnings per share $0.43 $1.77 $1.74 - ----------------------------------------------- ------------------- ---------------------- ----------------------- Fully diluted net earnings per share $0.43 $1.76 $1.73 - ----------------------------------------------- ------------------- ---------------------- ----------------------- </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. This is a non-GAAP financial measure of the level of noninterest income and expense. The return on average assets for the first quarter of 2006 was 1.45%, down slightly from the 1.51% for the same period in the prior year. The return on average equity also experienced a decline. The net interest margin declined by 49 basis points. This decrease was due to rising interest rates. Interest expense has continued to grow at a faster pace than interest income. Growth The following table shows NBI's key growth indicators: <TABLE> <CAPTION> March 31, 2006 December 31, 2005 December 31, 2004 - ------------------- ---------------------------- --------------------- ---------------------- <S> <C> <C> <C> Securities $275,828 $272,541 $250,708 - ------------------- ---------------------------- --------------------- ---------------------- Loans, net 484,391 487,162 472,199 - ------------------- ---------------------------- --------------------- ---------------------- Deposits 749,222 745,649 705,932 - ------------------- ---------------------------- --------------------- ---------------------- Total assets 847,956 841,498 796,154 - ------------------- ---------------------------- --------------------- ---------------------- </TABLE> At March 31, 2006 total assets were $847,956, an increase of $6,458 or 0.77%. If annualized, the growth rate would be approximately 3.1%. In order to reduce the compression of the net interest margin, management has exercised restraint when pricing large denomination time deposits. This approach has had positive influence on profitability; however, it has caused lower rates of deposit growth. 18
Asset Quality Key asset quality indicators are shown below: <TABLE> <CAPTION> March 31, 2006 December 31,2005 December 31, 2004 - --------------------------------------------- ----------------------- --------------------- ---------------------- <S> <C> <C> <C> Nonperforming loans $ 92 $ 178 $ 394 - --------------------------------------------- ----------------------- --------------------- ---------------------- Loans past due over 90 days 184 546 754 - --------------------------------------------- ----------------------- --------------------- ---------------------- Other real estate owned 390 376 895 - --------------------------------------------- ----------------------- --------------------- ---------------------- Allowance for loan losses to loans 1.11% 1.11% 1.20% - --------------------------------------------- ----------------------- --------------------- ---------------------- Net charge-off ratio 0.04% 0.17% 0.30% - --------------------------------------------- ----------------------- --------------------- ---------------------- </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. Net Interest Income Net interest income for the period ending March 31, 2006 was $7,345, a decrease of $647 or 8.1%. The principal cause of the decline is rising interest rates. Specifically, the Company's interest-bearing liabilities have repriced upward at a faster pace than interest-earning assets. During the period the yield on earning assets rose by 7 basis points, while the cost of interest-bearing liabilities increased by 56 basis points. Net Interest Income - Trends and Future Expectations During 2005, 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. 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. The Federal Reserve Bank may yet raise interest rates to combat inflationary pressures. However, there is a general expectation that interest rates are at or near their peak. Once interest rates stabilize, the compression of the net interest margin should begin to abate which would have a positive effect on the level of net interest income. The general impact of a rising interest rate scenario on the Company's balance sheet is described on page 15 of the Company's 2005 Form 10K, which is incorporated by reference in this report. Interest Expense Interest expense for the three months ended March 31, 2006 was $4,238, an increase of $1,195, or 39.3%, from the same period the prior year. As previously discussed, rising interest rates have been the major contributor to this increase. 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. Provision and Allowance for Loan Losses The provision for loan losses for the three-month period ended March 31, 2006 was $17, a $173 decrease from the same period ended March 31, 2005. The ratio of the allowance for loan losses to total loans at the end of the first 19
three months of 2006 was 1.11%, which compares to 1.16% at the same period last year. The net charge-off ratio at March 31, 2006 was 0.04%, and it was 0.17% at March 31, 2005. 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. Because of the continued excellent overall quality of the loan portfolio, 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".) <TABLE> <CAPTION> Noninterest Income March 31, 2006 March 31, 2005 March 31, 2004 - ----------------------------------- ----------------------- ------------------------ ------------------------ <S> <C> <C> <C> Service charges on deposits $815 $675 $675 - ----------------------------------- ----------------------- ------------------------ ------------------------ Other service charges and fees 109 87 72 - ----------------------------------- ----------------------- ------------------------ ------------------------ Credit card fees 524 494 386 - ----------------------------------- ----------------------- ------------------------ ------------------------ Trust fees 380 408 509 - ----------------------------------- ----------------------- ------------------------ ------------------------ Other income 267 137 103 - ----------------------------------- ----------------------- ------------------------ ------------------------ Realized securities gains (losses) (36) (33) (6) - ----------------------------------- ----------------------- ------------------------ ------------------------ </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 Service charges on deposits were $815 at March 31, 2006, an increase of $140 or 20.74%. Of that increase, approximately $135 was due to increases in fees for overdrafts and returned checks. In early 2005 the Company increased its charge for each overdrawn item, and the amount of daily maximum charges was increased. 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. 20
Other service charges and fees at March 31, 2006 were $109, as compared with $87 for the same period the prior year. Of the $22 increase, approximately $10 was due to increases in fees associated with cashing income tax refund checks. Another $5 came from increased fees for letters of credit. The remainder of the increase were in the safe deposit box, and credit life insurance categories. 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. Credit card fees increased by $30 or 6.07% when March 31, 2006 and March 31, 2005 are compared. The increase was attributable to volume. 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 2006, the financial markets have experienced a degree of volatility. Income from estates is also unpredictable. Trust income for the first three months of 2006 was $380, a decrease of $28 from the previous year. The decline was the result of fluctuations in income derived from the settlement of estates. 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 identifiable. Other income increased $130 when March 31, 2006 and March 31, 2005 are compared. Of the $130 change, approximately $112 was attributable to increases in cash value associated with bank owned life insurance policies. Realized net gains and losses on securities include 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. Realized gains and losses were ($36) for the period ended March 31, 2006. The majority of this loss was attributable to write-downs in investments in limited liability companies (LLC's). <TABLE> <CAPTION> Noninterest Expense March 31, 2006 March 31, 2005 March 31, 2004 - ----------------------------- --------------------------- -------------------------- --------------------------- <S> <C> <C> <C> Salaries and employee benefits $2,911 $2,862 $2,518 - ----------------------------- --------------------------- -------------------------- --------------------------- Occupancy and furniture and fixtures 533 479 438 - ----------------------------- --------------------------- -------------------------- --------------------------- Data processing and ATM 301 467 279 - ----------------------------- --------------------------- -------------------------- --------------------------- Credit card processing 413 376 314 - ----------------------------- --------------------------- -------------------------- --------------------------- 21
- ----------------------------- --------------------------- -------------------------- --------------------------- Intangibles and goodwill amortization 284 266 238 - ----------------------------- --------------------------- -------------------------- --------------------------- Net costs of other real estate owned 14 108 59 - ----------------------------- --------------------------- -------------------------- --------------------------- Other operating expenses 1,043 1,131 974 - ----------------------------- --------------------------- -------------------------- --------------------------- </TABLE> Noninterest expense includes several categories. A brief description of the factors that affect each follows. 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 Qualified Pension plans (1) o Supplemental retirement plan (salary continuation agreements) o Employer FICA o Unemployment taxes (1) See the 2005 Form 10-K and the Proxy Statement for the 2006 Annual Meeting of Stockholders for further information. Salaries and employee benefits expense was $2,911 at March 31, 2006, an increase of $49 or 1.71% when compared with the same period in 2005. Included in the increase is an $83 expense associated with a supplemental retirement plan that provides for salary continuation agreements with selected officers of the Company and its affiliates. This expense was offset by income from bank owned life insurance on the plan participants. (See the discussion of "Other Income".) The Company employed 283 fulltime equivalent employees at March 31, 2006 and 274 at March 31, 2005. Occupancy costs include such items as depreciation expense, maintenance of the properties, repairs and real estate taxes. At March 31, 2006, occupancy and furniture and fixture expense was $533, an increase of $54 or 11.27% over the end of the first quarter last year. In anticipation of the planned merger of its NBB and BTC affiliates, the Company accrued $35 for the cost of new signage that will be required at the time of the merger, and this expense accounts for the majority of the increase in the occupancy, furniture and fixtures category. Data processing and ATM expense decreased by $166 when compared to March 31, 2005. A decline in maintenance cost of approximately $93 and a decrease in conversion expenses of $58 account for most of the decrease. 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. Credit card processing expense was $413 for the three months ended March 31, 2006, an increase of $37 from the same period in 2005. Volume accounted for the increase. Intangible expense is influenced by acquisitions, amortization schedules and impairment testing depending on the nature of the intangible. Core deposit intangibles are amortized while goodwill is subject to testing for impairment. Both generally increase with acquisitions. Intangibles amortization expense at March 31, 2006 was $284, an increase of $18 over the same period the previous year. The increase was associated with the acquisition of two branches acquired in February 2005. 22
Net cost of other real estate owned consists of losses on disposal, repairs, write-downs and other foreclosure costs. Net costs of other real estate owned was down $94 when compared to the first quarter of last year. This category can fluctuate substantially depending on the number of properties on hand, the gains or losses on sale and the amount of write-downs. 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. Other operating expenses for the first quarter of 2006 were $1,043, down $88 from the same period in the prior year. Balance Sheet Year-to-date daily averages for the major balance sheet categories are as follows: Assets March 31, 2006 December 31, 2005 - ------------------------------------------------------- ---------------------- Federal funds sold $ --- $ --- Interest-bearing deposits 14,089 14,819 Securities available for sale 163,429 151,431 Securities held to maturity 109,215 110,312 Mortgage loans held for sale 214 609 Real estate construction loans 27,378 26,926 Real estate mortgage loans 115,801 117,855 Commercial and industrial loans 264,958 260,197 Loans to individuals 83,273 88,690 Total Assets $ 839,478 $ 819,341 Liabilities and stockholders equity - ------------------------------------- Noninterest-bearing demand deposits $ 111,953 $114,186 Interest-bearing demand deposits 224,404 204,522 Savings deposits 54,550 57,836 Time deposits 351,034 347,471 Other borrowings 163 705 Shareholders' equity $93,419 $90,470 Loans 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 March 31, 2006 there was approximately $3,898 in outstanding commitments to extend mortgage loans. Construction loans were $27,290 at March 31, 2006 and $27,116 at December 31, 2005, an increase of $174. 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 March 31, 2006 were $117,326, which represents a decrease of $95 from December 31, 2005. 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. Commercial and industrial loans were $264,300 at March 31, 2006, an increase of $151 from December 31, 2005. 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 2005 Form 10-K for information related to "Concentrations of Credit". 23
Loans to individuals decreased by $2,997 when March 31, 2006 is compared to December 31, 2005. Total deposits at March 31, 2006 increased by $3,573 from December 31, 2005. Noninterest-bearing demand deposits increased by $5,450 when March 31, 2006 is compared to December 31, 2005. During the same period, interest-bearing demand deposits decreased by $371, and time deposits decreased by $2,211. Liquidity and Capital Resources Net cash provided by operating activities was $3,611 for the period ended March 31, 2006, which compares to $3,793 for the same period the previous year. Net cash used in investing activities was $8,541 for the period ended March 31, 2006, and $20,365 used for the period ended March 31, 2005. Net cash provided by financing activities was $3,085 for the period ending March 31, 2006. Management is unaware of any commitment that would have a material and adverse effect on liquidity at March 31, 2006. Total shareholders' equity grew by $2,321 from December 31, 2005 to March 31, 2006. Earnings and the changes in unrealized gains and losses for securities available for sale accounted for the net increase. During the first three months of 2006, the Company repurchased 10,700 shares of its own stock for approximately $255 at an average price of $23.81 (excluding broker commission). The Tier I and Tier II risk-based capital ratios at March 31, 2006 were 13.61% and 14.55%, respectively. The Company's leverage capital ratio was 9.64% 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> March 31, 2006 ----------------------------------------------- Assets <1Year 1-5 Years > 5 Years - ------------------------------------------- -------------- ---------------- --------------- <S> <C> <C> <C> Federal funds sold --- --- --- Interest-bearing deposits 17,253 --- --- Securities available for sale 27,295 84,667 56,598 Securities held to maturity 10,586 55,735 40,947 Mortgage loans held for sale 493 --- --- Loans, net of unearned income and deferred fees 169,802 248,895 71,112 -------------- ---------------- --------------- Total assets repricing/maturing 225,429 389,297 168,657 ============== ================ =============== Cumulative 225,429 614,726 783,383 ============== ================ =============== Liabilities Interest-bearing demand deposits 225,240 --- --- Savings deposits 55,210 --- --- Time deposits 183,570 166,793 514 Other borrowings 83 --- --- -------------- ---------------- --------------- Total liabilities/maturing 464,103 166,793 514 ============== ================ =============== Gap (238,674) 222,504 168,143 ============== ================ =============== Cumulative repricing gap (238,674) (16,170) 151,973 ============== ================ =============== Cumulative gap ratio 0.49 0.97 1.24 ============== ================ =============== </TABLE> As shown in the above table, the Company is liability sensitive. In other words, the Company's interest-bearing liabilities reprice and/or mature at a faster rate than its interest-earning assets. During periods of rising interest rates, such as we have recently experienced, this causes the Company's net interest margin to decrease. This in turn has a negative impact on overall profitability. 24
Derivatives and Off Balance Sheet Items 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'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 three months of 2006, 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, 2005 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 March 31, 2006. 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. 25
Part II Other Information Item 1. Legal Proceedings There were no material legal proceedings for the three months ended March 31, 2006. Item 1A. Risk Factors No material changes from risk factors as previously disclosed. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds The following table provides information about our purchases during the first quarter of 2006 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act. <TABLE> <CAPTION> - -------------------- -------------------- ----------------------- -------------------- ------------------------- Fiscal Period Total Number of Average Price Paid Total Number of Approximate Dollar Shares Purchased per Share(1) Shares Purchased Value of Shares That as Part of May Yet Be Purchased Publicly Announced Under the Plans or Plans or Programs(2) Programs(2) - -------------------- -------------------- ----------------------- -------------------- ------------------------- <S> <C> <C> <C> <C> January 10,700 $23.84 10,700 $306,054 - -------------------- -------------------- ----------------------- -------------------- ------------------------- </TABLE> 1) Average price per share includes commissions. 2) On May 12, 2005 the Board approved the repurchase of up to $1 million of common stock in the period from June 1, 2005 through May 31, 2006. Item 3. Defaults upon Senior Securities None for the three months ended March 31, 2006. Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits See Index of Exhibits. 26
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: May 10, 2006 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> <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) 3(i) Amended and Restated Articles of Incorporation of (incorporated herein by National Bankshares, Inc. reference to Exhibit 3.1 of Form 8-K filed on March 16, 2006) 4(i) Specimen copy of certificate for National (incorporated herein by Bankshares, Inc. common stock. 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) of 3(a) 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 echnology, Inc. reference to Exhibit 10(e) of and The National Bank of Blacksburg the Annual Report on Form 10-K for fiscal year ended December 31, 1992) 27
*10(iii)(A) National Bankshares, Inc. 1999 Stock Option Plan (incorporated herein by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on June 4, 1999) *10(iii)(A) Employment Agreement dated January 2002 between (incorporated herein by National Bankshares, Inc. and James G. Rakes reference to Exhibit 10(iii)(A) of Form 10-Q for the period ended June 30, 2002) *10(iii)(A) Employment Lease Agreement dated August 14, 2002, (incorporated herein by between National Bankshares, Inc. and The National reference to Exhibit 10(iii)(A) of form 10-Q for the period ended September 30, 2002) *10(iii)(A) Change in Control Agreement dated January 5, 2003, (incorporated herein by between National Bankshares, Inc. and Marilyn B. reference to Exhibit 10 iii 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 etween National Bankshares, Inc. and F. Brad reference to Exhibit 10 iii Denardo (A) of Form 10-K for the period ended December 31, 2002) *10(iii)(A) Salary Continuation Agreement dated February 8, (incorporated herein by 2006, between the National Bank of Blacksburg and reference to Exhibit James G. Rakes. 10(iii)(A) of Form 8-K filed on February 8, 2006) *10(iii)(A) Salary Continuation Agreement dated February 8, (incorporated herein by 2006, between the National Bank of Blacksburg and reference to Exhibit F. Brad Denardo. 10(iii)(A) of Form 8-K filed on February 8, 2006) *10(iii)(A) Salary Continuation Agreement dated February 8, (incorporated herein by 2006, between Bank of Tazewell County and J. Robert reference to Exhibit Buchanan. 10(iii)(A) of Form 8-K filed on February 8, 2006) *10(iii)(A) Salary Continuation Agreement dated February 8, (incorporated herein by 2006, between Bank of Tazewell County and Marilyn reference to Exhibit B. Buhyoff. 10(iii)(A) of Form 8-K filed on February 8, 2006) 31(i) Section 302 Certification of Chief Executive Officer Page 29 31(ii) Section 302 Certification of Chief Financial Officer Page 30 32(i) 18 U.S.C. Section 1350 Certification of Chief Executive Officer Page 31 32(ii) 18 U.S.C. Section 1350 Certification of Chief Financial Officer Page 31 </TABLE> * Indicates a management contract or compensatory plan required to be filed herein. 28
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: May 10, 2006 /s/ JAMES G. RAKES ------------------------- James G. Rakes Chairman President and Chief Executive Officer (Principal Executive Officer) 29
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: May 10, 2006 /s/ J. ROBERT BUCHANAN ------------------------------ J. Robert Buchanan Treasurer (Principal Financial Officer) 30
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 March 31, 2006, 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 March 31, 2006, 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 March 31, 2006, 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 March 31, 2006, 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 March 31, 2006, 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 March 31, 2006, 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) 31