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NKSH > SEC Filings for NKSH > Form 10-Q on 7-Nov-2012All Recent SEC Filings

Show all filings for NATIONAL BANKSHARES INC

Form 10-Q for NATIONAL BANKSHARES INC


7-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
$ in thousands, except per share data

The purpose of this discussion and analysis 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. Please refer to the financial statements and other information included in this report as well as the 2011 Annual Report on Form 10-K for an understanding of the following discussion and analysis.


Cautionary Statement Regarding Forward-Looking Statements

We make forward-looking statements in this Form 10-Q that are subject to significant risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon our management's views and assumptions as of the date of this report. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, changes in:

interest rates,
general economic conditions,
the legislative/regulatory climate,
monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation, and the impact of any policies or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 ("EESA") the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act") and other financial reform legislation,
unanticipated increases in the level of unemployment in the Company's trade area,
the quality or composition of the loan and/or investment portfolios,
demand for loan products,
deposit flows,
competition,
demand for financial services in the Company's trade area,
the real estate market in the Company's trade area,
the Company's technology initiatives,
loss or retirement of key executives,
adverse changes in the securities market, and
applicable accounting principles, policies and guidelines.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our "Risk Factors" in Item 1A. of our 2011 Annual Report on Form 10-K.
The recession continues to impact the national economy as well as the Company's market. Signs of economic recovery are mixed with continued high unemployment and diminished real estate values. The Company's trade area contains a diverse economy that includes large public colleges and universities, which somewhat insulated the Company's market from the dramatic declines in real estate values seen in some other areas of the country. Real estate values in the Company's market area saw moderate declines in 2009 and 2010 that appeared to stabilize in 2011 and 2012. If the economic recovery wavers or reverses, it is likely that unemployment will continue at higher-than-normal levels or rise in the Company's trade area. Because of the importance to the Company's markets of state-funded universities, cutbacks in the funding provided by the State as a result of the recession could also negatively impact employment. This could lead to an even higher rate of delinquent loans and a greater number of real estate foreclosures. Higher unemployment and the fear of layoffs causes reduced consumer demand for goods and services, which negatively impacts the Company's business and professional customers. A slow economic recovery could have an adverse effect on all financial institutions, including the Company.

Critical Accounting Policies

General

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from one previously acceptable method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the transactions could change.


Allowance for Loan Losses

The allowance for loan losses is an accrual of estimated losses that have been sustained in our loan portfolio. The allowance is reduced by charge-offs of loans and increased by the provision for loan losses and recoveries of previously charged-off loans. The determination of the allowance is based on two accounting principles, Accounting Standards Codification ("ASC") Topic 450-20 (Contingencies) which requires that losses be accrued when occurrence is probable and the amount of the loss is reasonably estimable, and ASC Topic 310-10 (Receivables) which requires accrual of losses on impaired loans if the recorded investment exceeds fair value.
Probable losses are accrued through two calculations, individual evaluation of impaired loans and collective evaluation of the remainder of the portfolio. Impaired loans are larger non-homogeneous loans for which there is a probability that collection will not occur according to the loan terms, as well as nonaccrual loans and loans whose terms have been modified in a troubled debt restructuring. Impaired loans with an estimated impairment loss are placed on nonaccrual status.

Impaired loans
Impaired loans are identified through the Company's credit risk rating process. Estimated loss for an impaired loan is the amount of recorded investment that exceeds the loan's fair value. Fair value of an impaired loan is measured by one of three methods: the fair value of collateral ("collateral method"), the present value of future cash flows ("cash flow method"), or observable market price. The Company applies the collateral method to collateral-dependent loans, loans for which foreclosure is eminent and to loans for which the fair value of collateral is a more reliable estimate of fair value. The cash flow method is applied to loans that are not collateral dependent and for which cash flows may be estimated.
The Company bases collateral-method fair valuation upon the "as-is" value of independent appraisals or evaluations. Updated appraisals or evaluations are ordered when the loan becomes impaired if the appraisal or evaluation on file is more than twelve months old. Appraisals and evaluations are reviewed for propriety and reasonableness and may be discounted if the Company determines that the value exceeds reasonable levels. If an updated appraisal or evaluation has been ordered but has not been received by a reporting date, the fair value may be based on the most recent available appraisal or evaluation, discounted for age.
The appraisal or evaluation value for a collateral-dependent loan for which recovery is expected solely from the sale of collateral is reduced by estimated selling costs. Estimated losses on collateral-dependent loans, as well as any other impairment loss considered uncollectible, are charged against the allowance for loan losses. For loans that are not collateral dependent, the impairment loss is accrued in the allowance. Impaired loans with partial charge-offs are maintained as impaired until the remaining balance is satisfied. Smaller homogeneous impaired loans that are not troubled debt restructurings or part of a larger impaired relationship are collectively evaluated.
Troubled debt restructurings are impaired loans and are measured for impairment under the same valuation methods as other impaired loans. Troubled debt restructurings are maintained in nonaccrual status until the loan has demonstrated reasonable assurance of repayment with at least six months of consecutive timely payment performance, unless the impairment measurement indicates a loss. Troubled debt restructurings with impairment losses remain in nonaccrual status.

Collectively-evaluated loans
Non-impaired loans and smaller homogeneous impaired loans that are not troubled debt restructurings and not part of a larger impaired relationship are grouped by portfolio segments that are made up of smaller loan classes. Loans within a segment or class have similar risk characteristics. Probable loss is determined by applying historical net charge-off rates as well as additional percentages for trends and current levels of quantitative and qualitative factors. Loss rates are calculated for and applied to individual classes and encompass losses for the current year and the previous year. Qualitative factors represented by delinquency rates, loan quality and concentrations are evaluated on a class level, with allocations based on the evaluation of trends and levels. Economic factors such as unemployment rates, bankruptcy rates and others are evaluated, with standard allocations applied consistently to relevant classes. The Company accrues additional estimated loss for criticized loans within each class and for loans designated high risk. High risk loans are defined as junior lien mortgages, loans with high loan-to-value ratios and loans with terms that require only interest payments. Both criticized loans and high risk loans are included in the base risk analysis for each class and are allocated additional reserves.

Estimation of the allowance for loan losses The estimation of the allowance involves analysis of internal and external variables, methodologies, assumptions and our judgment and experience. Key judgments used in determining the allowance for loan losses include internal risk rating determinations, market and collateral values, discount rates, loss rates, and our view of current economic conditions. These judgments are inherently subjective and our actual losses could be greater or less than the estimate. Future estimates of the allowance could increase or decrease based on changes in the financial condition of individual borrowers, concentrations of various types of loans, economic conditions or the markets in which collateral may be sold. The estimate of the allowance accrual determines the amount of provision expense and directly affects our financial results.


The estimate of the allowance for September 30, 2012 considered market and portfolio conditions during the first nine months of 2012 as well as the elevated levels of delinquencies and net charge-offs in 2011. Given the continued economic difficulties, the ultimate amount of loss could vary from that estimate. For additional discussion of the allowance, see Note 4 to the financial statements and "Asset Quality," and "Provision and Allowance for Loan Losses."

Goodwill and Core Deposit Intangibles

Goodwill is subject to at least an annual assessment for impairment by applying a fair value based test. The Company performs impairment testing in the fourth quarter of each year. The Company's most recent impairment test was performed in the fourth quarter of 2011 under accounting guidance in effect at that time. The Company's goodwill impairment analysis considered three valuation techniques appropriate to the measurement. The first technique used the Company's market capitalization as an estimate of fair value; the second technique estimated fair value using current market pricing multiples for companies comparable to NBI; while the third technique used current market pricing multiples for change-of-control transactions involving companies comparable to NBI. Each measure indicated that the Company's fair value exceeded its book value, validating that goodwill is not impaired.
Certain key judgments were used in the valuation measurement. Goodwill is held by the Company's bank subsidiary. The bank subsidiary is 100% owned by the Company, and no market capitalization is available. Because most of the Company's assets are comprised of the subsidiary bank's equity, the Company's market capitalization was used to estimate NBB's capitalization. Other judgments include the assumption that the companies and transactions used as comparables for the second and third technique were appropriate to the estimate of the Company's fair value, and that the comparable multiples are appropriate indicators of fair value, and compliant with accounting guidance.
Under accounting guidance adopted for years following 2011, the Company's test in 2012 will first assess qualitative factors to determine the likelihood that the fair value is below carrying value. If the assessment determines that the likelihood exceeds 50 percent that fair value is below carrying value, the Company will perform the fair value assessment as in previous years. If the initial assessment does not indicate the likelihood of fair value below carrying value, in accordance with ASC Topic 350, the Company will not perform estimation of fair value for goodwill.
Acquired intangible assets (such as core deposit intangibles) are recognized separately from goodwill if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its useful life. The Company amortizes intangible assets arising from branch transactions over their useful life. Core deposit 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 impairment testing showed that the expected cash flows of the intangible assets exceeded the carrying value.

Overview

National Bankshares, Inc. ("NBI") is a financial holding company incorporated under the laws of Virginia. Located in southwest Virginia, NBI has two wholly-owned subsidiaries, the National Bank of Blacksburg ("NBB") and National Bankshares Financial Services, Inc. ("NBFS"). NBB, which does business as National Bank from twenty-five office locations, is a community bank. NBB is the source of nearly all of the Company's revenue. NBFS does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.
NBI common stock is listed on the NASDAQ Capital Market and is traded under the symbol "NKSH." National Bankshares, Inc. has been included in the Russell Investments Russell 3000 and Russell 2000 Indexes since June 29, 2009.


Performance Summary

The following table presents NBI's key performance ratios for the nine months
ended September 30, 2012 and the year ended December 31, 2011. The measures for
September 30, 2012 are annualized, except for basic earnings per share and fully
diluted earnings per share.

                                    September 30,      December 31,
                                        2012               2011
Return on average assets                      1.62 %            1.71 %
Return on average equity                     12.14 %           12.89 %
Basic earnings per share           $          1.88     $        2.54
Fully diluted earnings per share   $          1.88     $        2.54
Net interest margin (1)                       4.40 %            4.59 %
Noninterest margin (2)                        1.37 %            1.45 %

(1) Net interest margin: Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets.

(2) Noninterest margin: Noninterest expense (excluding the provision for bad debts and income taxes) less noninterest income (excluding securities gains and losses) divided by average year-to-date assets.

The annualized return on average assets declined slightly for the nine months ended September 30, 2012 as compared to the year ended December 31, 2011, due primarily to growth in average assets. The annualized return on average equity declined 75 basis points for the same period, due to growth in average equity. Average equity tends to build in the months preceding the payment of dividends which have historically been paid semi-annually.
The annualized net interest margin was 4.40% at the end of the third quarter of 2012, down 19 basis points from the 4.59% reported for the year ended December 31, 2011. The primary factor driving the decrease in the net interest margin was the declining yield on earning assets offset by a smaller decline in the cost to fund earning assets.
The annualized noninterest margin decreased 8 basis points from the year ended December 31, 2011 primarily because of a decrease in noninterest expense. Please refer to the discussion under noninterest expense for further information.

Growth

NBI's key growth indicators are shown in the following table.

                                                     September       December 31,
                                                      30, 2012           2011         Percent Change
Interest-bearing deposits                           $     67,394     $     98,355              (31.48 ) %
Securities                                               359,807          318,913               12.82   %
Loans, net                                               583,207          580,402                0.48   %
Deposits                                                 924,383          919,333                0.55   %
Total assets                                           1,080,972        1,067,102                1.30   %

Total securities grew by 12.82% from December 31, 2011, while loans increased slightly. The increases were funded primarily by a decrease in interest-bearing deposits as well as, in smaller measure, by an increase in customer deposits.


Asset Quality

Key indicators of NBI's asset quality are presented in the following table.


                                                    September        September        December
                                                     30, 2012         30, 2011        31, 2011
Nonperforming loans                                $      6,130     $      4,344     $     5,204
Accruing restructured loans                               2,021            5,524           3,756
Loans past due 90 days or more, and still
accruing                                                    114              339             481
Other real estate owned                                   1,894            1,759           1,489
Allowance for loan losses to loans                         1.40 %           1.46 %          1.37 %
Net charge-off ratio                                       0.54 %           0.26 %          0.43 %
Ratio of nonperforming assets to loans, net of
unearned income and deferred fees, plus other
real estate owned                                          1.35 %           1.02 %          1.13 %
Ratio of allowance for loan losses to
nonperforming loans                                      134.65 %         200.71 %        155.03 %

The Company monitors asset quality indicators in managing credit risk and in determining the allowance and provision for loan losses. The recent economic recession and slow recovery have contributed to levels of some asset quality measures that are higher than normal for the Company. Nonperforming loans, net charge-offs and other real estate owned increased while accruing restructured loans and accruing loans past due 90 days or more improved when compared to both September 30, 2011 and December 31, 2011.
The Company's risk analysis determined an allowance for loan losses of $8,254 at September 30, 2012, an increase from $8,068 at December 31, 2011. The provision for the nine months ended September 30, 2012 was $2,554, an increase of $358 from $2,196 for the same period in 2011. The ratio of the allowance for loan losses to loans increased slightly from December 31, 2011, but decreased slightly from the level at September 30, 2011. The increase in the net charge-off ratio and in nonperforming loans contributed to the increase in the allowance for loan losses from December 31, 2011. The Company continues to monitor risk levels within the loan portfolio.
Other real estate owned increased $405 from December 31, 2011 and $135 from September 30, 2011, due to foreclosures. As of September 30, 2012, total properties approximating $470 are in various stages of foreclosure and may impact other real estate owned in future quarters. It is not possible to accurately predict the future total of other real estate owned because property sold at foreclosure may be acquired by third parties and NBB's other real estate owned properties are regularly marketed and sold.


Net Interest Income

The net interest income analysis for the nine months ended September 30, 2012
and 2011 follows:

                                   September 30, 2012                           September 30, 2011
                                                        Average                                     Average
                          Average                        Yield/        Average                       Yield/
                          Balance        Interest         Rate         Balance       Interest         Rate
Interest-earning
assets:
Loans, net (1)(2)(3)    $   588,844     $   26,820           6.08 %   $ 588,710     $   27,594           6.27 %
Taxable securities          163,070          4,991           4.09 %     157,759          5,115           4.33 %
Nontaxable securities
(1)(4)                      164,432          7,431           6.04 %     163,366          7,602           6.22 %
Interest-bearing
deposits                     96,410            187           0.26 %      56,998            104           0.24 %
Total
interest-earning
assets                  $ 1,012,756     $   39,429           5.20 %   $ 966,833     $   40,415           5.59 %
Interest-bearing
liabilities:
Interest-bearing
demand deposits         $   415,839     $    3,144           1.01 %   $ 375,536     $    3,081           1.10 %
Savings deposits             64,323             28           0.06 %      57,816             34           0.08 %
Time deposits               302,887          2,899           1.28 %     315,980          3,892           1.65 %
Total
interest-bearing
liabilities             $   783,049     $    6,071           1.04 %   $ 749,332     $    7,007           1.25 %
Net interest income
and interest rate
spread                                  $   33,358           4.16 %                 $   33,408           4.34 %
Net yield on average
interest-earning
assets                                                       4.40 %                                      4.62 %

(1) Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 35% in the two nine-month periods presented.

(2) Included in interest income are loan fees of $642 and $560 for the nine months ended September 30, 2012 and 2011, respectively.

(3) Nonaccrual loans are included in average balances for yield computations.

(4) Daily averages are shown at amortized cost.

The net interest margin for the nine months ended September 30, 2012 decreased 22 basis points from the nine months ended September 30, 2011. The decrease in net interest margin was driven by a decline in the yield on earning assets of 39 basis points offset by a decline in the cost of interest-bearing liabilities of 21 basis points. Both loans and securities experienced a decline in yields. The 19 basis point decline in the yield on loans stemmed from contractual repricing terms and the renegotiation of loan interest rates in response to competition. The yield on taxable securities was 24 basis points lower for the nine months ended September 30, 2012, when compared with the same period in 2011, while the yield on nontaxable securities declined 18 basis points over the same period. The market yield for securities of a comparable term has declined over the past year, causing matured and called bonds to be replaced with lower yielding investments. The decline in the cost of interest-bearing liabilities came primarily from a 37 basis point reduction in the cost of time deposits when the nine-month periods ended September 30, 2012 and September 30, 2011 are compared.
The Company's yield on earning assets and cost of funds are largely dependent on the interest rate environment. In the recent past, historically low interest rates caused funding costs to decline at a faster pace than the yield on earning assets. The decline in deposit pricing has begun to slow while competitive and market forces continue to pressure the yield on earning assets. The Company's cost of funding is more sensitive to interest rate changes than is the yield on earning assets.

Provision and Allowance for Loan Losses

The provision for loan losses for the nine month period ended September 30, 2012 was $2,554, compared with $2,196 for the nine months of 2011. The ratio of the allowance for loan losses to total loans at the end of the third quarter of 2012 was 1.40%, which compares to 1.37% at December 31, 2011. The net charge-off ratio was 0.54% at September 30, 2012 and 0.43% at December 31, 2011. See "Asset Quality" for additional information.


Noninterest Income

                                                          Nine Months Ended
                                                    September 30,        September
                                                             2012         30, 2011     Percent Change
Service charges on deposits                         $       1,956     $      1,952                0.20   %
Other service charges and fees                                130              174              (25.29 ) %
Credit card fees                                            2,441            2,365                3.21   %
Trust fees                                                  1,037              817               26.93   %
BOLI income                                                   605              559                8.23   %
Other income                                                  341              293               16.38   %
Realized securities gains (losses)                             33               (7 )            571.43   %

Service charges on deposit accounts for the nine months ended September 30, 2012 remained at a similar level as the same period in 2011. . . .

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