FIRST NATIONAL CORP /VA/ - Quarter Report: 2004 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2004

For the transition period from              to             

Commission file number 0-23976

FIRST NATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

(540) 465-9121

(Registrant’s telephone number, including area code)

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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of May 4, 2004, the latest practicable date for determination, 1,462,062 shares of common stock, par value $2.50 per share, of the registrant were outstanding.

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Part I – Financial Information

Item 1. Financial Statements

FIRST NATIONAL CORPORATION

Consolidated Balance Sheets

(in thousands, except share data)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

Three months ended March 31, 2004 and 2003

(in thousands, except share data)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

Three months ended March 31, 2004 and 2003

(in thousands)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

(Continued)

Three months ended March 31, 2004 and 2003

(in thousands)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity

Three months ended March 31, 2004 and 2003

(in thousands, except share data)

(unaudited)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Notes to Consolidated Financial Statements

(unaudited)

Note 1. General

The accompanying unaudited consolidated financial statements of First National Corporation and its subsidiaries (the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications consisting of a normal and recurring nature considered necessary to present fairly the financial positions at March 31, 2004 and December 31, 2003, the results of operations for the three months ended March 31, 2004 and 2003, and statements of cash flows and changes in shareholders’ equity for the three months ended March 31, 2004 and 2003.

Operating results for the three month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain reclassifications have been made to prior period balances to conform to the current period presentation.

Note 2. Securities

Amortized costs and fair values of securities available for sale at March 31, 2004 and December 31, 2003 are as follows:

The Company had no securities classified as held to maturity at March 31, 2004 or December 31, 2003.

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Notes to Consolidated Financial Statements

(unaudited)

At March 31, 2004, investments in an unrealized loss position that are temporarily impaired are as follows:

The table above provides information about securities that have been in an unrealized loss position for less than twelve consecutive months, and also those securities that have been in an unrealized loss position for more than twelve consecutive months. At March 31, 2004, there were no securities in an unrealized loss position for twelve consecutive months or more. The Company invests in U.S Agency and mortgage-backed securities, obligations of state and political subdivisions, corporate equity securities and restricted securities. Restricted securities include required equity investments in certain correspondent banks. We consider all of the securities with unrealized losses to be temporarily impaired due to interest rate factors and not credit-related factors. At March 31, 2004, there were five U.S. agency mortgage-backed securities and two obligations of state and political subdivisions in an unrealized loss position. Ninety-eight percent of the Company’s investment securities have credit ratings of AAA and the weighted-average repricing term of the investment portfolio was 3.3 years at March 31, 2004.

Note 3. Loans

Loans at March 31, 2004 and December 31, 2003, are summarized as follows:

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Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses

Transactions in the allowance for loan losses for the three months ended March 31, 2004 and 2003 were as follows:

Note 5. Capital Requirements

A comparison of the Company’s and its wholly-owned subsidiary’s, First Bank (the Bank), capital as of March 31, 2004 and December 31, 2003 with the minimum regulatory guidelines were as follows:

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Notes to Consolidated Financial Statements

(unaudited)

Note 6. Company Obligated Mandatorily Redeemable Capital Securities

On March 11, 2003, First National (VA) Statutory Trust I (“the Trust”), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, commonly called trust preferred securities. On March 26, 2003, $3,000,000 of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at March 31, 2004 was 4.26%. The securities have a mandatory redemption date of March 26, 2033, and are subject to varying call provisions beginning March 26, 2008. The principal asset of the Trust is $3,000,000 of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities.

While these securities are debt obligations of the Company, they are included in capital for regulatory capital ratio calculations. Under present regulations, the trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. As of March 31, 2004, the total amount of trust preferred securities issued by the Trust can be included in the Company’s Tier 1 capital.

Note 7. Benefit Plans

Components of net periodic benefit cost for the quarter ended March 31, 2004 and 2003 were as follows:

The Company previously disclosed in its Annual Report on Form 10-KSB in its consolidated financial statements for the year ended December 31, 2003, that it expected to contribute $247,834 to its pension plan in 2004. At March 31, 2004, a contribution of $546,474 had been made. This increase was a direct result of increases in the Company’s maximum allowable tax-deductible contribution. The Company presently anticipates no further contributions during the remainder of 2004.

Note 8. Earnings per Share

Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result form the assumed issuance. There are no potential common shares that would have a dilutive effect.

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INDEPENDENT ACCOUNTANT’S REPORT

To the Board of Directors

First National Corporation

Strasburg, Virginia

We have reviewed the accompanying consolidated balance sheet of First National Corporation and subsidiaries as of March 31, 2004, and the related consolidated statements of income, shareholders’ equity and cash flows for the three month periods ended March 31, 2004 and 2003. These financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of First National Corporation as of December 31, 2003 and the related consolidated statements of income, shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated January 19, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003 is fairly stated, in all material respects, in relation to the balance sheet from which it has been derived.

Winchester, Virginia

May 12, 2004

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Caution About Forward Looking Statements

Certain information in this discussion may include forward looking statements that are subject to 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. 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 subject to significant uncertainties because they are based upon or are affected by certain factors. We have identified factors in the “Caution About Forward Looking Statements” section of our Annual Report on Form 10-KSB for the year ended December 31, 2003, which can be accessed from our website at www.firstbank-va.com.

Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward looking statements. In addition, our past results of operations do not necessarily indicate our future results.

First National Corporation (the Company) is the financial holding company of First Bank (the Bank). First Bank owns First Bank Financial Services, Inc., which invests in partnerships that provide title insurance and investment services. The following discussion and analysis of the financial condition and results of operations of the Company for the three months ended March 31, 2004 should be read in conjunction with the consolidated financial statements and related notes. The results of operations for the three months ended March 31, 2004 may not be indicative of the results to be achieved for the year.

Critical Accounting Policies

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 either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

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) Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 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.

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The Bank’s allowance for loan losses has two basic components: the specific allowance and the formula allowance. Both of these components are determined based upon estimates that can and do change when the actual events occur.

The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans. The specific allowance uses various techniques to arrive at an estimate of loss. First, an analysis of the borrower’s overall financial condition, resources and payment record; the prospects for support from financial guarantors; and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Additionally, historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could differ from the estimates.

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The formula allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans, including residential mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, a formula allowance is used for the remaining pool of larger balance, non-homogeneous loans that were not allocated a specific allowance upon their review. The formula allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include an analysis of historical delinquency and loss experience over a five-year period, together with analyses that reflect current economic trends and conditions. The formula allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future.

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures.

Credit Policies

The principal risk associated with each of the categories of loans in the Bank’s portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased, depending on prevailing economic conditions. In an effort to manage the risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. The risk associated with real estate mortgage loans, commercial and consumer loans varies, based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

The Bank’s Board of Directors approves all loans greater than $1 million or loans that exceed individual loan officer lending limits established by the Bank. The President and the Senior Loan Administrator can combine their lending limits to approve loans up to $1 million. All loans greater than $500 thousand are reported to the board. The Loan Policy Committee consists of five independent directors and the meetings are attended by certain members of management. The committee approves the Bank’s Loan Policy and loans to be charged-off. They also review the allowance for loan loss adequacy calculation as well as the loan watch list and other management reports. The committee meets on a quarterly basis and the chairman of the committee then reports to the Board of Directors.

Residential loan originations come primarily from walk-in customers, real estate brokers and builders. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment and credit history of the applicant. If commercial real estate is involved, information is also obtained concerning cash flow available for debt service. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines as well as the guidelines issued by the purchasers of loans, depending on the type of loan involved. Real estate collateral is appraised by independent fee appraisers who have been pre-approved by the senior loan administrator.

Construction Lending

The Bank makes local construction loans, primarily residential, and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. At March 31, 2004, construction, land and land development loans outstanding were $29.8 million, or 11.09% of gross loans. The average life of most construction loans is approximately one year and they reprice monthly to meet the market, typically prime plus one percent. Because the interest rate charged on these loans float with the market, they assist the Bank in managing interest rate risk. Construction lending entails significant additional risks, compared with residential

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mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction lending is attributable to the fact that loan funds are advanced upon the security of the land or home under construction, which value is estimated prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of appraised value, in addition to analyzing the creditworthiness of its borrowers. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners.

Commercial Business Loans

Commercial business loans generally have a higher degree of risk than residential mortgage loans, but typically have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate. At March 31, 2004, commercial loans totaled $33.1 million, or 12.3% of the total loan portfolio.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. At March 31, 2004, commercial real estate loans aggregated $93.9 million or 34.9% of the Bank’s gross loans.

In its underwriting of commercial real estate, the Bank may lend, under federal regulation, up to 85% of the secured property’s appraised value, although the Bank’s loan to original appraised value ratio on such properties is typically 80% or less in many cases. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners. The Bank also carefully evaluates the location of the security property.

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. Loan quality is analyzed based on guidelines issued by the applicable secondary market investor. The non-conforming one-to-four family loans originated by the Bank that do not generally meet investor guidelines are underwritten using the Bank’s underwriting guidelines. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Senior Loan Administrator.

Typically, all fixed rate mortgage loans are originated with the intent to sell. In order to meet community needs and retain a competitive edge, the Bank occasionally originates non-conforming fixed rate loans. At March 31, 2004, $77.4 million, or 28.8%, of the Bank’s loan portfolio consisted of one-to-four-family residential real estate loans.

In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if required, flood insurance. Flood determination letters with life of loan tracking are obtained on all federally related transactions with improvements serving as security for the transaction. The Bank does require escrows for real estate taxes and insurance for secondary market loans.

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Consumer Lending

The Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans, and credit card loans. At March 31, 2004, the Bank had consumer loans of $32.4 million or 12.0% of gross loans. Such loans are generally made to customers with whom the Bank has a pre-existing relationship. The Bank currently originates most of its consumer loans in its geographic market area.

Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Overview

Earnings and assets continued to grow during the first quarter of 2004. Net income for the quarter ended March 31, 2004 was $897 thousand, an increase of $153 thousand or 20.6%, compared to $744 thousand for the same period in 2003. Net income per share, basic and diluted, increased $0.12 per share from $0.49 in the first quarter of 2003 to $0.61 for the same period in 2004. The increase in earnings resulted primarily from a continuing increase in the Bank’s net interest income. Annualized return on average assets was 1.02% for the first three months of 2004 compared to 1.00% during the same period in 2003. Annualized return on average equity increased 221 basis points to 15.01% for the first quarter of 2004 compared to 12.80% for the same period in 2003.

Assets increased 6.7% to $366.5 million at March 31, 2004 from $343.6 at December 31, 2003. Growth occurred primarily in the loan portfolio where loans, net of the allowance for loan losses, increased 8.5% or $20.9 million from $245.6 million at December 31, 2003 to $266.5 million at March 31, 2004. The securities portfolio decreased $1.7 million to $69.2 million at March 31, 2004 from $70.9 million at December 31, 2003. This decrease was a direct result of the strong loan demand that occurred in the first quarter of 2004.

Results of Operations

General. Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on earning assets, predominately loans and securities, exceeds interest expense on interest-bearing liabilities, predominately deposits and other borrowings. The provision for loan losses and the amount of noninterest income and expense also impact net income. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Net interest margin is calculated by dividing tax equivalent net interest income by average earning assets. Noninterest income and expense consists of income from service charges on deposit accounts; fees charged for other services; gains and losses from the sale of assets, including loans held for sale, securities, and premises and equipment; general and administrative expenses; and income tax expense.

Net income of the Company increased in the first three months of 2004 compared to the first quarter of 2003 as a result of continued growth in earning assets. In the first quarter of 2004, the growth in net interest income and noninterest income exceeded the growth in noninterest expenses. During the same three month period in 2003, net interest income also increased as the Company continued to experience favorable asset growth.

Net Interest Income. Net interest income increased 23.1% from $2.5 million for the quarter ended March 31, 2003 to $3.1 million for the quarter ended March 31, 2004. The decline in interest expense (5.2%) combined with an increase in interest income (11.4%) generated an increase in net interest income of $584 thousand. This increase in net interest income resulted from an increase in interest-earning assets and an improvement in the net interest margin. The net interest margin was 3.86% for the three months ended March 31, 2004, compared to 3.68% for the same period in 2003.

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Interest income as a percent of average earning assets decreased from 6.22% in the first quarter of 2003 to 5.90% for the same period in 2004. Interest expense as a percent of average interest-bearing liabilities also decreased from 3.03% in the first quarter of 2003 to 2.51% in the same period of 2004. Net interest margin was 3.86% in the first quarter of 2004 compared to 3.68% for the first quarter of 2003. The decrease in the yield on interest bearing liabilities exceeded the decrease in the yield on earning assets, resulting in the improved net interest margin for the first quarter of 2004 compared to 2003. We do not anticipate significant changes in the net interest margin in future periods based on our interest rate sensitivity analysis.

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The following table shows the Company’s average balances, interest income and expense, yields and the net interest margin for the three months ended March 31, 2004, 2003 and 2002.

Average Balances, Income and Expense, Yields and Rates

(dollars in thousands)

Three Months Ended March 31,