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First Community Bancshares 10-K 2006
First Community Bancshares, Inc. 10-K
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
 
For the fiscal year ended December 31, 2005
 
Commission file number 000-19297
 
FIRST COMMUNITY BANCSHARES, INC.
 
     
Nevada   55-0694814
(State or other jurisdiction of incorporation)   (IRS Employer Identification No.)
     
P.O. Box 989
Bluefield, Virginia
  24605-0989
(Address of principal executive offices)   (Zip Code)
 
(276) 326-9000
 
Securities registered pursuant to Section 12(b) of the Act:
None
 
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  o Yes     þ No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  o Yes     þ No
 
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.  þ Yes     o No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
 
Large accelerated filer  o Accelerated filer  þ Non-accelerated filer  o     
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes     þ No
 
State the aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2005.
 
$384,602,389 based on the closing sales price at that date
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
Class — Common Stock, $1.00 Par Value; 11,229,852 shares outstanding as of March 7, 2006
 
 
Portions of the Proxy Statement for the annual meeting of shareholders to be held April 25, 2006, are incorporated by reference in Part III of this Form 10-K.
 


 

 
 
             
        Page
 
  Business   3
  Risk Factors   6
  Unresolved Staff Comments   8
  Properties   8
  Legal Proceedings   9
  Submission of Matters to a Vote of Security Holders   9
 
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   9
  Selected Financial Data   11
  Management’s Discussion and Analysis of Financial Condition and Results of Operation   12
  Quantitative and Qualitative Disclosures About Market Risk   34
  Financial Statements and Supplementary Data   36
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   81
  Controls and Procedures   81
  Other Information   81
 
  Directors and Executive Officers of the Registrant   81
  Executive Compensation   84
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   84
  Certain Relationships and Related Transactions   84
  Principal Accounting Fees and Services   84
 
  Exhibits and Financial Statement Schedules   85
    Signatures   87
 EX-10.13
 EX-12
 EX-23
 EX-31.1
 EX-31.2
 EX-32


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PART I
 
ITEM 1.   BUSINESS.
 
 
First Community Bancshares, Inc. (the “Company”) is a one-bank holding company incorporated in the State of Nevada and serves as the holding company for First Community Bank, N. A. (the “Bank”), a national association that conducts commercial banking operations within the states of Virginia, West Virginia, North Carolina and Tennessee. United First Mortgage, Inc., acquired in the latter part of 1999, was a wholly-owned subsidiary of the Bank and served as a wholesale and retail distribution channel for the Bank’s mortgage banking business segment. In August 2004, the Company sold 100% of its interest in the mortgage banking subsidiary. Accordingly, the Company’s financial statements have been reformatted to segregate the assets, liabilities, operations and cash flows of this “discontinued operating segment.” The required information concerning discontinued operations is set forth in Note 16 of the Consolidated Financial Statements included herein. The Bank also owns Stone Capital Management (“Stone Capital”), an investment advisory firm purchased in January 2003. The Company had total consolidated assets of approximately $1.9 billion at December 31, 2005 and conducts commercial and mortgage banking business through fifty-one full-service banking locations, ten loan production offices, and six trust and investment management offices.
 
Currently, the Company is a bank holding company, and the banking operations are expected to remain the principal business and major source of revenue. The Company provides a mechanism for ownership of the subsidiary banking operations, provides capital funds as required, and serves as a conduit for distribution of dividends to stockholders. The Company also considers and evaluates options for growth and expansion of the existing subsidiary banking operations. The Company currently derives substantially all of its revenues from dividends paid by its subsidiary bank. Dividend payments by the Bank are determined in relation to earnings, asset growth and capital position and are subject to certain restrictions by regulatory agencies as described more fully under Regulation and Supervision of this item.
 
 
The Company and its subsidiaries employed 716 full-time equivalent employees at December 31, 2005. Management considers employee relations to be excellent.
 
 
The Company is a bank holding company and, as such, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The BHC Act requires the prior approval of the Federal Reserve Board for a bank holding company to acquire or hold more than a 5% voting interest in any bank, and restricts interstate banking activities. The BHC Act allows interstate bank acquisitions anywhere in the country and interstate branching by acquisition and consolidation in those states that had not opted out by January 1, 1997.
 
The BHC Act restricts the Company’s nonbanking activities to those which are determined by the Federal Reserve Board to be closely related to banking. The BHC Act does not place territorial restrictions on the activities of nonbank subsidiaries of bank holding companies. The Company’s banking subsidiary is subject to limitations with respect to transactions with affiliates.
 
The Federal Reserve Board has adopted capital adequacy guidelines pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHC Act. The Federal Reserve Board capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets, with at least one-half of that amount consisting of Tier I or core capital and up to one-half of that amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common stockholders’ equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stocks which may be included as Tier I capital), less goodwill and, with certain exceptions, intangibles. Tier II capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as Tier I capital; term subordinated debt


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and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for the bulk of assets which are typically held by a bank holding company, including multi-family residential and commercial real estate loans, commercial business loans and consumer loans. Single-family residential first mortgage loans which are not past-due (90 days or more) or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighting system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics. At December 31, 2005, the Company’s Tier I capital and total capital ratios were 10.54% and 11.65%, respectively.
 
In addition to the risk-based capital requirements, the Federal Reserve Board requires bank holding companies to maintain a minimum leverage capital ratio of Tier I capital to total assets of 3.0%. Total assets for this purpose does not include goodwill and any other intangible assets and investments that the Federal Reserve Board determines should be deducted from Tier I capital. The Federal Reserve Board has announced that the 3.0% Tier I leverage capital ratio requirement is the minimum for the top-rated bank holding companies without any supervisory, financial or operational weaknesses or deficiencies or those which are not experiencing or anticipating significant growth. Other bank holding companies are expected to maintain Tier I leverage capital ratios of at least 4.0% to 5.0% or more, depending on their overall condition. The Company’s leverage ratio, at December 31, 2005, was 7.77%.
 
The enactment of the Graham-Leach-Bliley Act of 1999 (the “GLB Act”) represented a pivotal point in the history of the financial services industry. The GLB Act removed large parts of a regulatory framework that had its origins in the 1930s. Since March 2000, banks, other depository institutions, insurance companies, and securities firms have been permitted to enter into combinations that allow a single financial services organization to offer customers a more complete array of financial products and services. The GLB Act provides a new regulatory framework for financial holding companies, which have as their primary regulator the Federal Reserve Board. Functional regulation of a financial holding company’s separately regulated subsidiaries is conducted by their primary functional regulator. The GLB Act requires “satisfactory” or higher Community Reinvestment Act compliance for insured depository institutions and their financial holding companies in order for them to engage in new financial activities. The GLB Act also provides a federal right to privacy of non-public personal information of individual customers. The Company and its subsidiaries are also subject to certain state laws that deal with the use and distribution of non-public personal information.
 
The Bank is subject to the provisions of the National Bank Act, is under the supervision of and is subject to periodic examination by the Comptroller of the Currency (the “OCC”), and is subject to the rules and regulations of the OCC, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (“FDIC”).
 
The Bank is also subject to certain laws of each state in which such bank is located. Such state laws may restrict branching of banks within the state and acquisition or merger involving banks located in other states. Virginia, West Virginia, North Carolina, and Tennessee have all adopted nationwide reciprocal interstate banking.
 
The Federal Deposit Insurance Corporation Act, as amended (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” An FDIC-insured bank will be “well capitalized” if it has a total capital ratio of 10% or greater, a Tier 1 capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure. A depository institution’s capital tier will depend upon where its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. As of December 31, 2005, the Bank had capital levels that qualify it as being “well capitalized” under such regulations.


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The Bank is subject to capital requirements adopted by the OCC similar to the capital requirements for the Company. The capital ratios of the Bank are set forth in Note 13 to the Consolidated Financial Statements included herewith.
 
The monetary policies of regulatory authorities, including the Federal Reserve Board and the FDIC, have a significant effect on the operating results of banks and holding companies. The nature of future monetary policies and the effect of such policies on the future business and earnings of the Company cannot be predicted.
 
The USA Patriot Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires such financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions. Compliance with the Patriot Act by the Company has not had a material impact on the Company’s results of operations or financial condition.
 
The Sarbanes-Oxley Act of 2002 comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Securities Exchange Act of 1934, as amended. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies and their directors and executive officers; and (v) new and increased civil and criminal penalties for violation of the securities laws.
 
In response to the Sarbanes-Oxley legislation, the Board of Directors of the Company approved a series of actions to strengthen and improve its already strong corporate governance practices. Included in those actions was the adoption of a new Code of Ethics, Corporate Governance Guidelines and new charters for its Audit, Compensation, and Nominating Committees.
 
 
The Company makes available free of charge on its website at www.fcbinc.com its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and all amendments thereto, as soon as reasonably practicable after the Company files such reports with, or furnishes them to, the Securities and Exchange Commission. Investors are encouraged to access these reports and the other information about the Company’s business on its website. Information found on the Company’s website is not part of this Annual Report on Form 10-K. The Company will also provide copies of its Annual Report on Form 10-K, free of charge, upon written request of its Investor Relations department at the Company’s main address, P.O. Box 989, Bluefield, VA 24605.
 
Forward-Looking Statements
 
This Annual Report on Form 10-K may include “forward-looking statements”, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among others, statements with respect to the Company’s beliefs, plans, objectives, goals, guidelines, expectations, anticipations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors, many of which are beyond the Company’s control. The words “may”, “could”, “should”, “would”, “believe”, “anticipate”, “estimate”, “expect”, “intend”, “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company’s financial performance to differ materially from that expressed in such forward-looking statements: the strength of the United States economy in general and the strength of the local economies in which the Company conducts operations; the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; inflation, interest rate, market and monetary fluctuations; the timely development of competitive new products and services of the


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Company and the acceptance of these products and services by new and existing customers; the willingness of customers to substitute competitors’ products and services for the Company’s products and services and vice versa; the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking, securities and insurance); technological changes; the effect of acquisitions, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions; the growth and profitability of the Company’s non-interest or fee income being less than expected; unanticipated regulatory or judicial proceedings; changes in consumer spending and saving habits; and the success of the Company at managing the risks involved in the foregoing.
 
The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement.
 
ITEM 1A.   RISK FACTORS.
 
   The Company and its subsidiary business are subject to interest rate risk and variations in interest rates may negatively affect its financial performance.
 
We are unable to predict actual fluctuations of market interest rates with complete accuracy. Rate fluctuations are affected by many factors, including inflation, recession, a rise in unemployment, a tightening of the money supply and domestic and international disorder and instability in domestic and foreign financial markets.
 
Changes in the interest rate environment may reduce profits. We expect that the Company and the Bank will continue to realize income from the differential or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. Changes in levels of market interest rates could materially and adversely affect the Company’s net interest spread, levels of prepayments and cash flows, the market value of its securities portfolio, and overall profitability.
 
   The Bank’s ability to pay dividends is subject to regulatory limitations which, to the extent the Company requires such dividends in the future, may affect the Company’s ability to pay its obligations and pay dividends.
 
The Company is a separate legal entity from the Bank and its subsidiaries and does not have significant operations of its own. The Company currently depends on the Bank’s cash and liquidity as well as dividends to pay the Company’s operating expenses and dividends to shareholders. No assurance can be made that in the future the Bank will have the capacity to pay the necessary dividends and that the Company will not require dividends from the Bank to satisfy the Company’s obligations. The availability of dividends from the Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition of the Company and other factors that the OCC, the Bank’s primary regulator, could assert that payment of dividends or other payments by the Bank are an unsafe or unsound practice. In the event the Bank is unable to pay dividends sufficient to satisfy the Company’s obligations and the Bank is unable to pay dividends to the Company, the Company may not be able to service its obligations as they become due, including payments required to be made to the FCBI Capital Trust, a business trust subsidiary of the Company, or pay dividends on the Company’s common stock. Consequently, the inability to receive dividends from the Bank could adversely affect the Company’s financial condition, results of operations, cash flows and prospects.
 
   The Bank’s allowance for loan losses may not be adequate to cover actual losses.
 
Like all financial institutions, the Bank maintains an allowance for loan losses to provide for probable loan defaults and non-performance. The Bank’s allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect the Bank’s operating results. The Bank’s allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of our regulators, changes in the size and composition of the loan portfolio and industry information. Also included in management’s estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. The


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amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Bank’s control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Bank’s loans and allowance for loan losses. While we believe that the Bank’s allowance for loan losses is adequate to provide for probable losses, we cannot assure you that we will not need to increase the Bank’s allowance for loan losses or that regulators will not require us to increase this allowance. Either of these occurrences could materially and adversely affect the Bank’s earnings and profitability.
 
   The Company’s business is subject to various lending and other economic risks that could adversely impact the Company’s results of operations and financial condition.
 
Changes in economic conditions, particularly an economic slowdown, could hurt the Company’s business. The Company’s business is directly affected by political and market conditions, broad trends in industry and finance, legislative and regulatory changes, and changes in governmental monetary and fiscal policies and inflation, all of which are beyond the Company’s control. A deterioration in economic conditions, in particular an economic slowdown within the Company’s geographic region, could result in the following consequences, any of which could hurt the Company’s business materially:
 
  •  loan delinquencies may increase;
 
  •  problem assets and foreclosures may increase;
 
  •  demand for the Company’s products and services may decline; and
 
  •  collateral for loans made by the Company may decline in value, in turn reducing a client’s borrowing power, and reducing the value of assets and collateral associated with the Company’s loans held for investment.
 
   A downturn in the real estate market could hurt the Company’s business.
 
The Company’s business activities and credit exposure are concentrated in Virginia, West Virginia, North Carolina, Tennessee and the surrounding southeast region. A downturn in this regional real estate market could hurt the Company’s business because of the geographic concentration within this regional area. If there is a significant decline in real estate values, the collateral for the Company’s loans will provide less security. As a result, the Company’s ability to recover on defaulted loans by selling the underlying real estate would be diminished, and we would be more likely to suffer losses on defaulted loans.
 
   The Company’s level of credit risk is increasing due to the expansion of its commercial lending, and the concentration on middle market customers with heightened vulnerability to economic conditions.
 
Commercial business and commercial real estate loans generally are considered riskier than single-family residential loans because they have larger balances to a single borrower or group of related borrowers. Commercial business and commercial real estate loans involve risks because the borrower’s ability to repay the loan typically depends primarily on the successful operation of the business or the property securing the loan. Most of the commercial business loans are made to small business or middle market customers who may have a heightened vulnerability to economic conditions. Moreover, a portion of these loans have been made or acquired by the Company in the last several years and the borrowers may not have experienced a complete business or economic cycle.
 
   The Bank may suffer losses in its loan portfolio despite its underwriting practices.
 
The Bank seeks to mitigate the risks inherent in the Bank’s loan portfolio by adhering to specific underwriting practices. These practices include analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Although the Bank believes that its underwriting criteria are appropriate for the various kinds of loans it makes, the Bank may incur losses on loans that meet its underwriting criteria, and these losses may exceed the amounts set aside as reserves in the Bank’s allowance for loan losses.


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   The Company and its subsidiaries are subject to extensive regulation which could adversely affect them.
 
The Company and its subsidiaries’ operations are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of the Company’s operations. The Company believes that it is in substantial compliance in all material respects with applicable federal, state and local laws, rules and regulations. Because the Company’s business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There are various laws, rules and regulations that impact the Company’s operations, including, among other things, matters pertaining to corporate governance, requirements for listing and maintenance on national securities exchanges and over the counter markets, Securities and Exchange Commission (“SEC”) rules pertaining to public reporting disclosures and banking regulations governing the amount of loans that a financial institution, such as the Bank, can acquire for investment from an affiliate. In addition, the Financial Accounting Standards Board (“FASB”), made changes which require, among other things, the expensing of the costs relating to the issuance of stock options. These laws, rules and regulations, or any other laws, rules or regulations, that may be adopted in the future, could make compliance more difficult or expensive, restrict the Company’s ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Bank and otherwise adversely affect the Company’s business, financial condition or prospects.
 
   The Company faces strong competition from other financial institutions, financial service companies and other organizations offering services similar to those offered by the Company and its subsidiaries, which could hurt the Company’s business.
 
The Company’s business operations are centered primarily in Virginia, West Virginia, North Carolina, Tennessee and the surrounding southeast region. Increased competition within this region may result in reduced loan originations and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. Many competitors offer the types of loans and banking services that we offer. These competitors include other savings associations, national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Bank’s competitors include other state and national banks and major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns.
 
Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger clients. These institutions, particularly to the extent they are more diversified than the Company, may be able to offer the same loan products and services that the Company offers at more competitive rates and prices. If the Company is unable to attract and retain banking clients, the Company may be unable to continue the Bank’s loan and deposit growth and the Company’s business, financial condition and prospects may be negatively affected.
 
ITEM 1B.   UNRESOLVED STAFF COMMENTS.
 
The Company has no unresolved staff comments as of the filing date of this 2005 Annual Report on Form 10-K.
 
ITEM 2.   PROPERTIES.
 
The Company generally owns its offices, related facilities, and unimproved real property. The principal offices of the Company are located at One Community Place, Bluefield, Virginia, where the Company owns and occupies approximately 36,000 square feet of office space. The Bank operates fifty-one full-service branches and ten loan production offices throughout the four-state region of Virginia, West Virginia, North Carolina and Tennessee. The Bank also provides wealth management services through two trust and investment management offices, as well as Stone Capital, an investment advisory firm, which has four offices. The Company’s banking subsidiary owns 42 of its banking offices while others are leased or are located on leased land. There are no mortgages or liens against any property of the Bank or the Company. The Bank operates 50 Automated Teller Machines (“ATM’s”).


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In Virginia, the Bank operates offices in Blacksburg, Bluefield, Clintwood, Drakes Branch, Emporia, Max Meadows, Norfolk, Pound, Richlands, Richmond, Tazewell, and Wytheville. In West Virginia, the Bank operates offices in Athens, Beckley, Bluefield, Bridgeport, Buckhannon, Cowen, Craigsville, Grafton, Hinton, Linside, Man, Mullens, Oceana, Pineville, Princeton, Richwood, Rowlesburg, Summersville, and Teays Valley. In North Carolina, the Bank operates offices in Charlotte, Elkin, Hays, Mount Airy, Sparta, Taylorsville, and Winston-Salem. In Tennessee, the Bank operates offices in Fall Branch, Johnson City, Kingsport, and Piney Flats. A complete listing of all branches and ATM sites can be found on the Internet at www.fcbresource.com. Information on such website is not part of this Annual Report on Form 10-K.
 
ITEM 3.   LEGAL PROCEEDINGS.
 
The Company is currently a defendant in various legal actions and asserted claims involving lending and collection activities and other matters in the normal course of business. While the Company and legal counsel are unable to assess the ultimate outcome of each of these matters with certainty, they are of the belief that the resolution of these actions should not have a material adverse affect on the financial position of the Company.
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
 
 
ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The number of common stockholders of record on December 31, 2005 was 3,613 and outstanding shares totaled 11,251,803. The number of common stockholders is measured by the number of recordholders.
 
The Company’s common stock trades on the NASDAQ National Market under the symbol FCBC. On December 31, 2005, the Company’s year-end common stock price was $31.16, a 13.60% decrease from the $36.08 closing price on December 31, 2004.
 
Book value per common share was $17.29 at December 31, 2005, compared with $16.29 at December 31, 2004, and $15.57 at the close of 2003. The year-end market price for the Company’s common stock of $31.16 represents 180.2% of the Company’s book value as of the close of the year and reflects total market capitalization of $350.6 million. Utilizing the year-end market price and 2005 diluted earnings per share, First Community common stock closed the year trading at a price/earnings multiple of 13.4 times diluted earnings per share.
 
Cash dividends for 2005 totaled $1.02 per share, up $0.02 or 2.0% from the $1.00 paid in 2004. The 2005 dividends resulted in a cash yield on the year-end market value of 3.27%. Total dividends paid for the current and prior year totaled $11.5 million and $11.2 million, respectively.


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The following table sets forth the high and low stock prices, book value per share, and dividends paid per share on the Company’s common stock during the periods indicated.
 
                                 
                Book Value
       
                Per Share
    Cash
 
                (End of
    Dividends
 
    High     Low     Period)     Per Share  
 
2005
                               
First Quarter
  $ 36.21     $ 27.39     $ 16.35     $ 0.255  
Second Quarter
    33.20       26.25       16.83       0.255  
Third Quarter
    34.25       28.02       17.15       0.255  
Fourth Quarter
    33.71       27.14       17.29       0.255  
                                 
                            $ 1.02  
                                 
2004
                               
First Quarter
  $ 32.79     $ 28.82     $ 15.83     $ 0.25  
Second Quarter
    33.00       24.42       15.28       0.25  
Third Quarter
    32.71       29.11       16.08       0.25  
Fourth Quarter
    37.67       31.37       16.29       0.25  
                                 
                            $ 1.00  
                                 
 
The Company’s stock repurchase plan, as amended, allows the purchase and retention of up to 550,000 shares. The plan has no expiration date, remains open and no plans have expired during the reporting period. No determination has been made to terminate the plan or to stop making purchases. The following table sets forth open market purchases by the Company of its equity securities during 2005. The repurchase of Company stock has the effect of increasing earnings per share. During 2005, the weighted-average increase in the number treasury shares had an insignificant impact on earnings per share.
 
                                 
                      Maximum
 
                Total Number
    Number of
 
    Total
          of Shares
    Shares That
 
    Number of
    Average
    Purchased as
    May Yet Be
 
    Shares
    Price Paid
    Part of Publicly
    Purchased
 
    Purchased     per Share     Announced Plan     Under the Plan  
 
January 1-31, 2005
    303     $ 32.63       303       281,000  
February 1-29, 2005
                      281,000  
March 1-31, 2005
                      281,000  
April 1-30, 2005
    2,000       28.12       2,000       281,216  
May 1-31, 2005
    2,123       29.46       2,123       330,080  
June 1-30, 2005
                      328,821  
July 1-31, 2005
                      331,845  
August 1-31, 2005
    5,000       30.50       5,000       328,169  
September 1-30, 2005
    491       29.44       491       327,678  
October 1-31, 2005
                      327,678  
November 1-30, 2005
    6,100       30.89       6,100       330,133  
December 1-31, 2005
    25,517       32.22       25,517       305,491  
                                 
Total
    41,534     $ 31.38       41,534          
                                 


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ITEM 6.   SELECTED FINANCIAL DATA.
 
                                         
    At or for the Year Ended December 31,  
Five-Year Selected Financial Data
  2005     2004     2003     2002     2001  
 
Balance Sheet Summary
(at end of period) (in thousands)
                                       
Securities(a)
  $ 428,554     $ 410,218     $ 473,177     $ 334,018     $ 383,657  
Loans held for sale
    1,274       1,194       424       865       797  
Loans, net of unearned income
    1,331,039       1,238,756       1,026,191       927,621       904,496  
Allowance for loan losses
    14,736       16,339       14,624       14,410       13,952  
Assets related to discontinued operations
                22,372       71,631       70,267  
Total assets
    1,952,483       1,830,822       1,672,727       1,524,363       1,478,235  
Deposits
    1,405,944       1,359,064       1,225,536       1,139,628       1,078,260  
Other indebtedness
    129,231       131,855       144,616       59,172       80,814  
Liabilities related to discontinued operations
                17,992       65,519       64,908  
Total liabilities
    1,757,982       1,647,589       1,497,692       1,371,901       1,345,194  
Stockholders’ equity
    194,501       183,233       175,035       152,462       133,041  
                     
Summary of Earnings (in thousands)
                                       
Total interest income
  $ 109,508     $ 96,136     $ 90,641     $ 92,580     $ 89,805  
Total interest expense
    35,880       26,953       26,397       32,299       39,847  
Provision for loan losses
    3,706       2,671       3,419       4,208       5,134  
Non-interest income
    22,305       17,329       14,542       10,617       10,693  
Non-interest expense
    55,591       48,035       37,590       32,720       29,939  
Income from continuing operations before income taxes
    36,636       35,806       37,777       33,970       25,578  
Income tax expense
    10,191       9,786       11,058       9,740       7,733  
Income from continuing operations
    26,445       26,020       26,719       24,230       17,845  
(Loss) income from discontinued operations before income taxes
    (233 )     (5,746 )     (2,174 )     798       1,958  
Income tax (benefit) expense
    (91 )     (2,090 )     (693 )     309       669  
(Loss) income from discontinued operations
    (142 )     (3,656 )     (1,481 )     489       1,289  
Net income
    26,303       22,364       25,238       24,719       19,134  
                     
Per Share Data
                                       
Basic earnings per share
  $ 2.33     $ 1.99     $ 2.27     $ 2.26     $ 1.75  
Basic earnings per common share — continuing operations
    2.35       2.32       2.41       2.22       1.63  
Basic (loss) earnings per common share — discontinued operations
    (0.02 )     (0.33 )     (0.14 )     0.04       0.12  
Diluted earnings per common share
  $ 2.32     $ 1.97     $ 2.25     $ 2.25     $ 1.75  
Diluted earnings per common share — continuing operations
    2.33       2.29       2.39       2.21       1.63  
Diluted (loss) earnings per common share — discontinued operations
    (0.01 )     (0.32 )     (0.14 )     0.04       0.12  
Cash dividends
  $ 1.02     $ 1.00     $ 0.98     $ 0.91     $ 0.81  
Book value at year-end
  $ 17.29     $ 16.29     $ 15.57     $ 14.02     $ 12.17  


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    At or for the Year Ended December 31,  
Five-Year Selected Financial Data
  2005     2004     2003     2002     2001  
 
Selected Ratios
                                       
Return on average assets
    1.37 %     1.24 %     1.56 %     1.68 %     1.49 %
Return on average assets — continuing
    1.38 %     1.45 %     1.70 %     1.72 %     1.44 %
Return on average equity
    13.79 %     12.53 %     15.13 %     17.16 %     14.80 %
Return on average equity — continuing
    13.87 %     14.58 %     16.02 %     16.82 %     13.80 %
Average equity to average assets
    9.91 %     9.88 %     10.32 %     9.79 %     10.05 %
Average equity to average assets — continuing
    9.91 %     9.96 %     10.64 %     10.22 %     10.42 %
Dividend payout
    43.78 %     50.25 %     43.17 %     40.16 %     46.23 %
Risk based capital to risk adjusted assets
    11.65 %     12.09 %     14.55 %     13.33 %     12.10 %
Leverage ratio
    7.77 %     7.62 %     8.83 %     8.10 %     7.93 %
 
 
(a) The 2001-2004 periods reflect the reclassification of Federal Reserve Bank and Federal Home Loan Bank stock from Securities Available for Sale to Other Assets, consistent with the 2005 presentation.
 
ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
 
This discussion should be read in conjunction with the consolidated financial statements, notes and tables included throughout this report. All statements other than statements of historical fact included in this report, including statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act. As discussed below, the financial statements, footnotes, schedules and discussion within this report have been reformatted to conform to the presentation required for “discontinued operations” pursuant to the Company’s sale of its mortgage banking subsidiary.
 
 
First Community Bancshares, Inc. is a bank holding company which provides commercial banking services and has positioned itself as a regional community bank and a financial services alternative to larger banks which often provide less emphasis on personal relationships, and smaller community banks which lack the capital and resources to efficiently serve customer needs. The Company has focused its growth efforts on building financial partnerships and more enduring and complete relationships with businesses and individuals through a very personal approach to banking and financial services. The Company and its operations are guided by a strategic plan which includes growth through acquisitions and through office expansion in new market areas including strategically identified metro markets in Virginia, West Virginia, North Carolina and Tennessee. While the Company’s mission remains that of a community bank, management believes that entry into new markets will accelerate the Company’s growth rate by diversifying the demographics of its customer base and customer prospects and by generally increasing its sales and service network.
 
Despite strong competition, the Company has succeeded in establishing new offices in seven new market areas including four new loan production offices in the last year and three new full service offices since the second quarter of 2003. The Company has also completed two bank acquisitions and one wealth management acquisition since January 2003 and has grown total assets by 17% over the last two years and 32% over the last four years. The Company continues its pursuit of community banking partners and is progressing with plans for new offices within its established target markets. Additional details regarding recent acquisitions and expansion are included under the heading Recent Acquisitions and Branching Activity.

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Throughout 2005, short-term market interest rates increased significantly, while long-term market rates remained largely unchanged. Those changes have resulted in a flat interest rate curve, an environment that has led to compression of net interest margins.
 
The local economies in which the Company operates are diverse and cover the majority portion of a four state region. West Virginia and Southwest Virginia continue to benefit from increasing crude oil prices. These economies have significant exposure to extractive industries, such as coal and natural gas, which become more active and lucrative when oil prices rise. The local economies in the central portion of North Carolina have suffered in recent years due to foreign competition in both furniture and textiles as well as consolidation in the financial services industry. Despite these detractions, the economies in this region continue to benefit from strong real estate development, good commercial occupancy rates and national companies relocating and expanding in the Triad and Central Piedmont areas. The Eastern Virginia local economies are experiencing strong growth in residential and commercial development as those areas continue to benefit from a wide array of corporate activities and relocations.
 
 
As the Company competes for increased market share and growth in both loans and deposits it continues to encounter strong competition from many sources. Bank expansion through de novo branches and Loan Production Offices has grown in popularity as a means of reaching out to new markets. Many of the markets targeted by the Company are also being entered by other banks in nearby markets and, in some cases, from more distant markets. Despite strong competition from other banks, credit unions and mortgage companies, the Company has seen success in newly established offices in Winston-Salem as well as other markets in both Virginia and North Carolina. The Company attributes this measure of success to its recruitment of local, established bankers and loan personnel in those targeted markets. Competitive forces do impact the Company through pressure on interest yields, product fees and loan structure and terms; however, the Company has countered these pressures with its relationship style and pricing and a disciplined approach to loan underwriting.
 
 
The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and consolidated results of operations.
 
Estimates, assumptions, and judgments are necessary principally when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded based upon the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third party sources, when available. When third party information is not available, valuation adjustments are estimated by management primarily through the use of internal modeling techniques and appraisal estimates.
 
The Company’s accounting policies are fundamental to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operation. The following is a summary of the Company’s more subjective and complex “critical accounting policies.” In addition, the disclosures presented in the Notes to the Consolidated Financial Statements and in Management’s Discussion and Analysis provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified i.) the determination of the allowance for loan losses, ii.) accounting for acquisitions and intangible assets, and iii.) accounting for income taxes as the accounting areas


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that require the most subjective or complex judgments. Derivatives hedging practices were previously included, but were eliminated in August 2004 in connection with the disposition of the Company’s mortgage banking subsidiary.
 
 
The allowance for loan losses is established and maintained at levels management deems adequate to cover losses inherent in the portfolio and is based on management’s evaluation of the risks in the loan portfolio and changes in the nature and volume of loan activity. In June 2005, the Company reclassified $392 thousand of its allowance for loan losses to a separate allowance for lending-related commitments, which is included in other liabilities. Estimates for loan losses are determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of the Company’s regulators, changes in the size and composition of the loan portfolio and industry information. Also included in management’s estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. These events may include, but are not limited to, a general slowdown in the economy, fluctuations in overall lending rates, political conditions, legislation that may directly or indirectly affect the banking industry, and economic conditions affecting specific geographic areas in which the Company conducts business.
 
The Company determines the allowance for loan losses by making specific allocations to impaired loans and loan pools that exhibit inherent weaknesses and various credit risk factors. Allocations to loan pools are developed giving weight to risk ratings, historical loss trends and management’s judgment concerning those trends and other relevant factors. These factors may include, among others, actual versus estimated losses, regional and national economic conditions, business segment and portfolio concentrations, industry competition and consolidation, and the impact of government regulations. The foregoing analysis is performed by management to evaluate the portfolio and calculate an estimated valuation allowance through a quantitative and qualitative analysis that applies risk factors to those identified risk areas.
 
This risk management evaluation is applied at both the portfolio level and the individual loan level for commercial loans and credit relationships while the level of consumer and residential mortgage loan allowance is determined primarily on a total portfolio level based on a review of historical loss percentages and other qualitative factors including concentrations, industry specific factors and economic conditions. The commercial portfolio requires more specific analysis of individually significant loans and the borrower’s underlying cash flow, business conditions, capacity for debt repayment and the valuation of secondary sources of payment, such as collateral. This analysis may result in specifically identified weaknesses and corresponding specific impairment allowances.
 
The use of various estimates and judgments in the Company’s ongoing evaluation of the required level of allowance can significantly impact the Company’s results of operations and financial condition and may result in either greater provisions against earnings to increase the allowance or reduced provisions based upon management’s current view of portfolio and economic conditions and the application of revised estimates and assumptions.
 
 
The Company may, from time to time, engage in business combinations with other companies. The acquisition of a business is generally accounted for under purchase accounting rules promulgated by the FASB. Purchase accounting requires the recording of underlying assets and liabilities of the entity acquired at their fair market value. Any excess of the purchase price of the business over the net assets acquired and any identified intangibles is recorded as goodwill. Fair values are assigned based on quoted prices for similar assets, if readily available, or appraisal by qualified independent parties for relevant asset and liability categories. Financial assets and liabilities are typically valued using discount models which apply current discount rates to streams of cash flow. All of these valuation methods require the use of assumptions which can result in alternate valuations and varying levels of goodwill and, in some cases, amortization expense or accretion income.
 
Management must also make estimates of useful or economic lives of certain acquired assets and liabilities. These lives are used in establishing amortization and accretion of some intangible assets and liabilities, such as the intangible associated with core deposits acquired in the acquisition of a commercial bank.


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Goodwill is recorded as the excess of the purchase price, if any, over the fair value of the revalued net assets. Goodwill is tested at least annually in the month of November for possible impairment. This testing again uses a discounted cash flow model applied to the anticipated stream of cash flows from operations of the business or segment being tested. Impairment testing necessarily uses estimates in the form of growth and attrition rates, anticipated rates of return, and discount rates. These estimates have a direct bearing on the results of the impairment testing and serve as the basis for management’s conclusions as to impairment.
 
 
The establishment of provisions for federal and state income taxes is a complex area of accounting which also involves the use of judgments and estimates in applying relevant tax statutes. The Company operates in multiple state tax jurisdictions and this requires the appropriate allocation of income and expense to each state based on a variety of apportionment or allocation bases. Management strives to keep abreast of changes in tax law and the issuance of regulations which may impact tax reporting and provisions for income tax expense. The Company is also subject to audit by federal and state tax authorities. Results of these audits may produce indicated liabilities which differ from Company estimates and provisions. The Company continually evaluates its exposure to possible tax assessments arising from audits and records its estimate of possible exposure based on current facts and circumstances. The Company recently completed a state tax audit. The results of that audit are discussed under the heading “Results of Operations — Income Tax Expense.”
 
 
On December 2, 2005, the Company completed the sale of its Clifton Forge, Virginia, branch location to Sonabank, N. A. The sale included deposits and repurchase agreements totaling approximately $45 million and loans of approximately $7 million. The transaction resulted in an approximate $4.4 million pre-tax gain on sale.
 
The Company has plans to open five de novo branches, convert three loan production offices to full service locations, and open two new loan production offices in 2006 and 2007. Most of these locations will be in the Richmond, Virginia and Winston-Salem, North Carolina metropolitan areas.
 
The following schedule details branch and loan production office openings since January 1, 2004.
 
         
Quarter Opened
 
Location
 
Type
 
Q1 2004
  Mount Airy, North Carolina   Loan Production Office
Q1 2004
  Charlotte, North Carolina   Loan Production Office
Q1 2004
  Piney Flats, Tennessee   Full Service Branch
Q2 2004
  Blacksburg, Virginia   Loan Production Office
Q2 2004
  Norfolk, Virginia   Loan Production Office
Q4 2004
  Princeton, West Virginia   Full Service Branch
Q2 2005
  Clarksburg, West Virginia   Loan Production Office
Q3 2005
  Charleston, West Virginia   Loan Production Office
Q4 2005
  Roanoke, Virginia   Loan Production Office
Q4 2005
  Kernersville, North Carolina   Loan Production Office
 
After the close of business on March 31, 2004, PCB Bancorp, Inc., a Tennessee-chartered bank holding company (“PCB”) headquartered in Johnson City, Tennessee, was acquired by the Company. PCB had five full service branch offices located in Johnson City, Kingsport and surrounding areas in Washington and Sullivan Counties in East Tennessee. At acquisition, PCB had total assets of $171.0 million, total net loans of $128.0 million and total deposits of $150.0 million. These resources were included in the Company’s financial statements beginning with the second quarter of 2004.
 
Under the terms of the merger agreement, shares of PCB common stock were purchased for $40.00 per share in cash. The total deal value, including the cash-out of outstanding stock options, was approximately $36.0 million. Concurrent with the PCB acquisition, Peoples Community Bank, the wholly-owned subsidiary of PCB, was merged into the Bank. As a result of the acquisition and preliminary purchase price allocation, approximately $21.3 million


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in goodwill was recorded which represents the excess of the purchase price over the fair market value of the net assets acquired and identified intangibles.
 
 
 
Net income for 2005 was $26.3 million, up $3.9 million from $22.4 million in 2004. Basic and diluted earnings per share for 2005 were $2.33 and $2.32, respectively, compared to basic and diluted earnings per share of $1.99 and $1.97, respectively, in 2004.
 
The Company’s key profitability ratios are return on average assets (net income as a percentage of average assets) and return on average equity (net income as a percentage of average common shareholder’s equity). Returns on average assets for the last two years were 1.37% and 1.24%. The returns on average equity for the last two years were 13.79% and 12.53%. The Company continues to compare favorably to national peer returns of 1.16% and 13.51%, respectively, based on the September 2005 Bank Holding Company Performance Report.
 
 
The primary source of the Company’s earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities while deposits and borrowings represent the major portion of interest-bearing liabilities. For purposes of the following discussion, comparison of net interest income is done on a tax equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable (see the table titled Average Balance Sheets and Net Interest Income Analysis).
 
Net interest income was $73.6 million for 2005, compared to $69.2 million for 2004. Tax-equivalent net interest income totaled $77.7 million for 2005, an increase of $4.8 million from the $72.9 million reported for 2004. The increase reflects a $6.3 million increase due to increased volume, which was partially offset by a $1.5 million decrease due to rate changes on the underlying assets and liabilities.
 
During 2005, average earning assets increased $118.3 million while average interest-bearing liabilities increased $100.5 million over the comparable period. The yield on average earning assets increased 37 basis points to 6.42% from 6.05% for 2004. The rate earned on assets was positively impacted by the continued increases in short-term market interest rates throughout 2005.
 
Total cost of average interest-bearing liabilities increased 47 basis points during 2005, as such liabilities were also affected by increases in short-term market interest rates. The net result was a decrease of 10 basis points to net interest rate spread, or the difference between interest income on earning assets and expense on interest-bearing liabilities. 2005 spread was 4.01% compared to 4.11% for the same period last year. The Company’s tax-equivalent net interest margin of 4.39% for 2005 was essentially unchanged with a small decrease of 2 basis points from 4.41% in 2004.
 
The largest contributor to the increase in the yield on average earning assets in 2005, on a volume-weighted basis, was the $142.9 million increase in loans held for investment. The loan portfolio contributed approximately $13.1 million to the change in interest income, while the portfolio’s average yield increased 28 basis points from the prior year to 6.91%. The yield on variable-rate loans tied to prime and other indices increased in response to the recent increases in short-term interest rates.
 
During 2005, the tax-equivalent yield on securities available for sale increased 36 basis points to 4.98% while the average balance decreased by $17.0 million. Although the total portfolio decreased through the period, the average tax-equivalent yield increased due to the addition of higher-rate securities and the sale of lower-rate securities. Funds received from the paydowns, maturities, calls, and sales of investment securities helped fund loan growth.
 
Average interest-bearing balances with banks remained steady during 2005, while the yield increased 154 basis points to 3.36%. The yield on those balances is directly correlated to the increases in the target federal funds rate which occurred throughout the year.


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The Company attempts to control the cost of deposited funds in relation to the prevailing economic climate and competitive forces. The Company achieves its balance sheet management goals through its Asset/Liability Management Committee. Throughout 2005, the pressures of increasing short-term interest rates resulted in an increase of 40 basis points in the average cost of interest-bearing deposits. The average rate paid on interest-bearing demand deposits remained consistent, while the average rate paid on savings, which includes money market and passbook accounts, increased 32 basis points. The Company was successful in keeping rates paid on interest-bearing checking accounts relatively stable and increased money market account rates to remain competitive. Average time deposits increased $46.2 million while the average rate paid increased 48 basis points to 2.92%. During the first quarter, the Company ran a successful certificate of deposit campaign, which generated market-rate deposits centered mostly in the Richmond and Winston-Salem markets. The level of average non-interest-bearing demand deposits increased $16.0 million to $228.8 million compared to the prior year.
 
Average federal funds purchased and repurchase agreements increased $19.3 million due mostly to increases in the balances of customer repurchase agreements. The average rate paid on those funds also increased, as they are closely tied to the target federal funds rate. Average Federal Home Loan Bank (“FHLB”) advances increased $29.5 million as the Company borrowed $75 million through the year. Interest paid on those borrowings increased 19 basis points as interest rates were increasing on adjustable-rate borrowings. Other borrowings remained steady, but the rate paid increased 198 points because the majority of such borrowings consist of the Company’s trust preferred borrowings, which are tied to LIBOR.
 
Average Balance Sheets and Net Interest Income Analysis
 
                                                                         
    2005     2004     2003  
    Average
          Yield/
    Average
          Yield/
    Average
          Yield/
 
    Balance     Interest(1)     Rate(1)     Balance     Interest(1)     Rate(1)     Balance     Interest(1)     Rate(1)  
    (Dollars in thousands)  
 
Earning Assets:
                                                                       
Loans Held for Investment:(2)
                                                                       
Taxable
  $ 1,299,328     $ 89,788       6.91 %   $ 1,154,166     $ 76,519       6.63 %   $ 971,402     $ 70,185       7.23 %
Tax-Exempt
    2,692       177       6.58 %     4,965       297       5.98 %     5,252       380       7.24 %
                                                                         
Total
    1,302,020       89,965       6.91 %     1,159,131       76,816       6.63 %     976,654       70,565       7.23 %
Securities Available for Sale:(5)
                                                                       
Taxable
    262,715       11,062       4.21 %     313,033       12,094       3.86 %     312,834       13,083       4.18 %
Tax-Exempt
    144,242       9,193       6.37 %     110,904       7,474       6.74 %     94,910       6,750       7.11 %
                                                                         
Total
    406,957       20,255       4.98 %     423,937       19,568       4.62 %     407,744       19,833       4.86 %
Held to Maturity Securities:
                                                                       
Taxable
    399       15       3.76 %     419       25       5.97 %     598       33       5.52 %
Tax-Exempt
    28,336       2,269       8.01 %     35,535       2,853       8.03 %     39,083       3,231       8.27 %
                                                                         
Total
    28,735       2,284       7.95 %     35,954       2,878       8.00 %     39,681       3,264       8.23 %
Interest-Bearing Deposits with Banks
    32,100       1,077       3.36 %     32,430       591       1.82 %     39,062       595       1.52 %
Federal Funds Sold
                        60       1       1.67 %     711       9       1.27 %
                                                                         
Total Earning Assets
    1,769,812     $ 113,581       6.42 %     1,651,512     $ 99,854       6.05 %     1,463,852     $ 94,266       6.44 %
Other Assets
    153,410                       140,379                       103,520                  
Assets Related to Discontinued Operations
                          14,950                       49,780                  
                                                                         
Total
  $ 1,923,222                     $ 1,806,841                     $ 1,617,152                  
                                                                         
                                                                         


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    2005     2004     2003  
    Average
          Yield/
    Average
          Yield/
    Average
          Yield/
 
    Balance     Interest(1)     Rate(1)     Balance     Interest(1)     Rate(1)     Balance     Interest(1)     Rate(1)  
    (Dollars in thousands)  
 
Interest-Bearing Liabilities:
                                                                       
Demand Deposits
  $ 152,774     $ 401       0.26 %   $ 149,502     $ 366       0.24 %   $ 129,072     $ 373       0.29 %
Savings Deposits
    368,339       4,309       1.17 %     366,074       3,112       0.85 %     279,972       2,185       0.78 %
Time Deposits
    661,498       19,321       2.92 %     615,346       15,001       2.44 %     610,201       17,392       2.85 %
Federal Funds Purchased and Repurchase Agreements
    128,551       2,782       2.16 %     109,223       1,405       1.29 %     100,817       1,599       1.59 %
FHLB Borrowings and other long-term debt
    177,832       9,068       5.10 %     148,384       7,070       4.76 %     93,032       4,848       5.21 %
                                                                         
Total Interest-bearing Liabilities
    1,488,994       35,881       2.41 %     1,388,529       26,954       1.94 %     1,213,094       26,397       2.18 %
Demand Deposits
    228,781                       212,777                       178,961                  
Other Liabilities
    14,772                       13,980                       14,609                  
Liabilities Related to Discontinued Operations
                          13,113                       43,676                  
Stockholders’ Equity
    190,675                       178,442                       166,812                  
                                                                         
Total
  $ 1,923,222                     $ 1,806,841                     $ 1,617,152                  
                                                                         
Net Interest Income
          $ 77,700                     $ 72,900                     $ 67,869          
                                                                         
Net Interest Rate Spread(3)
                    4.01 %                     4.11 %                     4.26 %
                                                                         
Net Interest Margin(4)
                    4.39 %                     4.41 %                     4.64 %
                                                                         
 
 
(1) Fully Taxable Equivalent at the rate of 35%. (see tax equivalent adjustment table below)
 
(2) Non-accrual loans are included in average balances outstanding but with no related interest income during the period of non-accrual.
 
(3) Represents the difference between the yield on earning assets and cost of funds.
 
(4) Represents tax equivalent net interest income divided by average interest-earning assets.
 
(5) FHLB and FRB stock are included in securities available for sale as they are earning assets.
 
The following table recaps the adjustments incorporated when converting net interest earnings to a tax-equivalent basis:
 
                         
    2005     2004     2003  
    (Amounts in thousands)  
 
Loans — tax exempt
  $ 62     $ 103     $ 133  
Securities available for sale — tax exempt
    3,216       2,616       2,362  
Securities held to maturity — tax exempt
    794       999       1,131  
 
Rate and Volume Analysis of Interest
 
The following table summarizes the changes in interest earned and paid resulting from changes in volume of earning assets and paying liabilities and changes in their interest rates. In this analysis, the change in interest due to both rate and volume has been allocated to the volume and rate columns in proportion to absolute dollar amounts. This table will assist you in understanding the changes in the Company’s principal source of revenue, net interest income. The principal themes or trends which are evident in this table include:
 
  •  The increase in net interest income in 2005 was due largely to increases in earning assets resulting from growth seen in both the consumer and commercial loan portfolios.
 
  •  Increases in both rates earned on assets and paid on liabilities due to increases in benchmark short-term interest rates.

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  •  In 2005, margin compressed slightly as increases to the rates paid on money market accounts and certificates of deposit outpaced increases in the rates received on loans.
 
  •  The significant volume increase in 2004 was due in part to the PCB acquisition.
 
                                                 
    2005 Compared to 2004
    2004 Compared to 2003
 
    $ Increase/(Decrease) due to     $ Increase/(Decrease) due to  
    Volume     Rate     Total     Volume     Rate     Total  
    (Amounts in thousands)  
 
Interest Earned On(1):
                                               
Loans
  $ 9,782     $ 3,367     $ 13,149     $ 12,428     $ (6,177 )   $ 6,251  
Securities available for sale
    87       600       687       1,100       (1,365 )     (265 )
Securities held to maturity
    (578 )     (16 )     (594 )     (297 )     (89 )     (386 )
Interest-bearing deposits with other banks
    (6 )     492       486       (110 )     106       (4 )
Federal funds sold
    (1 )           (1 )     (10 )     2       (8 )
                                                 
Total interest-earning assets
    9,284       4,443       13,727       13,111       (7,523 )     5,588  
                                                 
Interest Paid On:
                                               
Demand deposits
    8       27       35       54       (61 )     (7 )
Savings deposits
    19       1,178       1,197       718       209       927  
Time deposits
    1,186       3,134       4,320       145       (2,537 )     (2,392 )
Federal funds purchased and repurchase agreements
    284       1,093       1,377       126       (320 )     (194 )
FHLB borrowings
    1,443       248       1,691       2,121       (473 )     1,648  
Other long-term debt
          307       307       562       13       575  
                                                 
Total interest-bearing liabilities
    2,940       5,987       8,927       3,726       (3,169 )     557  
                                                 
Change in net interest income
  $ 6,344     $ (1,544 )   $ 4,800     $ 9,385     $ (4,354 )   $ 5,031  
                                                 
 
 
(1) Fully taxable equivalent using a rate of 35%.
 
 
The provision for loan losses for the year ended December 31, 2005 was $3.7 million, an increase of $1.0 million when compared to the year ended December 31, 2004. The increase in loan loss provision between the periods is primarily attributable to new or increased specific allocations, increased commercial and residential real estate loan volume, and changes in various qualitative risk factors. Net charge-offs for 2005 and 2004 were $4.9 million and $2.7 million, respectively. Expressed as a percentage of average loans, net charge-offs increased from 0.24% for 2004, to 0.38% for 2005. The Company experienced a loss from a previously disclosed credit to a hospitality concern, which accounted for a large portion of the increase in net charge-offs in 2005. During 2005, the $4.4 million loan was charged down to its net realizable value of $2.2 million. The note was sold to a third party and the final net loss to the Company was $1.5 million.


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Details of non-interest income are summarized in the following table:
 
                         
    Years Ended December 31,  
    2005     2004     2003  
    (Amounts in thousands)  
 
Wealth management income
  $ 2,956     $ 2,489     $ 2,159  
Service charges on deposit accounts
    10,095       9,122       8,071  
Other service charges, commissions and fees
    2,785       2,239       2,013  
Other operating income
    5,716       1,875       1,101  
Net gains on sale of securities
    753       1,604       1,198  
                         
Total
  $ 22,305     $ 17,329     $ 14,542  
                         
 
Non-interest income consists of all revenues which are not included in interest and fee income related to earning assets. Non-interest income from continuing operations for 2005 was $22.3 million compared to $17.3 million in the same period of 2004. Wealth management income, which includes fees for trust services and commission and fee income generated by Stone Capital, increased $467 thousand in 2005, or 18.8%, compared to 2004 as a result of the Company’s continued focus on growth. Stone Capital has expanded its retail asset management services through the addition of two investment advisors and the licensing of a number of investment associates within the bank branches.
 
Service charges on deposit accounts increased $973 thousand, or 10.7%, while other service charges, commissions and fees reflected gains of $546 thousand, or 24.4%. Other service charges, commissions and fees increased largely because of ATM usage fees on foreign cards of $1.4 million and official check commissions of $256 thousand.
 
Other operating income includes $4.4 million in gain from the sale of the Clifton Forge, Virginia, branch location. The remaining components of other operating income decreased $525 thousand compared to 2004. 2005 included securities gains of $753 thousand, which were $851 thousand less than those recognized in 2004.
 
 
Total non-interest expense from continuing operations was $55.6 million, an increase of $7.6 million for 2005 over 2004. The single largest item contributing to the increase was the $3.8 million prepayment penalty incurred in connection with the early termination of $77.0 million of FHLB advances in late December. Salaries and benefits increased approximately $2.8 million due to increases in staffing to support added corporate services, continued branch and loan production office growth, and increased health benefits costs.
 
Occupancy and furniture and equipment expenses increased $344 thousand and $447 thousand, respectively, compared to 2004. The general level of occupancy and furniture and equipment costs in 2005 grew largely as a result of increases in depreciation and insurance costs associated with de novo branches and depreciation associated with continued investment in operating equipment and technology infrastructure.
 
All other operating expense accounts increased $100 thousand in 2005 compared to 2004. The most significant item within the increase in other operating expense was the increase in audit fees, which increased over $335 thousand year-over-year.
 
The Company uses a traditional efficiency ratio that is a non-GAAP financial measure of operating expense control and efficiency of operations. Management believes this traditional ratio better focuses attention on the core operating performance of the Company over time than does a GAAP-based ratio, and is highly useful in comparing period-to-period operating performance of the Company’s core business operations. It is used by management as part of its assessment of its performance in managing non-interest expenses. However, this measure is supplemental and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the traditional efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions.


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In general, the efficiency ratio is non-interest expenses as a percentage of net interest income plus non-interest income. Non-interest expenses used in the calculation of the traditional, non-GAAP efficiency ratio exclude amortization of goodwill and intangibles and non-recurring expenses. Income for the traditional ratio is increased for the favorable effect of tax-exempt income (see Table I), and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and non-recurring gains. The measure is different from the GAAP based efficiency ratio, which also is presented in this report. The GAAP based measure is calculated using non-interest expense and income amounts as shown on the face of the Consolidated Statements of Income. The GAAP and traditional based efficiency ratios are reconciled in the table below.
 
The traditional, non-GAAP efficiency ratios for continuing operations for 2005, 2004, and 2003 were 53.9%, 53.2%, and 45.2%, respectively. Increases in the current year is reflective of the higher direct costs associated with the new offices in 2005 and 2004 and added corporate overhead required to support Company expansion. The following table details the components used in calculation of the efficiency ratios.
 
GAAP based and Traditional Efficiency Ratios
 
                                 
    2005     2004     2003        
    (Dollars in thousands)        
 
Non-interest expenses — GAAP based
  $ 55,591     $ 48,035     $ 37,590          
Net interest income plus non-interest income — GAAP based
    99,933       86,512     $ 78,786          
Efficiency ratio — GAAP based
    57.95 %     55.52 %     47.71 %        
Non-interest expenses — GAAP based
  $ 55,591     $ 48,035     $ 37,590          
Less non-GAAP adjustments:
                               
Foreclosed property expense
    (288 )     (500 )     (602 )        
Amortization of intangibles
    (435 )     (399 )     (243 )        
Prepayment penalties on FHLB advances
    (3,794 )                    
                                 
Non-interest expenses — traditional ratio
    51,074       47,136       36,745          
Net interest income plus non-interest income — GAAP based
    95,933       86,512       78,786          
Plus non-GAAP adjustments:
                               
Tax-equivalency
    4,072       3,719       3,626          
Less non-GAAP adjustments:
                               
Security gains
    (753 )     (1,604 )     (1,198 )        
Branch sale gains
    (4,366 )                    
                                 
      94,886       88,627       81,214          
Efficiency Ratio — traditional
    53.83 %     53.18 %     45.24 %        
                                 
 
 
On January 1, 2006, the Company adopted the equity-based compensation accounting provisions of Statement of Financial Accounting Standards (“SFAS”) 123R. Through December 31, 2005, the Company accounted for equity-based compensation under APB Opinion No. 25, using the intrinsic-value model. Under Opinion No. 25, the Company recognized no compensation expense related to stock options granted, and provided pro-forma disclosures of the effects of accounting for stock options under the fair value model. The Company has selected the modified prospective method of transition. Management expects the adoption of the new equity-based compensation accounting standard to result in increased compensation expense. The total compensation cost related to nonvested stock option awards that management expects to recognize is approximately $721 thousand. The weighted average period over which that compensation cost is expected to be recognized is 1.9 years. Future awards of stock options will increase the amount of compensation expense to be recognized under SFAS 123R.


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Income tax expense is comprised of federal and state current and deferred income taxes on pre-tax earnings of the Company. Income taxes as a percentage of pre-tax income may vary significantly from statutory rates due to items of income and expense which are excluded, by law, from the calculation of taxable income. These items are commonly referred to as permanent differences. The most significant permanent differences for the Company include i) income on state and municipal securities which are exempt from federal income tax, ii) certain dividend payments which are deductible by the Company, iii) tax credits generated by investments in low income housing and iv) for 2004, goodwill impairment expense which is not deductible.
 
Consolidated income taxes for 2005 were $10.1 million, a 27.7% effective tax rate, compared to $7.7 million, an effective tax rate of 25.6%, for 2004. The effective tax rate for the 2004 was less than 2005 due to the tax benefits realized from the divestiture of the mortgage banking subsidiary. Specifically, the non-deductible impairment charges recognized in 2003 and the first two quarters of 2004 reduced the book carrying basis of the investment in the mortgage subsidiary and resulted in a permanent difference during the third quarter of 2004 upon sale of the entity. This difference reduced the 2004 effective tax rate to 25.6% and is the primary cause of the increase in the effective tax rate when comparing 2004 to 2005.
 
The previously disclosed state tax audit of state income, franchise, and sales tax in one of the Company’s tax jurisdictions was concluded during the fourth quarter of 2005. The outcome of this audit was favorable to the Company and resulted in total state income and franchise tax refunds of approximately $473 thousand. During the fourth quarter the company submitted the required claims of refund to the state. The Company anticipates receiving these refunds during the first quarter of 2006.
 
 
Net income for 2004 was $22.4 million, down $2.8 million from $25.2 million in 2003. Basic and diluted earnings per share for 2004 were $1.99 and $1.97, respectively, compared to basic and diluted earnings per share of $2.27 and $2.25, respectively, in 2003.
 
The Company’s key profitability ratios are return on average assets (net income as a percentage of average assets) and return on average equity (net income as a percentage of average common shareholder’s equity). Return on average assets for 2004 and 2003 were 1.24% and 1.56%, respectively. The return on average equity for those years were 12.53% and 15.13%, respectively. The returns compare with national peer returns of 1.20% and 14.00%, respectively, based on the September 2004 Bank Holding Company Performance Report.
 
 
Net interest income from continuing operations was $69.2 million for the year ended December 31, 2004 compared to $64.2 million for the corresponding period in 2003. Tax equivalent net interest income totaled $72.9 million for 2004, an increase of $5.0 million from the $67.9 million reported in 2003. This $5.0 million increase includes a $9.5 million increase due to an increase in earning assets, which were added to the portfolio at declining replacement rates. This increase was partially offset by a net $4.4 million reduction due to rate changes on the underlying assets and liabilities as asset yields fell in the declining rate environment. Average earning assets increased $187.7 million while average interest-bearing liabilities increased $175.4 million. The yield on average earning assets decreased 39 basis points from 6.44% for the year ended December 31, 2003 to 6.05% for the year ended December 31, 2004. This decrease was accompanied by a 24 basis point decline in the cost of funds during the same periods. As a result, the net interest rate spread at December 31, 2004 was lower at 4.11% compared to 4.26% for the same period last year. The Company’s tax equivalent net interest margin of 4.41% for the year ended December 31, 2004 decreased 23 basis points from 4.64% in 2003.
 
The largest contributor to the decrease in the yield on average earning assets in 2004, on a volume-weighted basis, was the decrease in the overall tax equivalent yield on loans held for investment of 60 basis points from the prior year to 6.63%, as loans repriced downward in response to the declining rate environment of the preceding year and continued low rates in the first half of 2004. The average balance of loans increased $182.5 million, largely due to the PCB acquisition in Tennessee and expansion offices in North Carolina. The decline in asset yield is


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attributable to the recent interest rate environment which created refinancing or repricing incentives for fixed-rate borrowers to lower their borrowing costs. Strong competition for commercial loans also held loan yields lower in 2004.
 
During 2004, the taxable equivalent yield on securities available for sale decreased 24 basis points to 4.62% while the average balance increased by $16.2 million. Consistent with the current rate environment, the Company and the securities industry as a whole have experienced rapid turnover in securities as higher yielding securities are either called or prepaid as refinancing opportunities arise. The increasing average security balance is the result of continued reinvestment of available funds. The average balance of investment securities held to maturity decreased $3.7 million, while the average yield decreased 23 basis points to 8.00%. Securities held to maturity are largely comprised of tax-free municipal securities. Compared to 2003, average interest-bearing balances with banks decreased $6.6 million between 2003 and 2004, while the yield increased 30 basis points to 1.82%.
 
The average cost of interest-bearing liabilities decreased by 24 basis points from 2.18% in 2003 to 1.94% in 2004 while the average volume of interest-bearing liabilities increased $175.4 million.
 
Compared to 2003, the average balance of FHLB and other short-term convertible and callable borrowings increased in 2004 by $58.6 million to $240.6 million while the average rate decreased 3 basis points to 3.15%, the result of the addition of balances acquired with the CommonWealth and PCB acquisitions, the addition of new advances at lower rates partially offset by the maturity of a $25 million FHLB advance in December 2004. The average balance of all other borrowings increased $5.1 million in 2004 compared to 2003; the result of the issuance of $15 million in subordinated debentures late in the third quarter of 2003, while the rate paid decreased 30 basis points.
 
In addition, the average balances of interest-bearing demand and savings deposits increased $20.4 million and $86.1 million, respectively. The average rate paid on demand deposits decreased by 5 basis points while the average rate paid on savings increased by 7 basis points (the result of higher rates paid by PCB on certain money market accounts). Average time deposits increased $5.1 million while the average rate paid decreased 41 basis points from 2.85% in 2003 to 2.44% in 2004. The level of average non-interest-bearing demand deposits increased $33.8 million to $212.8 million at December 31, 2004 compared to 2003. Average interest-bearing deposits and non-interest bearing demand deposits for CommonWealth Bank, which was acquired in June 2003, totaled $66.1 million and $25.1 million, respectively in 2004 and $35.9 million and $18.1 million, respectively in 2003. Included in the 2004 average balances related to the PCB acquisition were interest-bearing and non-interest bearing deposits of $97.7 million and $14.2 million at December 31, 2004.
 
 
The provision for loan losses for the year ended December 31, 2004 decreased $748 thousand compared to the year ended December 31, 2003. The provision for loan losses was $2.7 million in 2004 and $3.4 million in 2003. Net charge-offs for 2004 and 2003 were $2.7 million and $4.8 million, respectively. Expressed as a percentage of average loans held for investment, net charge-offs decreased from 0.49% for 2003, to 0.24% for 2004.
 
 
Total non-interest income increased approximately $2.8 million, or 19.2%, from $14.5 million for the year ended December 31, 2003 to $17.3 million for the corresponding period in 2004. Service charges on deposit accounts increased $1.1 million or 13.0% while other service charges, commissions and fees reflected gains of $226 thousand or 11.2%. Other operating income improved 70.3%, or $774 thousand, in 2004.
 
During 2004, the Company realized a gain on sale of securities of approximately $1.6 million due largely to the sale of $25.0 million of corporate bonds held in the Company’s available for sale investment portfolio, the market value of which had declined in step with the flattening of the Treasury yield curve. The proceeds from the sale of these securities in the second quarter of 2004 provided sufficient liquidity to pay-off overnight borrowings and assisted the Company in funding increased loan demand. These gains, along with smaller gains on securities called, compared to those of the same period of 2003 reflect a year over year increase of $406 thousand.


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Wealth management revenues, which include fees for trust services, increased $330 thousand in 2004 versus 2003. The increase in fiduciary revenues in 2004 relates to both account and asset growth within the trust division which came under new management in early 2004. The increase in revenues includes an increase of $106 thousand in mutual fund shareholder service fees which were previously retained by an outsourced investment advisor and increased estate fees of $52 thousand. Stone Capital asset management fees grew from $371 thousand in 2003 to $531 thousand in 2004. This growth reflects the initial stages of expansion of the retail asset management services under Stone Capital and its addition of investment advisors and the licensing of a number of investment associates within the bank branches.
 
 
Total non-interest expense from continuing operations was $48.0 million, an increase of 27.8% or $10.4 million for 2004 over 2003. A $6.0 million or 29.1% increase in salaries and benefits and a $2.8 million increase in other operating expenses account for 85% of this increase, resulting from the Company’s expansion into Blacksburg, Virginia, Eastern Virginia, East Tennessee, and Charlotte, Winston-Salem and Mount Airy, North Carolina. This expansion brings with it the associated costs of additional branch personnel, corporate services and support, added technology and infrastructure as further detailed below.
 
The $6.0 million increase in salaries and benefits includes the addition of CommonWealth Bank in June 2003 ($1.0 million), the acquisition of PCB in the second quarter of 2004 ($1.9 million), the salaries and benefits associated with three North Carolina de novo branches opened in late 2003 and the opening of two new North Carolina loan production offices in the first quarter of 2004 ($1.2 million), and three new loan production offices in Virginia and West Virginia ($230 thousand), as well as a general increase in salaries and benefits as staffing needs at several locations were satisfied in order to support added corporate services and continued branch growth.
 
Occupancy and furniture and equipment expenses increased $647 thousand and $878 thousand, respectively, compared to 2003 for a total of $1.5 million. The general level of occupancy and furniture and equipment costs grew largely as a result of the CommonWealth acquisition ($156 thousand), the PCB Bancorp acquisition ($477 thousand), increases in depreciation and insurance costs associated with new de novo branches ($210 thousand) and depreciation associated with continued investment in operating equipment and technology infrastructure.
 
All other operating expense accounts increased $2.8 million in 2004 compared to 2003. Significant increases were related to the additional costs associated with the opening of three new branches in Winston-Salem and two loan production offices in Charlotte and Mount Airy, North Carolina ($119 thousand), the opening of three loan production offices in Virginia and West Virginia ($68 thousand), the acquisition of CommonWealth in Richmond, Virginia ($263 thousand) and the Tennessee acquisition of PCB Bancorp ($616 thousand). Other operational and data processing expenses also increased as a result of the acquisition and branching activity, such as correspondent bank fees, insurance, courier and OCC assessments.
 
The efficiency ratios for continuing operations for 2004 and 2003 were 53.2% and 45.2%, respectively. Increases in the current year is reflective of the higher direct costs associated with the acquisitions and new offices in 2003 and 2004 and added corporate overhead required to support Company expansion.
 
 
Consolidated income taxes were $7.7 million for 2004, a 25.6% effective tax rate, compared with $10.3 million, an effective tax rate of 29.1% in 2003. During 2004, the Company sold its mortgage subsidiary. Prior to the disposition of the mortgage subsidiary the Company recognized goodwill impairment expense in 2003 and the first two quarters of 2004. Because the goodwill impairment charges were not deductible, they increased the effective tax rate for 2003 and for the first two quarters of 2004. The impairment charges did, however, reduce the book carrying basis of the mortgage subsidiary which resulted in a tax benefit of $950 thousand at the time of sale. This difference reduced the combined effective tax rate for 2004 to 25.6% from 29.1% in 2003.


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FINANCIAL POSITION
 
 
Securities available for sale were $404.4 million at December 31, 2005, compared to $376.0 million at December 31, 2004, an increase of $28.4 million.
 
The Company attempts to maintain an acceptable level of interest rate risk within its securities portfolio. At December 31, 2005, the average life and duration of the portfolio were 7.0 years and 5.4, respectively. Average life and duration were somewhat higher than December 31, 2004, at 4.0 years and 3.5, respectively. However, the Company has been shifting towards more floating-rate securities. At December 31, 2005, 22% of the portfolio was floating-rate, compared to 16% at December 31, 2004.
 
Available for sale and held to maturity securities are reviewed quarterly for possible other-than-temporary impairment. This review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Company’s intent and ability to hold the security to recovery or maturity. A decline in value that is considered to be other-than-temporary would be recorded as a loss within non-interest income in the Consolidated Statements of Income. At December 31, 2005, the combined depreciation in value of the individual securities in an unrealized loss position for more than 12 months was less than 1% of the combined reported value of the aggregate securities portfolio. Management does not believe any unrealized loss, individually or in the aggregate, as of December 31, 2005, represents other-than-temporary impairment. The Company has the intent and ability to hold these securities until such time as the value recovers or the securities mature. Furthermore, the Company believes the decline in value is attributable to changes in market interest rates and not the credit quality of the issuer.
 
The following table details amortized cost and fair value of securities available for sale December 31, 2005, 2004, and 2003.
 
                                                 
    December 31,  
    2005     2004     2003  
    Amortized
    Fair
    Amortized
    Fair
    Amortized
    Fair
 
    Cost     Value     Cost     Value     Cost     Value  
    (Amounts in thousands)  
 
U.S. Government agency securities
  $ 92,739     $ 91,424     $ 46,541     $ 45,946     $ 72,856     $ 72,259  
States and political subdivisions
    151,118       152,168       142,882       145,146       100,708       103,051  
Corporate Notes
    61,466       61,274       37,589       38,129       66,021       69,656  
                                                 
      305,323       304,866       227,012       229,221       239,585       244,966  
Mortgage-backed securities
    94,954       92,994       142,427       142,979       184,773       186,723  
Equities
    5,390       6,521       2,626       3,797       2,517       3,468  
                                                 
Total
  $ 405,667     $ 404,381     $ 372,065     $ 375,997     $ 426,875     $ 435,157  
                                                 
 
 
Investment securities held to maturity are comprised primarily of high-grade state and municipal bonds. These securities generally carry AAA bond ratings, most of which also carry credit enhancement insurance by major insurers of investment obligations. The portfolio totaled $24.2 million at December 31, 2005 compared to $34.2 million at December 31, 2004. This decrease is reflective of continuing paydowns, maturities and calls within the portfolio. The market value of investment securities held to maturity was 102.9% and 104.1% of book value at December 31, 2005 and 2004, respectively. Recent trends in interest rates have had little effect on the portfolio market value since December 31, 2004, due to its larger percentage of municipal securities which display less price sensitivity to rate changes.


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The average final maturity of the held to maturity investment portfolio decreased from 7.4 years in 2004 to 5.3 years in 2005 with the tax-equivalent yield decreasing from 8.00% at year-end 2004 to 7.95% at the close of 2005. The average maturity of the investment portfolio, based on market assumptions for prepayment, is 1.6 years and 1.91 years at December 2005 and 2004, respectively. The average maturity data differs from final maturity data because of the use of assumptions as to anticipated prepayments.
 
The following table details amortized cost and fair value of securities held to maturity at December 31, 2003.
 
                                                 
    December 31,  
    2005     2004     2003  
    Amortized
    Fair
    Amortized
    Fair
    Amortized
    Fair
 
    Cost     Value     Cost     Value     Cost     Value  
    (Amounts in thousands)  
 
States and political subdivisions
  $ 23,781     $ 24,486     $ 33,814     $ 35,202     $ 37,521     $ 39,557  
Corporate Notes
    375       374       375       375       375       375  
                                                 
      24,156       24,860       34,189       35,577       37,896       39,932  
Mortgage-backed securities
    17       17       32       33       124       128  
                                                 
Total
  $ 24,173     $ 24,877     $ 34,221     $ 35,610     $ 38,020     $ 40,060  
                                                 
 
 
To mitigate interest rate risk, the Company sells most of the long-term, fixed-rate mortgage loans it originates in the secondary market. At December 31, 2005, the Company held $1.3 million of loans for sale to the secondary market. The gross notional amount of outstanding commitments to originate mortgage loans for customers at December 31, 2005, was $9.2 million on 53 loans.
 
 
Total loans held for investment increased $92.3 million to $1.33 billion at December 31, 2005, from $1.24 billion at December 31, 2004 as a result of increased loan production and contributions by new loan production offices. Average loan to deposit ratio increased to 92.3% at December 31, 2005, compared with 86.3% at December 31, 2004. 2005 average loans held for investment of $1.30 billion increased $142.9 million when compared to the average for 2004 of $1.16 billion. The increase in average loans reflects the impact of the acquisition of PCB on March 31, 2004 and growth through the Company’s de novo and loan production office expansion efforts, along with the existing branches.


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The held for investment loan portfolio continues to be diversified among loan types and industry segments. The following table presents the various loan categories and changes in composition at year-end 2001 through 2005.
 
Loan Portfolio Summary
 
                                         
    December 31,  
    2005     2004     2003     2002     2001  
    (Amounts in thousands)  
 
Commercial, Financial and Agricultural
  $ 110,211     $ 99,302     $ 69,395     $ 74,186     $ 96,641  
Real Estate — Commercial
    464,510       453,899       317,421       285,847       259,717  
Real Estate — Construction
    143,976       112,705       98,510       72,275       77,402  
Real Estate — Residential
    504,387       457,417       421,299       364,087       332,671  
Consumer
    106,206       113,639       119,195       131,385       138,426  
Other
    1,808       2,012       992       726       961  
                                         
Total
    1,331,098       1,238,974       1,026,812       928,506       905,818  
Less Unearned Income
    59       218       621       885       1,322  
                                         
      1,331,039       1,238,756       1,026,191       927,621       904,496  
Less Allowance for Loan Losses
    14,736       16,339       14,624       14,410       13,952  
                                         
Net Loans
  $ 1,316,303     $ 1,222,417     $ 1,011,567     $ 913,211     $ 890,544  
                                         
 
The Company maintained no foreign loans in the periods presented.
 
The following table details the maturities and rate sensitivity of the Company’s loan portfolio at December 31, 2005.
 
Maturities and Rate Sensitivity of Loan Portfolio at December 31, 2005
 
                                         
    Remaining Maturities  
          Over
                   
    One Year
    One to
    Over
             
    and Less     Five Years     Five Years     Total     Percent  
    (Dollars in thousands)  
 
Commercial, Financial and Agricultural
  $ 51,817     $ 54,461     $ 3,933     $ 110,211       8.28 %
Real Estate — Commercial
    73,225       271,105       120,180       464,510       34.90 %
Real Estate — Construction
    89,616       50,948       3,412       143,976       10.82 %
Real Estate — Mortgage*
    43,226       148,193       312,967       504,386       37.89 %
Consumer*
    18,289       79,820       8,039       106,148       7.97 %
Other
    51       1,616       141       1,808       0.14 %
                                         
    $ 276,224     $ 606,143     $ 448,672     $ 1,331,039       100.00 %
                                         
Rate Sensitivity:
                                       
Pre-determined Rate
  $ 108,324     $ 447,653     $ 105,749     $ 661,726       49.71 %
Floating or Adjustable Rate
    167,900       158,490       342,923       669,313       50.29 %
                                         
    $ 276,224     $ 606,143     $ 448,672     $ 1,331,039       100.00 %
                                         
 
 
* Amounts are net of $59 thousand of unearned income; $1 thousand in the Real Estate — Mortgage category and $58 thousand in Consumer.


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The allowance is increased by charges to earnings in the form of provisions and by recoveries of prior charge-offs, and decreased by charge-offs. The provisions are calculated to bring the allowance to a level, which, according to a systematic process of measurement, is reflective of the required amount needed to absorb probable losses.
 
Management performs monthly assessments to determine the appropriate level of the allowance. Differences between actual loss experience and estimates are reflected through adjustments that are made by either increasing or decreasing the loss provision based upon current measurement criteria. Commercial, consumer and mortgage loan portfolios are evaluated separately for purposes of determining the loan loss portion of the allowance. The specific components of the loan allowance include allocations to individual commercial credits and allocations to the remaining non-homogeneous and homogeneous pools of loans. Management’s allocations are based on judgment of qualitative and quantitative factors about both the macro and micro economic conditions reflected within the portfolio of loans and commitments and the economy as a whole. Factors considered in this evaluation include, but are not necessarily limited to, probable losses from loan and other credit arrangements, general economic conditions, changes in credit concentrations or pledged collateral, historical loan loss experience, and trends in portfolio volume, maturity, composition, delinquencies, and non-accruals. While management has attributed the allowance for loan losses to various portfolio segments, the allowance is available for the entire portfolio.
 
The allowance for loan losses was $14.7 million at December 31, 2005, compared to $16.3 million at December 31, 2004. The decrease in the allowance since December 2004 is primarily attributable to changes in various qualitative risk factors specific to the portfolio and increased charge-offs for 2005. Management considers the allowance adequate based upon its analysis of the portfolio as of December 31, 2005. However, no assurance can be made that additions to the allowance for loan losses will not be required in future periods.
 
The following table details loan charge-offs and recoveries by loan type for the five years ended December 31, 2001 through 2005.
 
Summary of Loan Loss Experience
 
                                         
    Years Ended December 31,  
    2005     2004     2003     2002     2001  
    (Dollars in thousands)  
 
Allowance for loan losses at beginning of period
  $ 16,339     $ 14,624     $ 14,410     $ 13,952     $ 12,303  
Acquisition balances
          1,786       1,583       395       484  
Charge-offs:
                                       
Commercial, financial, agricultural and commercial real estate
    5,017       1,925       3,302       2,162       1,979  
Real estate — residential
    385       723       686       464       720  
Installment
    1,534       1,526       2,133       2,243       2,181  
                                         
Total Charge-offs
    6,936       4,174       6,121       4,869       4,880  
                                         
Recoveries:
                                       
Commercial, financial and agricultural
    1,413       727       711       167       155  
Real estate — residential
    188       90       58       129       298  
Installment
    418       615       564       428       458  
                                         
Total Recoveries
    2,019       1,432       1,333       724       911  
                                         
Net charge-offs
    4,917       2,742       4,788       4,145       3,969  
Provision charged to operations
    3,706       2,671       3,419       4,208       5,134  
Reclassification of allowance for lending-related commitments(1)
    (392 )                        
                                         
Allowance for loan losses at end of period
  $ 14,736     $ 16,339     $ 14,624     $ 14,410     $ 13,952  
                                         


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(1) At June 30, 2005, the Company reclassified $392 thousand of its allowance for loan losses to a separate allowance for lending-related liabilities. Net income and prior period balances were not affected by this reclassification. The allowance for lending-related liabilities is included in other liabilities.
 
The following table details the allocation of the allowance for loan losses for the five years ended December 31, 2005.
 
 
                                                                                 
    December 31,  
    2005     2004     2003     2002     2001  
    (Dollars in thousands)  
 
Commercial, Financial and Agricultural
  $ 9,993       58 %   $ 11,700       57 %   $ 9,414       47 %   $ 8,905       47 %   $ 8,399       47 %
Real Estate — Mortgage
    2,462       34 %     2,084       34 %     2,207       41 %     1,684       39 %     3,543       38 %
Consumer
    2,281       8 %     2,555       9 %     3,003       12 %     3,821       14 %     2,010       15 %
Unallocated
          0 %           0 %           0 %           0 %           0 %
                                                                                 
Total
  $ 14,736       100 %   $ 16,339       100 %   $ 14,624       100 %   $ 14,410       100 %   $ 13,952       100 %
                                                                                 
 
 
Non-performing assets include loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned, and repossessions. The levels of non-performing assets for the last five years are presented in the following table.
 
Summary of Non-Performing Assets
 
                                         
    December 31,  
    2005     2004     2003     2002     2001  
    (Amounts in thousands)  
 
Non-accrual loans
  $ 3,383     $ 5,168     $ 2,993     $ 3,075     $ 3,633  
Loans 90 days or more past due and still accruing interest
    11                   91       1,351  
Other real estate owned
    1,400       1,419       2,091       2,855       3,029  
Repossessions
    55       1                    
                                         
Total non-performing assets
  $ 4,849     $ 6,588     $ 5,084     $ 6,021     $ 8,013  
                                         
Non-performing loans as a percentage of total loans
    0.25 %     0.42 %     0.29 %     0.34 %     0.55 %
Non-performing assets as a percentage of total loans and other real estate owned
    0.36 %     0.53 %     0.49 %     0.65 %     0.88 %
Allowance for loan losses as a percentage of non-performing loans
    434.2 %     316.2 %     488.6 %     455.1 %     279.9 %
Allowance for loan losses as a percentage of non-performing assets
    303.9 %     248.0 %     287.6 %     239.3 %     174.1 %
 
Total non-performing assets were $4.8 million at December 31, 2005 compared to $6.6 million at December 31, 2004, a decrease of $1.7 million. Non-accrual loans decreased by $1.8 million to $3.4 million at December 31, 2005. Ongoing activity within the classification and categories of non-performing loans continues to include collections on delinquencies, foreclosures and movements into or out of the non-performing classification as a result of changing customer business conditions. Loans 90 days past due and still accruing at December 31, 2005 and 2004, were $11 thousand and $0, respectively. Other real estate owned decreased $19 thousand to $1.4 million in 2005 and is carried at the lesser of estimated net realizable value or cost.


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Certain loans included in the non-accrual category have been written down to the estimated realizable value or have been assigned specific reserves within the allowance for loan losses based upon management’s estimate of loss upon ultimate resolution.
 
During 2005, 2004 and 2003, $1.3 million, $2.1 million, and $1.6 million, respectively, of assets were acquired through foreclosure and transferred to other real estate owned.
 
In addition to non-performing loans reflected in the foregoing table, the Company has identified certain performing loans as impaired based upon management’s evaluation of credit strength, projected ability to repay in accordance with the contractual terms of the loans and varying degrees of dependence on the sale of related collateral for liquidation of the loans.
 
The following table presents the Company’s investment in loans considered to be impaired and related information on those impaired loans.
 
                         
    2005     2004     2003  
    (Amounts in thousands)  
 
Recorded investment in loans considered to be impaired
  $ 4,645     $ 8,319     $ 7,649  
Loans considered to be impaired that were on a non-accrual basis
    3,383       2,096       1,609  
Recorded investment in impaired loans with related allowance
    3,555       8,319       7,189  
Allowance for loan losses related to loans considered to be impaired
    1,528       2,647       2,422  
Average recorded investment in impaired loans
    5,687       8,483       7,798  
Total interest income recognized on impaired loans
    338       389       443  
Recorded investment in impaired loans with no related allowance
    1,090             460  
 
The Company has considered all impaired loans in the evaluation of the adequacy of the allowance for loan losses at December 31, 2005. The following table presents detail of non-performing loans for the five years ended December 31, 2005. Additional information regarding nonperforming loans can be found in Note 5, Allowance for Loan Losses, included in the Financial Statements under Item 8 of this report.
 
 
                                                 
    December 31,        
    2005     2004     2003     2002     2001        
    (Amounts in thousands)        
 
Non-accruing Loans
  $ 3,383     $ 5,168     $ 2,993     $ 3,075     $ 3,633          
Loans Past Due Over 90 Days and still accruing interest
    11                   91       1,351          
Restructured Loans Performing in Accordance with Modified Terms
    302       354       356       345       518          
Gross Interest Income Which Would Have Been Recorded Under Original Terms of Non-Accruing and Restructured Loans
    380       439       282       222       291          
Actual Interest Income During the Period
    161       293       194       108       97          
 
There are no outstanding commitments to lend additional funds to borrowers related to restructured loans.
 
Potential Problems Loans — In addition to loans which are classified as non-performing, the Company closely monitors certain loans which could develop into problem loans. These potential problem loans present characteristics of weakness or concentrations of credit to one borrower. At December 31, 2005, there were no significant potential problem loans.
 
Although the Company’s loans are made primarily in the four-state region in which it operates, the Company had no concentrations of loans to one borrower or industry representing 10% or more of outstanding loans at December 31, 2005.


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Total deposits grew by $46.9 million, or 3.4%, during 2005. Noninterest-bearing demand deposits increased by $9.0 million, or 4.1%, while interest-bearing demand deposits decreased $5.8 million, or 3.9%. Savings deposits, which are made of up money market accounts and passbook savings, decreased $30.0 million, or 7.8%, while time deposits increased $73.6 million, or 12.2%. The attrition from savings and the increase in time deposits reflects the continued migration of new and current customer funds in response to the upward movement in time deposit interest rates. Adding to the increase in time deposits were the results of the Company’s successful first quarter certificate of deposit marketing campaign.
 
Average total deposits increased to $1.41 billion for 2005 versus $1.34 billion in 2004, an increase of 5.0%. Average savings deposits increased by $2.3 million while average time deposits increased by $46.2 million. Average interest-bearing demand and non-interest bearing demand deposits increased by $3.3 million and $16.0 million, respectively. In 2005, the average rate paid on interest bearing deposits was 2.03%, up from 1.63% in 2004.
 
Average Deposits and Average Rates
 
                                                                         
    2005     2004     2003  
    Average
                Average
                Average
             
    Balance     Interest     Rate     Balance     Interest     Rate     Balance     Interest     Rate  
    (Dollars in thousands)  
 
Interest-bearing liabilities:
                                                                       
Demand deposits
  $ 152,774     $ 401       0.26 %   $ 149,502     $ 366       0.24 %   $ 129,072     $ 373       0.29 %
Savings deposits
    368,339       4,309       1.17 %     366,074       3,112       0.85 %     279,972       2,185       0.78 %
Time deposits
    661,498       19,321       2.92 %     615,346       15,001       2.44 %     610,201       17,392       2.85 %
                                                                         
Total interest-bearing deposits
  $ 1,182,611     $ 24,031       2.03 %   $ 1,130,922     $ 18,479       1.63 %   $ 1,019,245     $ 19,950       1.96 %
                                                                         
Non-interest bearing demand deposits
  $ 228,781                     $ 212,777                     $ 178,961                  
                                                                         
 
Scheduled Maturities of Certificates of Deposit Greater than $100,000 As of December 31, 2005
 
         
    (Amounts in thousands)  
 
Three Months or Less
  $ 61,762  
Over Three to Six Months
    35,218  
Over Six to Twelve Months
    59,398  
Over Twelve Months
    91,104  
         
Total
  $ 247,482  
         
 
 
The Company’s borrowings consist primarily of overnight federal funds purchased from the FHLB and other sources, securities sold under agreements to repurchase, and FHLB borrowings. This category of liabilities represents wholesale sources of funding and liquidity for the Company.
 
Federal funds purchased were $82.5 million and $32.5 million, at year-end 2005 and 2004, respectively. Securities sold under repurchase agreements were $124.2 million and $109.9 million at December 31, 2005 and 2004, respectively. These agreements are sold to customers as an alternative to available deposit products. The underlying securities included in repurchase agreements remain under the Company’s control during the effective period of the agreements.


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Short-term borrowings include overnight federal funds, and securities sold under agreements to repurchase. Balances and rates paid on short-term borrowings for continuing operations are summarized as follows:
 
                                                 
    2005     2004     2003  
    Amount     Rate     Amount     Rate     Amount     Rate  
    (Dollars in thousands)  
 
At year-end
  $ 206,654       2.79 %   $ 142,357       1.55 %   $ 97,651       1.02 %
Average during the year
    128,551       2.16 %     109,223       1.29 %     100,817       1.59 %
Maximum month-end balance
    206,654               142,357               131,128          
 
Short-term borrowings increased on average approximately $19.3 million compared to the prior year as a result of continued loan demand and increases in portfolio assets. Funding cost is managed by the Company’s Asset/Liability Management Committee, which monitors, among other things, product and pricing, overall cost of funds, and maintenance of an acceptable net interest margin.
 
In December 2005, the Company prepaid certain of its highest interest rate FHLB advances. The retired obligations had a weighted-average interest rate and maturity of 5.96% and 4.3 years, respectively. In connection with the early termination, the Company incurred prepayment penalties of approximately $3.8 million. In January 2006, the Company borrowed $75 million in new adjustable-rate advances from the FHLB. $50 million of the advances were hedged by an interest rate swap to approximate a fixed rate of 4.34%. The remaining $25 million floats at an interest rate equal to 3-month LIBOR less 45 basis points.
 
At December 31, 2005, FHLB borrowings included $106.1 million in convertible and callable advances and $7.7 million of noncallable advances for a total of $113.8 million. The weighted-average interest rates of all advances were 4.17% and 5.54% at December 31, 2005 and 2004, respectively. At December 31, 2005, the FHLB advances had maturities between twelve months and 8 years. The scheduled maturities of the advances are as follows:
 
         
    (Amounts in thousands)  
 
2006
  $ 384  
2007
    6,260  
2008
    25,000  
2009
     
2010
    25,000  
2011 and thereafter
    57,123  
         
    $ 113,767  
         
 
Also included in other indebtedness is $15.5 million of junior subordinated debentures issued by the Company in October 2003 to an unconsolidated trust subsidiary.
 
 
Liquidity represents the Company’s ability to respond to demands for funds and is primarily derived from maturing investment securities, overnight investments, periodic repayment of loan principal, and the Company’s ability to generate new deposits. The Company also has the ability to attract short-term sources of funds and draw on credit lines that have been established at financial institutions to meet cash needs.
 
Total liquidity of $681.0 million at December 31, 2005, is comprised of the following: cash on hand and deposits with other financial institutions of $57.5 million; securities available for sale of $404.4 million; securities held to maturity due within one year of $1.8 million; and FHLB credit availability of $217.3 million.
 
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally used to pay down short-term borrowings. On a longer-term basis, the Company maintains a strategy of investing in securities, mortgage-backed obligations and loans with varying maturities. The Company uses sources of funds primarily to meet ongoing commitments, to pay maturing savings certificates and savings withdrawals, fund loan commitments and maintain a portfolio of securities. At December 31, 2005, approved loan commitments


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outstanding amounted to $198.1 million. Certificates of deposit scheduled to mature in one year or less totaled $422.4 million. Management believes that the Company has adequate resources to fund outstanding commitments and could either adjust rates on certificates of deposit in order to retain or attract deposits in changing interest rate environments or replace such deposits with advances from the FHLB or other funds providers if it proved to be cost effective to do so.
 
The following table presents contractual cash obligations as of December 31, 2005.
 
Cash Obligations
 
                                         
    December 31, 2005
 
    Total Payments Due by Period  
          Less Than
    Two to
    Four to
    After
 
    Total     1 Year     Three Years     Five Years     5 Years  
    (Amounts in thousands)  
 
Deposits without a stated maturity(1)
  $ 730,040     $ 730,040     $     $     $  
Federal funds borrowed and overnight security repurchase agreements
    165,951       165,951                    
Certificates of Deposit — Principal
    675,904       422,395       173,480       76,849       3,180  
Certificates of Deposit — Interest
    29,900       15,283       10,694       3,419       504  
Certificates of Deposit(2)(3)
    705,804       437,678       184,174       80,268       3,684  
Securities sold under agreements to repurchase
    40,782       38,617       1,352       813        
FHLB Advances(2)(3)
    145,170       7,448       43,554       34,293       59,875  
Trust Preferred Indebtedness
    45,967       1,097       2,194       2,194       40,482  
Leases
    3,510       780       1,382       588       760  
                                         
Total
  $ 1,671,273     $ 1,215,660     $ 232,656     $ 118,156     $ 104,801  
                                         
 
 
(1) Excludes Interest.
 
(2) Includes interest on both fixed and variable-rate obligations. The interest associated with variable-rate obligations is based upon interest rates in effect at December 31, 2005. The interest to be paid on variable-rate obligations is affected by changes in market interest rates, which materially affect the contractual obligation amounts to be paid.
 
(3) Excludes carrying value adjustments such as unamortized premiums or discounts.
 
The following table presents detailed information regarding the Company’s off-balance sheet arrangements at December 31, 2005.
 
 
                                         
    December 31, 2005
 
    Amount of Commitment Expiration Per Period  
          Less Than
    Two to
    Four to
    After
 
    Total     One Year     Three Years     Five Years     Five Years  
    (Amounts in thousands)  
 
Commitments:
                                       
Commercial lines of credit
  $ 118,250     $ 73,232     $ 29,730     $ 11,523     $ 3,765  
Consumer lines of credit
    71,722       29,062       1,611       2,336       38,713  
Letters of credit
    8,140       7,006       930       130       74  
                                         
Total commitments
  $ 198,112     $ 109,300     $ 32,271     $ 13,989     $ 42,552  
                                         
 
Lines of credit with no stated maturity date are included in commitments for less than one year.


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In January 2006, the Company entered into a pay fixed and receive variable interest rate swap. The swap effectively fixes $50 million of FHLB borrowings at 4.34% for a period of five years. Management does not anticipate this derivative transaction will have a significant impact on reported earnings or cash flows.
 
 
Total stockholders’ equity increased $11.3 million to $194.5 million at December 31, 2005, as the Company continued to balance capital adequacy and returns to stockholders. The increase in equity was due mainly to net earnings of $26.3 million after dividends paid to stockholders of $11.5 million.
 
Risk-based capital guidelines and leverage ratio measure capital adequacy of banking institutions. At December 31, 2005, the Company’s Tier I capital ratio was 10.54% compared with 10.80% in 2004. The Company’s total risk-based capital-to-asset ratio was 11.65% at the close of 2005 compared with 12.09% in 2004. Both of these ratios are well above the current minimum level of 8% prescribed for bank holding companies. The leverage ratio is the measurement of total tangible equity to total assets. The Company’s leverage ratio at December 31, 2005 was 7.77% versus 7.62% at December 31, 2004, both of which are well above the minimum levels prescribed by the Federal Reserve. See Note 12 of the Notes to Consolidated Financial Statements.
 
 
As part of its community banking services, the Company offers trust management and estate administration services through its Trust and Financial Services Division (Trust Division). The Trust Division reported market value of assets under management of $487 million and $506 million at December 31, 2005 and 2004, respectively. The Trust Division manages inter vivos trusts and trusts under will, develops and administers employee benefit plans and individual retirement plans and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature and complexity of the account.
 
The Trust Division employs 18 professionals and full time equivalent support staff with a wide variety of estate and financial planning, investing and plan administration skills. The Trust Division is located within the Company’s banking offices in Bluefield, West Virginia. Services and trust development activities are offered to other branch locations and primary markets through the Bluefield-based division.
 
ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment.
 
The Company’s primary component of operational revenue, net interest income, is subject to variation as a result of changes in interest rate environments in conjunction with unbalanced repricing opportunities on earning assets and interest-bearing liabilities. Interest rate risk has four primary components including repricing risk, basis risk, yield curve risk and option risk. Repricing risk occurs when earning assets and paying liabilities reprice at differing times as interest rates change. Basis risk occurs when the underlying rates on the assets and liabilities the institution holds change at different levels or in varying degrees. Yield curve risk is the risk of adverse consequences as a result of unequal changes in the spread between two or more rates for different maturities for the same instrument. Lastly, option risk is due to “embedded options”, often called put or call options, given or sold to holders of financial instruments.
 
In order to mitigate the effect of changes in the general level of interest rates, the Company manages repricing opportunities and thus, its interest rate sensitivity. The Company seeks to control its interest rate risk (“IRR”) exposure to insulate net interest income and net earnings from fluctuations in the general level of interest rates. To measure its exposure to IRR, quarterly simulations of net interest income are performed using financial models that


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project net interest income through a range of possible interest rate environments including rising, declining, most likely and flat rate scenarios. The results of these simulations indicate the existence and severity of IRR in each of those rate environments based upon the current balance sheet position, assumptions as to changes in the volume and mix of interest-earning assets and interest-paying liabilities and management’s estimate of yields to be attained in those future rate environments and rates that will be paid on various deposit instruments and borrowings. Specific strategies for management of IRR have included shortening the amortized maturity of new fixed-rate loans, increasing the volume of adjustable-rate loans to reduce the average maturity of the Bank’s interest-earning assets, and monitoring the term structure of liabilities to maintain a balanced mix of maturity and repricing to mitigate the potential exposure. The simulation model used by the Company captures all earning assets, interest-bearing liabilities and all off-balance sheet financial instruments and combines the various factors affecting rate sensitivity into an earnings outlook. Based upon the latest simulation, the Company believes that it is biased slightly toward liability sensitive position. Absent adequate management, liability sensitive positions can negatively impact net interest income in a rising rate environment or, alternatively, positively impact net interest income in a falling rate environment.
 
The Company has established policy limits for tolerance of interest rate risk that allow for no more than a 10% reduction in projected net interest income based on quarterly income simulations compared to forecasted results. In addition, the policy addresses exposure limits to changes in the Economic Value of Equity according to predefined policy guidelines. The most recent simulation indicates that current exposure to interest rate risk is within the Company’s defined policy limits as short-term rates are anticipated to remain relatively stable throughout 2006.
 
The following table summarizes the impact of immediate and sustained rate shocks in the interest rate environment on net interest income and the economic value of equity as of December 31, 2005 and 2004. The model simulates plus and minus 200 basis points from the flat rate simulation at December 31, 2005. This table, which illustrates the prospective effects of hypothetical interest rate changes, is based upon numerous assumptions including relative and estimated levels of key interest rates over a twelve-month time period. This type of modeling technique, although useful, does not take into account all strategies that management might undertake in response to a sudden and sustained rate shock as depicted. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables.
 
Rate Sensitivity Analysis
 
                                 
2005  
Increase (Decrease)
  Change in
          Change in
       
in Interest Rates
  Net Interest
    %
    Market Value
    %
 
(Basis Points)
  Income     Change     of Equity     Change  
    (Dollars in thousands)  
 
200
  $ (764 )     (1.0 )   $ (13,392 )     (4.6 )
100
    (403 )     (0.5 )     (6,211 )     (2.2 )
(100)
    (950 )     (1.3 )     (4,376 )     (1.5 )
(200)
    (4,299 )     (5.8 )     (15,755 )     (5.5 )
 
                                 
2004  
Increase (Decrease)
  Change in
          Change in
       
in Interest Rates
  Net Interest
    %
    Market Value
    %
 
(Basis Points)
  Income     Change     of Equity     Change  
 
200
  $ 2,768       4.0     $ (6,497 )     (2.5 )
100
    1,622       2.4       (2,495 )     (1.0 )
(100)
    (2,770 )     (4.0 )     (10,114 )     (3.9 )


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FIRST COMMUNITY BANCSHARES, INC.
 
 
                 
    December 31,  
    2005     2004  
    (Amounts in thousands,
 
    except share data)  
 
ASSETS
Cash and due from banks
  $ 46,872     $ 37,294  
Interest-bearing balances with banks
    10,667       17,452  
                 
Total cash and cash equivalents
    57,539       54,746  
Securities available for sale (amortized cost of $405,667, 2005; $372,065, 2004)
    404,381       375,997  
Securities held to maturity (fair value of $24,877, 2005; $35,610, 2004)
    24,173       34,221  
Loans held for sale
    1,274       1,194  
Loans held for investment, net of unearned income
    1,331,039       1,238,756  
Less allowance for loan losses
    14,736       16,339  
                 
Net loans held for investment
    1,316,303       1,222,417  
Premises and equipment, net
    34,993       37,360  
Other real estate owned
    1,400       1,419  
Interest receivable
    10,232       8,554  
Other assets
    41,069       33,604  
Goodwill
    59,182       58,828  
Other intangible assets
    1,937       2,482  
                 
Total Assets
  $ 1,952,483     $ 1,830,822  
                 
 
LIABILITIES
Deposits:
               
Noninterest-bearing
  $ 230,542     $ 221,499  
Interest-bearing
    1,175,402       1,137,565  
                 
Total Deposits
    1,405,944       1,359,064  
Interest, taxes and other liabilities
    16,153       14,313  
Federal funds purchased
    82,500       32,500  
Securities sold under agreements to repurchase
    124,154       109,857  
FHLB borrowings and other indebtedness
    129,231       131,855  
                 
Total Liabilities
    1,757,982       1,647,589  
                 
Stockholders’ Equity
               
Preferred stock, par value undesignated; 1,000,000 shares authorized; no shares issued and outstanding in 2005 and 2004
           
Common stock, $1 par value; shares authorized: 25,000,000 in 2005 and 15,000,000 in 2004; shares issued: 11,496,312 in 2005 and 11,472,311 in 2004; shares outstanding: 11,251,803 in 2005 and 11,250,927 in 2004
    11,496       11,472  
Additional paid-in capital
    108,573       108,263  
Retained earnings
    82,828       68,019  
Treasury stock, at cost
    (7,625 )     (6,881 )
Accumulated other comprehensive income
    (771 )     2,360  
                 
Total Stockholders’ Equity
    194,501       183,233  
                 
Total Liabilities and Stockholders’ Equity
  $ 1,952,483     $ 1,830,822  
                 
 
See Notes to Consolidated Financial Statements.
 


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FIRST COMMUNITY BANCSHARES, INC.
 
 
                         
    Years Ended December 31,  
    2005     2004     2003  
    (Amounts in thousands,
 
    except share and per share data)  
 
Interest Income:
                       
Interest and fees on loans
  $ 89,903     $ 76,713     $ 70,432  
Interest on securities — taxable
    11,077       12,119       13,117  
Interest on securities — nontaxable
    7,451       6,712       6,488  
Interest on federal funds sold and deposits in banks
    1,077       592       604  
                         
Total interest income
    109,508       96,136       90,641  
                         
Interest Expense:
                       
Interest on deposits
    24,030       18,478       19,950  
Interest on short-term borrowings
    9,721       7,585       5,792  
Interest on long-term debt
    2,129       890       655  
                         
Total interest expense
    35,880       26,953       26,397  
                         
Net interest income
    73,628       69,183       64,244  
Provision for loan losses
    3,706       2,671       3,419  
                         
Net interest income after provision for loan losses
    69,922       66,512       60,825  
                         
Noninterest Income:
                       
Wealth management income
    2,956       2,489       2,159  
Service charges on deposit accounts
    10,095       9,122       8,071  
Other service charges, commissions and fees
    2,785       2,239       2,013  
Other operating income
    5,716       1,875       1,101  
Net gains on sale of securities
    753       1,604       1,198  
                         
Total noninterest income
    22,305       17,329       14,542  
                         
Noninterest Expense:
                       
Salaries and employee benefits
    29,481       26,646       20,644  
Occupancy expense of bank premises
    3,903       3,559       2,912  
Furniture and equipment expense
    3,319       2,872       1,994  
Core deposit amortization
    435       399       243  
Prepayment penalties on FHLB advances
    3,794              
Other operating expense
    14,659       14,559       11,797  
                         
Total noninterest expense
    55,591       48,035       37,590  
                         
Income from continuing operations before income taxes
    36,636       35,806       37,777  
Income tax expense
    10,191       9,786       11,058  
                         
Income from continuing operations
    26,445       26,020       26,719  
                         
Loss from discontinued operations before income tax
    (233 )     (5,746 )     (2,174 )
Income tax benefit
    (91 )     (2,090 )     (693 )
                         
Loss from discontinued operations
    (142 )     (3,656 )     (1,481 )
                         
Net income
  $ 26,303     $ 22,364     $ 25,238  
                         
Basic earnings per common share
  $ 2.33     $ 1.99     $ 2.27  
                         
Diluted earnings per common share
  $ 2.32     $ 1.97     $ 2.25  
                         
Basic earnings per common share from continuing operations
  $ 2.35     $ 2.32     $ 2.41  
                         
Diluted earnings per common share from continuing operations
  $ 2.33     $ 2.29     $ 2.39  
                         
Dividends declared per common share
  $ 1.02     $ 1.00     $ 0.98  
                         
Weighted average basic shares outstanding
    11,269,258       11,238,648       11,096,900  
                         
Weighted average diluted shares outstanding
    11,341,804       11,337,606       11,198,353  
                         
 
See Notes to Consolidated Financial Statements.
 


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FIRST COMMUNITY BANCSHARES, INC.
 
 
                                 
    Years Ended December 31,        
    2005     2004     2003        
    (Amounts in thousands)        
 
Cash flows from operating activities — continuing operations:
                               
Income from continuing operations
  $ 26,445     $ 26,020     $ 26,719          
Adjustments to reconcile net income to net cash provided by operating activities:
                               
Provision for loan losses
    3,706       2,671       3,419          
Depreciation and amortization of premises and equipment
    3,339       2,938       2,085          
Intangible amortization
    436       399       243          
Net investment amortization and accretion
    1,049       2,203       2,842          
Gains on the sale of assets
    (4,845 )     (1,786 )     (1,064 )        
Mortgage loans originated for sale
    (37,593 )     (26,751 )     (28,551 )        
Proceeds from sale of mortgage loans
    37,513       25,981       28,992          
Deferred income tax expense
    1,864       147       31          
(Increase) decrease in interest receivable
    (1,707 )     705       (150 )        
(Increase) decrease in other assets
    (6,549 )     (2,660 )     1,975          
Increase (decrease) in other liabilities
    1,137       1,310       (3,641 )        
                                 
Net cash provided by operating activities — continuing operations
    24,795       31,177       32,900          
                                 
Cash flows from investing activities — continuing operations:
                               
Proceeds from sales of securities available for sale
    33,159       45,391       3,283          
Proceeds from maturities and calls of securities available for sale
    44,115       144,573       150,877          
Proceeds from maturities and calls of held to maturity securities
    10,097       4,374       3,058          
Purchase of securities available for sale
    (111,223 )     (108,726 )     (300,858 )        
Purchase of securities held to maturity
                (75 )        
Net (increase) decrease in loans made to customers
    (104,307 )     (84,580 )     19,289          
Cash (used in) provided by divestitures and acquisitions, net
    (32,630 )     (26,340 )     1,324          
Purchase of premises and equipment
    (3,215 )     (7,336 )     (6,722 )