ITEM 1. BUSINESS
(A) BUSINESS DEVELOPMENT
Cardinal Bankshares Corporation (“Cardinal” or the “Company”) was incorporated as a Virginia corporation on March 12, 1996 to acquire the stock of Bank of Floyd (the “Bank”). The Bank was acquired by the Company on June 30, 1996.
The Bank was organized as a state chartered bank on February 24, 1951 through the consummation of a plan of consolidation between two state chartered community banks then operating in Floyd County, Virginia.
The Bank and its wholly owned subsidiary, FBC, Inc., are incorporated and operate under the laws of the Commonwealth of Virginia. As a state chartered Federal Reserve member, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve. FBC, Inc.’s assets and operations consist primarily of minority interests in title insurance companies.
(B) DESCRIPTION OF THE BUSINESS
The principal business of the Company and Bank is to provide comprehensive individual and corporate banking services through the Bank’s main office in Floyd, Virginia, and branch offices in Hillsville, Christiansburg, Roanoke, Salem and Willis, Virginia. The Bank’s wholly owned subsidiary, FBC, Inc., has interests in Virginia Title Center, LLC as well as Virginia Bankers Insurance Center, LLC, both of which act as title insurance companies. FBC, Inc. also has an interest in VBA Investment Services, LLC.
(1) SERVICES
The Bank is a full service retail commercial bank offering a wide range of services, including demand and time deposits as well as installment, mortgage and other consumer lending services. The Bank makes seasonal and term commercial loans, both alone and in conjunction with other banks or governmental agencies.
(2) COMPETITIVE CONDITIONS
The bank business is highly competitive. The Company competes as a financial intermediary with other commercial banks, savings and loan associations, credit unions and money market mutual funds operating in its trade area and elsewhere. As of December 31, 2006, there were two commercial banks (one of which is the Bank) operating a total of three offices in Floyd County, Virginia. The competing institution is not locally owned.
Floyd County generates approximately 63% of the Bank’s total deposits. In the other parts of the Bank’s trade area (the Virginia counties of Roanoke, Montgomery, and Carroll and the Cities of Roanoke and Salem, Virginia), there are a number of locally owned community banks, statewide banking organizations, and affiliate banks of southeast regional bank holding companies in operation.
(3) CUSTOMERS
Deposits are derived from a broad base of customers in its trade area. No material portion of deposits have been obtained from a single person or a few persons (including Federal, State, and local governments and agencies thereunder), the loss of which would have a materially adverse effect on the business of the Bank.
The majority of loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area. The majority of such customers are also depositors. The Company generally does not extend credit to any single borrower or group of related borrowers in excess of approximately $2.7 million. Although the Company has a reasonably diversified loan portfolio, it has a loan concentration relating to nonresidential buildings and real estate land developers. Total loans to this group amounted to approximately $33.1 million at December 31, 2006 and approximately $38.8 million at December 31, 2005.
(4) RIGHTS
No patents, trademarks, licenses, franchises or concessions held are of material significance to the Company.
(5) NEW SERVICES
The Company has expended no material dollars on research activities relating to new lines of business in the last two years.
(6) ENVIRONMENTAL LAWS
Compliance with Federal, State, or Local provisions regulating the discharge of materials into the environment has not had, nor is it expected to have in the future, a material effect upon the Company’s capital expenditures, earnings or competitive position.
(7) EMPLOYEES
The Bank had 29 officers, 35 full-time employees and 8 part-time employees as of December 31, 2006.
(8) SUPERVISION AND REGULATION
The Company and the Bank are subject to state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking, financial institutions, including the Company, are disadvantaged relative to other competitors who are not as highly regulated, and our costs of doing business are much higher. Some of the provisions of certain statutes, rules and regulations that affect our business include but are not limited to the Federal Bank Holding Company Act of 1956, The Virginia Banking Act, Gramm-Leach-Bliley Act, Sarbanes-Oxley Act of 2002, and the Community Reinvestment Act. The Bank is also subject to other federal laws regulating loan and deposit operations. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company and/or the Bank. Discussion related to other regulatory matters is in Note 14 in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 1A.
ITEM 1A. RISK FACTORS
The Company considers its risk factors to be very similar to other financial institutions. The Company has considered such risk factors and strategically plans and prepares should we be faced with such risks.
•
If market interest rates fluctuate, net interest income can be negatively affected in the short term.
•
Cardinal Bankshares, Inc. and its bank subsidiary are subject to regulatory capital adequacy guidelines. If the bank fails to meet capital adequacy guidelines, it could subject us to enforcement actions as well as impose restrictions on our business.
•
If the Company is not in compliance with governmental regulation, we can be subject to fines, penalties or restrictions on our business.
•
The Company is subject to stringent regulation by federal and state regulatory agencies. Our customers have confidentiality and fiduciary requirements. The Company has established policies, procedures and systems that are designed to comply with these requirements. We face complexity and costs related to our compliance efforts. We also face the potential for loss resulting from failed or inadequate internal processes and from external events. Adverse publicity and damage to our reputation from the failure or perceived failure to comply with legal, regulatory or capital requirements could affect our ability to comply with such requirements, could affect our ability to attract or maintain customer, or could result in enforcement actions, fines, penalties and lawsuits.
•
If there is significant economic downturn in areas that the bank services, there is likelihood that customers could become delinquent on their loans or other obligations to us. This could result in credit-related losses, which could adversely affect our performances.
•
Financial services in our market area are competitive with a number of commercial banks and credit unions seeking to do business with our customers. The actions of our competitors could make the Company lose customers, thus affecting our business.
•
The Company has established disaster recovery plans to continue operations in the event of a disaster. Business disruption could adversely impact our operations.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
NONE
ITEM 2.
ITEM 2. PROPERTIES
The present headquarters of the Company consists of a three-story brick building, with approximately 21,200 square feet of floor space located at 101 Jacksonville Circle, Floyd, Virginia. The Bank also owns its branch offices in Hillsville, Christiansburg and Roanoke, Virginia, which have drive-up facilities. The Bank’s Willis, Virginia and Salem, Virginia offices operate from a leased facility. Additional information about the Company’s properties and leases appears in Exhibit 99 attached to Form 10-K and in Note 6 in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
The Bank also owns a three-story brick building adjacent to its main office which serves as the Bank’s conference room, training room and which provides space for expansion of the financial services now offered.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company was named as a defendant in a complaint filed by a former employee with the United States Department of Labor under Section 806 of the Sarbanes-Oxley Act. The plaintiff alleged in his complaint that his termination in October, 2002 violated the Act. He is seeking reinstatement, back pay and damages. The Company maintains that the independent members of its Board of Directors terminated the plaintiff lawfully because he refused to comply with the directives of the Audit Committee in their attempt to look into certain matters raised by the plaintiff. The Audit Committee, after full investigation, later concluded that the matters raised by the plaintiff had no merit. The Board’s decision was initially upheld by the Department of Labor. The plaintiff appealed that decision. The Department of Labor Administrative Law Judge reversed the earlier decision in the Company’s favor and entered a decision in favor of the plaintiff in January 2004. The Company appealed that decision. The Administrative Review Board of the Department of Labor agreed to review the decision of the Administrative Law Judge in February 2004. Their decision to review suspended the decision of the Administrative Law Judge prior to any determination of damages by the Administrative Law Judge. In May 2004, the Administrative Review Board within the Department of Labor determined that it had accepted the Company’s petition for review prematurely.
Because of the uncertainty regarding the procedural handling of this case within the DOL, to preserve its ultimate ability to appeal to the Federal Courts, in June 2004, the Company filed with the United States Court of Appeals for the Fourth Circuit a Petition for Review of the decisions of the United States Department of Labor. The appeal was determined to be premature. The parties submitted evidence to the Administrative Law Judge of damages without a further hearing in December 2004 and January 2005. The Administrative Law Judge rendered a Supplemental Recommended Decision and Order in February 2005, which awarded damages to the plaintiff of $65 thousand, plus attorney’s fees of $108 thousand, and ordered the plaintiff’s reinstatement. The Company filed a petition for review to the Administrative Review Board of the Department of Labor. The case was accepted for review by the Administrative Review Board in March 2005. The Company’s management believes it has substantial grounds for a successful appeal of the decision in the plaintiff’s favor and will pursue appeals vigorously. Both sides have submitted briefs to the Administrative Review Board and are awaiting the Administrative Review Board’s decision.
Meanwhile plaintiff made several unsuccessful attempts to force his reinstatement on the Company. He moved the Administrative Law Judge for sanctions against the Company for failure to reinstate him. The motion was denied on August 9, 2005. On August 30, 2005, plaintiff filed a complaint in the United States District Court for the Western District of Virginia seeking to enforce what he claimed was a preliminary order of reinstatement issued by the Administrative Law Judge. The Court granted the Company’s motion to dismiss January 14, 2006, on the grounds that there is no preliminary order of reinstatement to enforce. Plaintiff then filed two motions simultaneously, one to the Administrative Law Judge seeking “expedited clarification” of the purported order of reinstatement and another to the U.S. District Court to alter or amend its dismissal of his petition. Both of plaintiff’s motions were denied, on January 24 and January 26, respectively.
Then, on February 8, 2006, the plaintiff made a motion to the Administrative Review Board for “expedited declaration” of preliminary order of reinstatement. This motion was granted by the ARB on March 31, 2006, essentially concluding that notwithstanding the District Court’s decision the Administrative Law Judge had issued a preliminary reinstatement order. On April 17, 2006, the Company filed a motion with the Department of Labor Administrative Review Board seeking a stay of the preliminary order of reinstatement. This motion was denied on June 9, 2006, leaving the preliminary order of reinstatement in effect.
On July 6, 2006, plaintiff filed another Petition to enforce the Department of Labor’s preliminary order of reinstatement with the United States District Court in Roanoke, Virginia. The Company moved to dismiss the petition on the basis that the Sarbanes-Oxley statute does not give the District Court jurisdiction to enforce a Department of Labor Preliminary Order of reinstatement. The Department of Labor intervened to support the plaintiff’s petition. Each of the Company’s directors intervened as individuals to oppose reinstatement. The American Association of Bank Directors similarly intervened in support of the Company and the Company’s Directors and to oppose enforcement of the Order of Reinstatement.
On October 5, 2006, the District Court granted Cardinal’s motion to dismiss, concluding that the Court did not have jurisdiction to enforce a Department of Labor Preliminary Order of Reinstatement.
On December 4, 2006, the plaintiff and the United States Department of Labor appealed the District Court’s dismissal to the United States Court of Appeals for the Fourth Circuit. The appeal is pending.
ITEM 4.
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 the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(A) The Company’s stock is traded on the OTC Bulletin Board under the symbol CDBK. The following table shows the trading ranges of the Common Stock for the previous five years. High and low (bid quotations/sales prices), known to the management of the Company, for each quarter in the last three fiscal years appears in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
Year
High
Low
$21.50
$19.10
$23.50
$20.00
$25.00
$19.90
$24.25
$17.60
$23.47
$14.80
(B) The approximate number of holders of the Bank’s 1,535,733 Common Stock Securities as of December 31, 2006, is 746.
(C) Dividends paid for 2006 were $0.58 and 2005 were $0.53 per share owned. The Company’s ability to declare and pay dividends in the future is dependent upon its consolidated net income, fiscal and general business condition. Subject to these considerations, as well as, laws and regulations governing the payment of dividends, the Company may declare dividends at the discretion of the Board of Directors only. The Company currently expects that dividends will continue to be paid in the foreseeable future.
(D) Stock Performance - The Company’s stock is traded on the OTC Bulletin Board under the symbol CDBK. The following graph compares the cumulative total return to the shareholders of the Company, based on transactions known to the Company for the last five fiscal years with the total return on the S&P 500 Index, an index of banks with assets less than $500 million, and the SNL <$500M Bank Index, assuming an investment of $100 in the Company’s common stock on December 31, 2001 and the reinvestment of dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required by Item 6 of Form 10-K appears in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The information required by Item 7 of Form 10-K appears in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by Item 7A of Form 10-K appears in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by Item 8 of Form 10-K appears in the Company’s 2006 Annual Report to Stockholders and is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
NONE
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Our Chief Executive Officer and Principal Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures in accordance with Rule 13a-14 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on the evaluation, the Chief Executive Officer and Principal Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in enabling us to record, process, summarize and report in a timely manner the information required to be disclosed in reports we file under the Exchange Act.
No change in our internal control over financial reporting occurred during our fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
NONE
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Item 10 of Form 10-K appears in the Company’s Proxy Statement for the 2007 Annual Meeting and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K appears in the Company’s Proxy Statement for the 2007 Annual Meeting and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K appears in the Company’s Proxy Statement for the 2007 Annual Meeting and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by Item 13 of Form 10-K appears in the Company’s Proxy Statement for the 2007 Annual Meeting and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 of Form 10-K appears in the Company’s Proxy Statement for the 2007 Annual Meeting and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of the report:
(b) REPORTS ON FORM 8-K filed during the fourth quarter of 2006:
On November 20, 2006, the Company filed a report on Form 8-K to announce results of operations for the quarter ended September 30, 2006.
On November 21, 2006 the Company filed a report on Form 8-K to announce the extension of the Company’s President and CEO’s Employment Agreement to February 21, 2010. The Company also announced that the Audit Committee of the Board of Directors was notified by the Company’s independent accountants, Larrowe & Company, PLLC (“Larrowe”), that it had merged with the firm of Elliott Davis, LLC, effective November 17, 2006, and that it would no longer operate or provide audit services as a separate entity. The Company’s Audit Committee approved the engagement of Elliott Davis, LLC, the successor firm in the merger, to serve as the Company’s independent accountants for the fiscal year ended December 31, 2006.
FINANCIAL STATEMENT SCHEDULES
See Item 15(a) 2 above.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CARDINAL BANKSHARES CORPORATION
/s/ Ronald Leon Moore
/s/ Stephanie K. Sigman
Ronald Leon Moore
Stephanie K. Sigman
Chairman, President &
Senior Vice President, Controller &
Chief Executive Officer
Principal Financial Officer
Date: March 27, 2007
Date: March 27, 2007
In accordance with the Exchange Act, this report has to be signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
Cardinal Bankshares Corporation and Subsidiaries
2006 Annual Report
Market for the Company’s Common Stock, Related Stockholder Matters, Stock Prices and Dividends
The Company’s common stock is traded on the OTC Bulletin Board under the symbol CDBK. Some Internet sites providing stock quotations may require the use of CDBK.OB to access information about Cardinal’s stock. As of December 31, 2006, the Company had issued and outstanding 1,535,733 shares of common stock which were held by approximately 746 stockholders of record.
Set forth below are the high and low (bid quotations/sales prices), known to the management of the Company, for each quarter in the last three fiscal years.
Cash dividends paid in 2006, 2005 and 2004, were $891 thousand, $814 thousand, and $768 thousand, respectively.
Cardinal Bankshares Corporation and Subsidiaries
Selected Historical Financial Information
In thousands, except share, per share and shares outstanding data
Cardinal Bankshares Corporation
Post Office Box 215
Floyd, Virginia 24091
To Our Shareholders and Our Banking Communities
We are again pleased to present Cardinal Bankshares Corporation’s Annual Report. Two thousand and six was another good year for the Company. We were on target in most of our goals. Total assets, deposits, net profit, and shareholder dividend increased. The one area in which we did not perform as expected was loan growth.
Total assets for the first time in Company history ended above $200 million, climbing to $207,849,000, a 5.92% increase. Deposits increased by $9.4 million, ending the year at $177,272,000, a 5.61% increase. Our net loans decreased by 5.62%, ending the year at $121,334,000, a decrease of $7.2 million.
Cardinal ended the year with net income of $2,511,000, an increase of $308,000 over 2005. Basic net earnings amounted to $1.63 per share for 2006. We also increased the provision for loan losses to $208,000. This amount was justified in an economy that appears uncertain at this time.
The cash dividend paid to shareholders in 2006 increased by 9.43% over the dividend paid in 2005. Cardinal paid a record 58¢ per share for 2006, making it a record 15th consecutive year of increased dividends.
Our technology center made several upgrades to hardware and software during the year. In September we began electronic presentment and receipt of all checks to the Federal Reserve System. This change was very timely as the Federal Reserve recently announced that they would stop most transportation of paper checks by 2010.
Our Risk Management Committee met numerous times in 2006. Their responsibility, to assess potential risk to our company, led to a strengthening of some controls in the organization. That committee will be an ongoing committee and will work to bolster the safety and soundness of our organization.
I would like to thank your Board of Directors for their work and dedication during a time when many others are beginning to question the risk-reward of a position with a financial institution. It is becoming evident that fewer individuals are willing to be placed in a position of personal liability by serving a financial institution when our Congress and regulators continue to enact laws and regulations without regard to size, cost or benefit.
I also want to recognize our staff for their effort and dedication that resulted in another record year for the Company.
In closing, I would be remiss if I did not remember Dennis McDaniel, Vice President and Manager of the Salem office. We lost Dennis on January 22, 2007 after a brief illness. Dennis served our company and his customers to the very end. I was privileged to visit with Dennis one day prior to his death. Even then his customers were very much in his heart and on his mind. Dennis touched the lives of his friends, his customers and the many young men that he coached in Salem athletics. He is missed by all of us at Cardinal.
Thank each of your for your continued support. We look forward to 2007 with plans to grow Cardinal Bankshares as a local independent community bank. We ask for your assistance and patronage in accomplishing this endeavor.
Sincerely,
/s/ Leon Moore
Leon Moore
Chairman, President & Chief Executive Officer
Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Cardinal Bankshares Corporation
Floyd, Virginia
We have audited the consolidated balance sheets of Cardinal Bankshares Corporation and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cardinal Bankshares Corporation and subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 9, to the consolidated financial statements, the Company adopted SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans during the year.
Galax, Virginia
March 20,
Cardinal Bankshares Corporation and Subsidiaries
Consolidated Balance Sheets
See Notes to Consolidated Financial Statements
Cardinal Bankshares Corporation and Subsidiaries
Consolidated Statements of Income
See Notes to Consolidated Financial Statements
Cardinal Bankshares Corporation and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
See Notes to Consolidated Financial Statements
Cardinal Bankshares Corporation and Subsidiaries
Consolidated Statements of Cash Flows
See Notes to Consolidated Financial Statements
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies
Organization
Cardinal Bankshares Corporation (the “Company”) was incorporated as a Virginia corporation on March 12, 1996 to acquire the stock of Bank of Floyd (the “Bank”). The Bank was acquired by the Company on June 30, 1996.
Bank of Floyd and its wholly owned subsidiary, FBC, Inc., are incorporated and operate under the laws of the Commonwealth of Virginia. As a state chartered Federal Reserve member, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve. The Bank serves the counties of Floyd, Carroll, Montgomery, and Roanoke, Virginia and the Cities of Roanoke, Christiansburg and Salem, Virginia, through seven banking offices. The Bank plans to open its eighth branch in Pulaski County, Virginia, serving the Fairlawn area, in late Spring 2007. FBC, Inc.’s assets and operations consist primarily of minority interests in an insurance company and a title insurance company.
The accounting and financial reporting policies of the Company conform to generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.
Principles of Consolidation
The consolidated financial statements of the Company include the accounts of the Company, the Bank and FBC, Inc. All material intercompany transactions and balances have been eliminated.
Critical Accounting Policies
The notes to the Company’s audited consolidated financial statements contain a summary of significant accounting policies. Management believes the policies with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity. Management must make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could cause reported results to differ materially. These critical policies and their application are periodically reviewed with the Audit Committee and Board of Directors.
Business Segments
The Company reports its activities as a single business segment. In determining proper segment definition, the Company considers the materiality of the potential segment and components of the business about which financial information is available and regularly evaluated, relative to resource allocation and performance assessment.
Advertising Expense
The Company expenses advertising costs as they are incurred. Advertising expense for the years presented is not material to the financial statements.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions in the application of certain of its accounting policies that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. As a result of unanticipated events or circumstances, actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and foreclosed real estate losses, management obtains independent appraisals for significant properties.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
Use of Estimates, continued
The majority of the Company’s loan portfolio consists of loans in Southwest Virginia. Accordingly, the ultimate collectibility of a substantial portion of the Company’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions. The regional economy is diverse, but is influenced by the agricultural, manufacturing, tourism and governmental segments.
While management uses available information to recognize loan and foreclosed real estate losses, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as a part of their routine examination process, periodically review the Company’s allowances for loan and foreclosed real estate losses. Such agencies may require additions and decreases to the allowances based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the allowances for loan and foreclosed real estate losses may change materially in the near term.
Cash and Cash Equivalents
For purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption “cash and due from banks.”
Interest-Bearing Deposits in Banks
Interest-bearing deposits in banks mature in one year and are carried at cost.
Trading Securities
The Company does not hold securities for short-term resale and therefore does not maintain a trading securities portfolio.
Securities Held to Maturity
Bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates.
Securities Available for Sale
Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as held to maturity securities.
Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders’ equity. Realized gains and losses on the sale of available for sale securities are recorded on the trade date and are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.
Declines in the fair value of individual held to maturity and available for sale securities below cost, that are other than temporary, are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses.
Loans Receivable
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off, are reported at their outstanding principal amount adjusted for charge-offs, the allowance for loan losses, deferred fees or costs on originated loans, and unamortized premiums or discounts on purchased loans.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
Loans Receivable, continued
Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the yield of the related loan. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method.
Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. When facts and circumstances indicate the borrower has regained the ability to meet required payments, the loan is returned to accrual status. Past due status of the loan is determined based on contractual terms.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and approved by the Company’s Board of Directors and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
Property and Equipment
Land is carried at cost. Bank premises, furniture and equipment are carried at cost, less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:
Years
Buildings and improvements
20-40
Furniture and equipment
5-20
Foreclosed Properties
Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value less cost to sell at the date of foreclosure. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in operations on foreclosed real estate. The historical average holding period for such properties is in excess of 23 months.
Pension Plan
A noncontributory defined benefit pension plan is provided for all employees who meet eligibility requirements. To be eligible, an employee must be 21 years of age and have completed one year of service. Plan benefits are based on final average compensation and years of service. The plan is funded in compliance with the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986, as amended.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”, which amends SFAS No. 87 and SFAS No. 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS No. 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement date - the date at which the benefit obligation and plan assets are measured - is required to be the company’s fiscal year end. SFAS No. 158 is effective for publicly held companies for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008. The Company adopted SFAS No. 158 in December 2006. See Note 9.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Income Taxes
Provision for income taxes is based on amounts reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
Income Taxes, continued
Deferred income tax liability relating to unrealized appreciation (or the deferred tax asset in the case of unrealized depreciation) on investment securities available for sale is recorded in other liabilities (assets). Such unrealized appreciation or depreciation is recorded as an adjustment to equity in the financial statements and not included in income determination until realized. Accordingly, the resulting deferred income tax liability or asset is also recorded as an adjustment to equity.
Basic Earnings per Share
Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period, after giving retroactive effect to stock splits and stock dividends.
Diluted Earning per Share
The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. For the years presented, the Company had no potentially dilutive securities outstanding.
Comprehensive Income
Annual comprehensive income reflects the change in the Company’s equity during the year arising from transactions and events other than investments by, and distributions to, stockholders. It consists of net income plus certain other changes in assets and liabilities that are reported as separate components of stockholders’ equity rather than as income or expense.
Financial Instruments
Derivatives that are used as part of the asset/liability management process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. In addition, forwards and option contracts must reduce an exposure’s risk, and for hedges of anticipatory transactions, the significant terms and characteristics of the transaction must be identified and the transactions must be probable of occurring. All derivative financial instruments held or issued by the Bank are held or issued for purposes other than trading.
In the ordinary course of business the Company has entered into off-balance-sheet financial instruments consisting of commitments to extend credit and commercial and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
The Company does not utilize interest-rate exchange agreements or interest-rate futures contracts.
Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
Fair Value of Financial Instruments, continued
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and due from banks: The carrying amounts reported in the balance sheet for these items approximate their fair values.
Interest-bearing deposits with banks: Fair values for time deposits are estimated using a discounted cash flow analysis that applies interest rates currently offered on certificates to a schedule of aggregated contractual maturities on such time deposits.
Federal funds sold: The carrying amounts reported in the balance sheet for these items approximate their fair values.
Available for sale, held to maturity and restricted equity securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of restricted equity securities approximate fair values.
Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable. The carrying amount of accrued interest receivable approximates its fair value.
Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits. The carrying amount of accrued interest payable approximates fair value.
Short-term and long-term debt: The carrying amounts of short-term debt approximate their fair values. The fair values for long-term debt are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms.
Other liabilities: For fixed-rate loan commitments, fair value considers the difference between current levels of interest rates and the committed rates. The carrying amounts of other liabilities approximates fair value.
New Accounting Pronouncements
The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of financial information by the Company.
In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in enterprises’ financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on January 1, 2007 and is currently analyzing the effects of the interpretation on its financial position, results of operations and cash flows.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Organization and Summary of Significant Accounting Policies, continued
New Accounting Pronouncements, continued
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This standard does not require any new fair value measurements, but rather eliminated inconsistencies found in various prior pronouncements. SFAS No. 157 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company’s financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115.” This statement permits, but does not require, entities to measure many financial instruments at fair value. The objective is to provide entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Entities electing this option will apply it when the entity first recognizes an eligible instrument and will report unrealized gains and losses on such instruments in current earnings. This statement 1) applies to all entities, 2) specifies certain election dates, 3) can be applied on an instrument-by-instrument basis with some exceptions, 4) is irrevocable and 5) applies only to entire instruments. One exception is demand deposit liabilities, which are explicitly excluded as qualifying for fair value. With respect to SFAS 115, available-for-sale and held-to-maturity securities at the effective date are eligible for the fair value option at that date. If the fair value option is elected for those securities at the effective date, cumulative unrealized gains and losses at that date shall be included in the cumulative-effect adjustment and thereafter, such securities will be accounted for as trading securities. SFAS 159 is effective for the Company on January 1, 2008. Earlier adoption is permitted in 2007 if the Company also elects to apply the provisions of SFAS 157, “Fair Value Measurement.” The Company is currently analyzing the fair value option provided under SFAS 159.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected have a material impact on the Company’s financial position, results of operations and cash flows.
Reclassification
Certain reclassifications have been made to the prior years’ financial statements to place them on a comparable basis with the current year. Net income and stockholders’ equity previously reported were not affected by these reclassifications.
Note 2. Restrictions on Cash and Due from Banks
To comply with banking regulations, the Company is required to maintain certain average cash reserve balances. The daily average cash reserve requirement was approximately $1.0 million for the two-week periods including December 31, 2006 and 2005.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 3. Securities
Debt and equity securities have been classified in the consolidated balance sheets according to management’s intent. The carrying amount of securities and their approximate fair values at December 31 follow:
Restricted equity securities, carried at cost, consist of investments in stock of the Federal Home Loan Bank of Atlanta (“FHLB”) and The Federal Reserve of Richmond (Federal Reserve), which are upstream correspondents of the Bank. The FHLB requires financial institutions to make equity investments in the FHLB in order to borrow from it. The Bank is required to hold that stock so long as it borrows from the FHLB. The Federal Reserve requires banks to purchase stock as a condition of membership in the Federal Reserve system.
Investment securities with amortized cost of approximately $6.0 million and $11.5 million at December 31, 2006 and 2005, respectively, were pledged as collateral on public deposits and for other purposes as required or permitted by law.
Gross realized gains and losses for the years ended December 31 are as follows:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 3. Securities, continued
The scheduled maturities of debt securities available for sale and held to maturity at December 31, 2006, were as follows:
For mortgage-backed securities, the Company reports maturities based on anticipated lives. Actual results may differ due to interest rate fluctuations.
The following table shows the unrealized losses and related fair values in the Company’s held to maturity and available for sale investment securities portfolios. This information is aggregated by investment category and by the length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 and 2005.
Management considers the nature of the investment, the underlying causes of the decline in market or fair value, the severity and duration of the decline and other evidence, on a security-by-security basis, in determining if the decline in fair value is other than temporary.
Management does not believe that the unrealized losses represent other than temporary declines in fair value. The investments are rate sensitive and change in value in direct correlation to changes in interest rates. Management further believes the unrealized losses are not due to credit risk and will be recovered through either accretion of discounts into income or maturity of the bonds at par value.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 4. Loans Receivable
The major components of loans in the Consolidated Balance Sheets are summarized below:
Note 5. Allowance for Loan Losses
Changes in the allowance for loan losses are as follows:
The following is a summary of information pertaining to impaired loans at December 31:
The Company is not committed to advance additional funds in connection with impaired loans.
Nonaccrual loans and loans past due 90 days or more at December 31, 2006, were $657 thousand and zero, respectively. At December 31, 2005, those amounts were zero and $49 thousand, respectively.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 6. Bank Premises and Equipment
Bank premises and equipment included in the Consolidated Balance Sheets are as follows:
The Bank has entered into long-term leases for two of its branch banking facilities under agreements accounted for as operating leases. These leases expire in 2009, including the exercise of renewal options ranging from three to five years. The Bank also entered into a long-term lease for land for one of its branches. The lease has an initial term of ten years, with automatic renewal in ten-year increments terminating in 2046. Rental expense was $59 thousand, $51 thousand and $29 thousand for 2006, 2005 and 2004, respectively. Future minimum lease payments are as follows:
Note 7. Deposits
The composition of deposits is as follows:
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2006 and 2005 was $32.9 million and $23.0 million, respectively. At December 31, 2006, the scheduled maturities of time deposits are as follows:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 8. Borrowings
Short-term debt consists of securities sold under agreements to repurchase, which generally mature within one day of the transaction date. Additional information is summarized below:
The Company has established various credit facilities to provide additional liquidity if and as needed. These include unsecured lines of credit with correspondent banks totaling $19.2 million and a secured line of credit with the Federal Home Loan Bank of Atlanta of approximately $24.0 million. Additional amounts are available from the Federal Home Loan Bank with additional collateral. At December 31, 2006 and 2005, there were no amounts outstanding under these agreements.
Note 9. Employee Benefit Plan
The Bank has a qualified noncontributory, defined benefit pension plan which covers substantially all of its employees. The benefits are primarily based on years of service and earnings. The following is a summary of the plan’s funded status:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 9. Employee Benefit Plan, continued
Estimated future benefit payments, which reflect expected future service, as appropriate, are as follows:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 9. Employee Benefit Plan, continued
The accumulated benefit obligation for the defined benefit pension plan was $2.3 million and $2.2 million at December 31, 2006 and 2005. Contributions are expected to be approximately $175 thousand in 2007. The Company’s defined benefit pension plan’s weighted-average asset allocations at December 31, by asset category are as follows:
The plan sponsor selects the expected long-term rate-of-return-on-assets assumption in consultation with their investment advisors and actuary, and with concurrence from their auditors. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed - especially with respect to real rates of return (net of inflation) - for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience - that may not continue over the measurement period - with higher significance placed on current forecasts of future long-term economic conditions.
Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further - solely for this purpose - the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).
As discussed in Note 1, the Company adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006. SFAS No. 158 requires the Company to recognize the overfunded or underfunded status of its defined benefit retirement plan in its consolidated balance sheet to recognize changes in that funded status in comprehensive income. The adoption of SFAS No. 158 had the following implications on the balance sheet as of December 31, 2006:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 10. Deferred Compensation and Life Insurance
Deferred compensation plans have been adopted for certain members of the Board of Directors for future compensation upon retirement. Under plan provisions aggregate annual payments ranging from $2 thousand to $8 thousand are payable for ten years certain, generally beginning at age 65. Liability accrued for compensation deferred under the plan amounts to $71 thousand and $81 thousand at December 31, 2006 and 2005, respectively.
Charges to income are based on present value of future cash payments, discounted at 8%, and amounted to $7 thousand, $6 thousand and $10 thousand for 2006, 2005 and 2004, respectively.
The Bank is owner and beneficiary of life insurance policies on these directors. Policy cash values, net of policy loans, totaled $94 thousand and $88 thousand at December 31, 2006 and 2005, respectively.
In 2002, the Bank adopted a supplemental executive retirement plan to provide benefits for a member of management. Under plan provisions, aggregate fixed payments of $45 thousand are payable for 20 years certain, beginning in 2007. The liability is calculated by discounting the anticipated future cash flows at 6.10%. The liability accrued for this obligation was $469 thousand and $364 thousand at December 31, 2006 and 2005, respectively. Charges to income are based on changes in the cash value of insurance which funds the liability.
Note 11. Fair Value of Financial Instruments
The estimated fair values of the Company’s financial instruments are as follows:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 12. Income Taxes
The components of income tax expense (benefit) are as follows:
A reconciliation of the expected income tax expense computed by applying the federal statutory rate of 34% to income included in the consolidated statements of income follows:
The tax effects of temporary timing differences that give rise to significant portions of the net deferred tax assets and deferred tax liabilities are presented below:
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 13. Commitments and Contingencies
Litigation
The Company was named as a defendant in a complaint filed by a former employee with the United States Department of Labor under Section 806 of the Sarbanes-Oxley Act. The plaintiff alleged in his complaint that his termination in October, 2002 violated the Act. He is seeking reinstatement, back pay and damages. The Company maintains that the independent members of its Board of Directors terminated the plaintiff lawfully because he refused to comply with the directives of the Audit Committee in their attempt to look into certain matters raised by the plaintiff. The Audit Committee, after full investigation, later concluded that the matters raised by the plaintiff had no merit. The Board’s decision was initially upheld by the Department of Labor. The plaintiff appealed that decision. The Department of Labor Administrative Law Judge reversed the earlier decision in the Company’s favor and entered a decision in favor of the plaintiff in January 2004. The Company appealed that decision. The Administrative Review Board of the Department of Labor agreed to review the decision of the Administrative Law Judge in February 2004. Their decision to review suspended the decision of the Administrative Law Judge prior to any determination of damages by the Administrative Law Judge. In May 2004, the Administrative Review Board within the Department of Labor determined that it had accepted the Company’s petition for review prematurely.
Because of the uncertainty regarding the procedural handling of this case within the DOL, to preserve its ultimate ability to appeal to the Federal Courts, in June 2004, the Company filed with the United States Court of Appeals for the Fourth Circuit a Petition for Review of the decisions of the United States Department of Labor. The appeal was determined to be premature. The parties submitted evidence to the Administrative Law Judge of damages without a further hearing in December 2004 and January 2005. The Administrative Law Judge rendered a Supplemental Recommended Decision and Order in February 2005, which awarded damages to the plaintiff of $65 thousand, plus attorney’s fees of $108 thousand, and ordered the plaintiff’s reinstatement. The Company filed a petition for review to the Administrative Review Board of the Department of Labor. The case was accepted for review by the Administrative Review Board in March 2005. The Company’s management believes it has substantial grounds for a successful appeal of the decision in the plaintiff’s favor and will pursue appeals vigorously. Both sides have submitted briefs to the Administrative Review Board and are awaiting the Administrative Review Board’s decision.
Meanwhile plaintiff made several unsuccessful attempts to force his reinstatement to the Company. He moved the Administrative Law Judge for sanctions against the Company for failure to reinstate him. The motion was denied on August 9, 2005. On August 30, 2005 plaintiff filed a complaint in the United States District Court for the Western District of Virginia seeking to enforce what he claimed was a preliminary order of reinstatement issued by the Administrative Law Judge. The Court granted the Company’s motion to dismiss January 14, 2006, on the grounds that there is no preliminary order of reinstatement to enforce. Plaintiff then filed two motions simultaneously, one to the Administrative Law Judge seeking “expedited clarification” of the purported order of reinstatement and another to the U.S. District Court to alter or amend its dismissal of his petition. Both of plaintiff’s motions were denied, on January 24 and January 26, respectively.
Then, on February 8, 2006, the plaintiff made a motion to the Administrative Review Board for “expedited declaration” of preliminary order of reinstatement. This motion was granted by the ARB on March 31, 2006, essentially concluding that notwithstanding the District Court’s decision the Administrative Law Judge had issued a preliminary reinstatement order. On April 17, 2006, the Company filed a motion with the Department of Labor Administrative Review Board seeking a stay of the preliminary order of reinstatement. This motion was denied on June 9, 2006, leaving the preliminary order of reinstatement in effect.
On July 6, 2006, plaintiff filed another Petition to enforce the Department of Labor’s preliminary order of reinstatement with the United States District Court in Roanoke, Virginia. The Company moved to dismiss the petition on the basis that the Sarbanes-Oxley statute does not give the District Court jurisdiction to enforce a Department of Labor Preliminary Order of reinstatement. The Department of Labor intervened to support the plaintiff’s petition. Each of the Company’s directors intervened as individuals to oppose reinstatement. The American Association of Bank Directors similarly intervened in support of the Company and the Company’s Directors and to oppose enforcement of the Order of Reinstatement.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 13. Commitments and Contingencies, continued
Litigation, continued
On October 5, 2006, the District Court granted Cardinal’s motion to dismiss, concluding that the Court did not have jurisdiction to enforce a Department of Labor Preliminary Order of Reinstatement.
On December 4, 2006, the plaintiff and the United States Department of Labor appealed the District Court’s dismissal to the United States Court of Appeals for the Fourth Circuit. The appeal is pending.
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets.
The Company’s exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of commitments at December 31 is as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis.
The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Company deems necessary.
Concentrations of Credit Risk
The majority of the Company’s loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area. The majority of such customers are depositors of the Bank. Investments in state and municipal securities involve governmental entities within and outside the Company’s market area. The concentrations of credit by type of loan are set forth in the Loans Receivable note. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Standby letters of credit are granted primarily to commercial borrowers. The Company, as a matter of policy, does not extend credit to any single borrower or group of related borrowers in excess of approximately $2.7 million.
Although the Company has a reasonably diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in and around Floyd, Carroll, Montgomery, and Roanoke Counties and the Cities of Roanoke and Salem, Virginia. A significant amount of the real estate loans set forth in the Loans Receivable note are secured by commercial real estate. The Company has a loan concentration relating to nonresidential buildings and real estate land developers. Total loans to this group amounted to approximately $33.1 million at December 31, 2006 and approximately $38.8 million at December 31, 2005.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 13. Commitments and Contingencies, continued
Concentrations of Credit Risk, continued
The Company has cash and cash equivalents on deposit with financial institutions which exceed federally insured limits.
Note 14. Regulatory Matters
Dividends
The Company’s dividend payments are made from dividends received from the Bank. The Bank, as a Virginia banking corporation, may pay dividends only out of its retained earnings. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure financial soundness of the Bank.
Intercompany Transactions
The Bank’s legal lending limit on loans to the Company are governed by Federal Reserve Act 23A, and differ from legal lending limits on loans to external customers. Generally, a bank may lend up to 10% of its capital and surplus to its Parent, if the loan is secured. If collateral is in the form of stocks, bonds, debentures or similar obligations, it must have a market value when the loan is made of at least 20% more than the amount of the loan, and if obligations of a state or political subdivision or agency thereof, it must have a market value of at least 10% more than the amount of the loan. If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers’ acceptances eligible for rediscount or purchase by a Federal Reserve Bank, requirements for collateral in excess of the loan amount do not apply. Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $1.9 million at December 31, 2006. At December 31, 2006, the Company had an outstanding loan payable to the Bank of $1.6 million.
Capital Requirement
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2006 and 2005, that the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2006, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 14. Regulatory Matters, continued
Capital Requirements, continued
The Company and the Bank’s actual capital amounts and ratios are also presented in the following table.
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 15. Transactions with Related Parties
The Company has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.
Aggregate loan transactions with related parties were as follows:
Note 16. Parent Company Financial Information
Condensed financial information of Cardinal Bankshares Corporation is presented as follows:
Balance Sheets
Cardinal Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Note 16. Parent Company Financial Information, continued
Statements of Income
Statements of Cash Flows
Management’s Discussion and Analysis
Overview
Management’s Discussion and Analysis is provided to assist in the understanding and evaluation of Cardinal Bankshares Corporation’s financial condition and its results of operations. The following discussion should be read in conjunction with the Corporation’s consolidated financial statements. Certain previously reported amounts have been reclassified to conform to current presentations.
Cardinal Bankshares Corporation, the parent company of Bank of Floyd, currently operates seven offices in Floyd, Montgomery, Roanoke and Carroll Counties of Virginia. The main office is in Floyd with a limited service office in Willis. The Roanoke offices are in the Cave Spring and Tanglewood Mall areas of Roanoke County. The West Salem office is located on West Main Street in Salem, Virginia. The Hillsville office is located in Carroll County on Route 52 in Hillsville, Virginia. Montgomery County is served by the branch in Christiansburg, Virginia. The bank plans to open its eighth branch in the Spring of 2007 in the Fairlawn community of Pulaski County, Virginia.
The individual market conditions of each county vary from rural to urban with Floyd County being the most rural and Roanoke the most urban. Each has its own growth pattern which varies in intensity. Bank of Floyd and bank personnel work with local, state and federal government leaders in an effort to attract business and industry to Floyd County.
Cardinal Bankshares reported net income for the year 2006 of $2.5 million slightly higher than the $2.2 million reported in 2005. Net income per diluted share was $1.63, $.19 higher than the $1.44 reported for the prior year.
Net interest income, on a taxable equivalent basis, was $7.9 million, higher by $400 thousand from $7.5 million in 2005. This increase was driven primarily by the 154 basis point increase in average rates earned on the Company’s deposits in other banks. Noninterest income increased by 21.7% to $924 thousand for 2006 compared to $759 thousand for 2005. Noninterest expense remained level at $5.0 million compared to $5.1 million at 2005.
Earning assets averaged $179.7 million, compared to $177.4 million in 2005, the increase driven primarily by an overall increase in deposits in other banks of $6.8 million. Average securities declined $627 thousand in 2006, due largely to issuer calls of U.S. Government Agency securities and paydowns on mortgage-backed securities. The federal funds sold average balance increased $400 thousand in 2006. Average loans decreased $4.4 million.
Interest-bearing liabilities averaged $137.1 million, level with 2005. Savings deposits reflected an average decrease of $4.9 million from 2005, while average time deposits and average large denomination deposits increased $2.5 million and $4.7 million, respectively.
Stockholders’ equity grew 5.5% to an average of $28.1 million in 2006 from $26.7 million in 2005. The return on average assets and average equity increased to 1.30% and 8.92%, respectively for 2006 compared to 1.15% and 8.26%, respectively, for 2005. Book value per share was $18.49 at December 31, 2006, compared to $17.62 at year-end 2005, representing an increase of 4.9%.
Management’s Discussion and Analysis
Table 1. Average Balances and Interest Rates (Taxable Equivalent Basis)
(1) Net interest spread is the difference between the average interest rate received on earning assets and the average interest rate paid for interest-bearing liabilities.
(2) Net interest margin is calculated by dividing taxable equivalent net interest earnings by total average earning assets.
(3) Average loan balances include nonaccrual loans.
(4) Interest income includes deferred loan fees.
Management’s Discussion and Analysis
Net Interest Income
Net interest income, the primary source of the Company’s earnings, is the amount by which interest and fee income generated by earning assets exceeds the interest paid on interest-bearing liabilities. Earning assets are comprised of loans, securities, federal funds sold and interest-bearing deposits in other banks. Interest-bearing liabilities consist of deposits, federal funds purchased and securities sold under agreements to repurchase. The volume and the general level of interest rates among earning assets and interest-bearing liabilities effect net interest income. Table 1 shows the average balance sheets for each of the years ended December 31, 2006, 2005 and 2004. In addition, the amounts of interest earned on earning assets, with related yields, and the interest paid on interest-bearing liabilities, together with rates, are shown. Loans placed on a nonaccrual status are included in the balances and were included in the computation of yields, upon which they had an immaterial effect. Interest on earning assets is on a taxable equivalent basis, which is computed using the federal corporate income tax rate of 34% for all three years.
Net interest income, on a taxable equivalent basis, was $7.9 million, an increase of 5.8%, or $432 thousand from the $7.5 million in 2005. The net interest margin was 4.41% for 2006, up 19 basis points from the 4.22% reported in 2005.
As illustrated in Table 2, the effect of increased rates affecting the Company’s loan portfolio is evident in the $1.1 million increase in loan interest income due to rates. The net increase in interest earning deposits volume added an additional $234 thousand in income.
During 2006, average interest earning deposits held at correspondent banks increased by $6.8 million to $11.8 million due mainly to the Company’s decrease in loan volume. Total average interest bearing liabilities remained level at $137.1 million for the year 2006.
Management’s Discussion and Analysis
Table 2. Rate/Volume Variance Analysis
Provision for Loan Losses
The allowance for loan losses represents the amount available for credit losses inherent in the Company’s loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. Management determines the provision for loan losses required to maintain an allowance adequate to provide for any potential losses. The factors considered in making this decision are the collectibility of past due loans, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of underlying collateral and general economic trends. In 2006, the provision for loan losses was $208 thousand, an increase of $160 thousand from the $48 thousand recorded in 2005. Based upon management’s periodic reviews of the loan portfolio using the previously mentioned factors, the current year increase in the provision for loan losses was felt appropriate. Management believes the provision recorded in 2006 maintains the allowance at a level adequate to cover potential losses. The allowance for loan losses as a percentage of total loans was 1.33% at year-end. This level is comparable to the 1.25% ratio averaged at year-end 2006 by the Company’s peer group, commercial banks with assets ranging between $100 million and $300 million. Loan recoveries, net of charge offs, were $5 thousand for 2006, compared to net charge offs of $252 thousand for 2005. Management does not anticipate any material changes in the delinquency rates or charge-offs and recoveries in connection with its normal lending activities.
Additional information regarding the Company’s allowance for loan losses is contained in Tables 12, 13 and 14, and in the discussion concerning Nonperforming and Problem Assets.
Noninterest Income
Noninterest income consists of revenues generated from a number of different financial services and activities. Service charges on deposit accounts including charges for insufficient funds items and fees charged for nondeposit services make up the majority of noninterest income. Noninterest income also includes fees charged for services such as safe deposit box rentals, letters of credit, and gains realized on the sale of securities. Noninterest income totaled $924 thousand in 2006, an increase of $165 thousand over the $759 thousand recorded in 2005. The largest increase in noninterest income resulted from an increase in other income. The primary sources of noninterest income for the past three years are summarized in Table 3.
Management’s Discussion and Analysis
Table 3. Noninterest Income
Noninterest Expense
Noninterest expense was $5.0 million for 2006, a decrease of $100 thousand from the $5.1 million recorded in 2005. Occupancy and equipment expenses accounted for most of the decrease.
Table 4 provides a further breakdown of noninterest expense for the past three years.
Table 4. Noninterest Expense
Income Taxes
Income tax expense is based on amounts reported in the statements of income, after adjustments for non-taxable income and non-deductible expenses, and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The deferred tax assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.
Income tax expense, substantially all Federal, was $763 thousand in 2006, $596 thousand in 2005 and $627 thousand in 2004 representing 23.3%, 21.3% and 21.9% of income before income taxes, respectively. Cardinal Bankshares’ deferred income tax benefits and liabilities result primarily from temporary differences in provisions for credit losses, valuation reserves, depreciation, deferred compensation, deferred income, pension expense and investment security discount accretion.
Net deferred income tax benefits of approximately $973 thousand and $643 thousand at December 31, 2006 and 2005, respectively, are included in other assets.
Management’s Discussion and Analysis
Earning Assets
In 2006, average earning assets increased to $179.7 million, $2.3 million higher than the 2005 average of $177.4 million. Total average earning assets represented 92.8% of total average assets in 2006. Average investment securities accounted for 19.4% of total average assets, while average loans remained the largest component of earning assets, accounting for 64.7% of total average assets in 2006, down slightly from the 67.8% level reported in 2005. A summary of average assets for the past three years is shown below in Table 5.
Table 5. Average Asset Mix
Loans
Average total loans were $125.3 million for 2006, a decrease of $4.4 million, or 3.4% from 2005. At December 31, 2006, the actual balance of loans secured by real estate represented the most significant portion of the loan portfolio at 90.6%. Total loans secured by 1-4 family residential properties represented 19.1% of total loans at the end of 2006, while nonfarm/nonresidential properties made up 58.3% of total loans. These loan portfolio proportions remained relatively unchanged from year-end 2005 levels.
Loan growth will continue to be a point of focus at Cardinal for 2007. The long-range strategic objective for meeting the Company’s loan growth aspirations will be achieved through continued hiring of additional loan officers, community involvement, expansion of the Company’s market footprint, broadening of the present array of loan products offered to include conforming fixed-rate mortgage loans, home equity lines of credit and SBA loans, and management’s strengthened efforts in offering small business financing and competively-priced products. Prudent business practices and stringent internal guidelines will continue to be followed in making lending decisions in order to balance the emphasis on loan growth with the desire to minimize exposure to loan losses.
Bank of Floyd makes both consumer and commercial loans to all neighborhoods within its market area, including the low-income and moderate-income areas. The Company’s market area is generally defined as the areas within the Virginia Counties of Floyd, Roanoke, Montgomery and Carroll, and the Cities of Roanoke, Salem and Christiansburg, Virginia. The Bank places emphasis on consumer based installment loans and commercial loans to small and medium sized businesses. Below market pricing and competition from unregulated organizations have also been a factor when generating new loans. The amounts of loans outstanding by type at year-end 2006 and 2005, and the maturity distribution of variable and fixed rate loans as of year-end 2006 are presented below in Table 6 and Table 7, respectively.
Management’s Discussion and Analysis
Table 6. Loan Portfolio Summary
Table 7. Loan Maturity Schedule
Management’s Discussion and Analysis
Investment Securities
The investment securities portfolio is managed to optimize the yield on excess funds while providing liquidity for unexpected deposit decreases or increased loan generation and diversification in the overall asset management of the Company. At December 31, 2006, the Company had $23.6 million in securities available for sale, compared to $19.3 million at year-end 2005. The average yield on taxable investment securities increased from 4.24% in 2005 to 4.63% in 2006 as a result of higher yielding securities, rising market rates of interest and increased volume.
Management of the investment portfolio has always been conservative with virtually all investments taking the form of purchases of U.S. Treasury, Government Sponsored Enterprises, Mortgage Backed Securities and issuances of State and local bond issues. All securities are high quality and high grade. Management views the investment portfolio as a source of income, and generally purchases securities with the intent of retaining them until maturity. However, adjustments in the portfolio are necessary from time to time to provide a source of liquidity to meet funding requirements for loan demand, deposit fluctuations and to manage interest rate risk. Accordingly, to meet such objectives, management may sell certain securities prior to their scheduled maturity. Table 8 presents the investment portfolio at the end of 2006 by major types of investments and maturity ranges. Actual maturities may differ from scheduled maturities in mortgage backed securities because the mortgages underlying the securities may be called or repaid prior to the scheduled maturity date. Maturities on all other securities are based on the earlier of the contractual maturity or the call date, if any.
At December 31, 2006, the market value of the investment portfolio was $41.1 million, representing a $149 thousand unrealized appreciation above amortized cost. This compared to a market value of $37.1 million and a $187 thousand unrealized appreciation above amortized cost a year earlier.
Table 8. Investment Securities
Management’s Discussion and Analysis
Deposits
Cardinal Bankshares relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid assets. More specifically, core deposits (total deposits less certificates of deposits in denominations of $100,000 or more) are the primary funding source. The Company’s balance sheet growth is largely determined by the availability of deposits in the markets it serves, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios. The sustained low interest rate environment and other market conditions have resulted in depositors shopping for deposit rates more than in the past. Increased customer awareness of interest rates has added to the importance of effective interest rate management. Accordingly, management must continuously monitor market pricing, competitors’ rates, and internal interest rate spreads to continue the Company’s growth and improve profitability. Cardinal Bankshares’ interest rate management goals include structuring rates in a manner that can promote both deposit and asset growth while increasing overall profitability of the Company.
Average total deposits for the year ended December 31, 2006 increased $1.9 million to $164.0 million compared to 2005. As shown in Table 9, the Company’s average interest-bearing deposits as a percent of total average deposits decreased to 83.5% in 2006, compared to 83.9% in 2005. Average noninterest-bearing demand deposits increased to $27.0 million in 2006 from $26.2 million in 2005. Average deposits for the past three years are summarized in Table 9 below.
Table 9. Deposit Mix
The average balance of certificates of deposit issued in denominations of $100,000 or more increased by approximately $4.7 million in 2006. Table 10 provides maturity information relating to Certificates of Deposit of $100,000 or more at December 31, 2006.
Table 10. Large Denomination Deposits $100,000 and Over
Analysis of time deposits of $100,000 or more at December 31, 2006 (In thousands):
Management’s Discussion and Analysis
Capital Adequacy
The Company’s capital serves to support asset growth and provide protection against loss to depositors and creditors. Cardinal Bankshares strives to maintain an optimum level of capital, commensurate with its risk profile, on which an attractive return to stockholders can be realized over both the near and long term, while serving depositors’, creditors’ and regulatory needs.
Common stock and capital surplus represents the stockholders’ investment in the Company and is a key source of capital. The largest component of capital for the Company is earnings retained after payment of dividends to stockholders. Total stockholders’ equity was $28.4 million at December 31, 2006, an increase of $1.3 million or 4.9% compared with $27.1 million for the same period in 2005.
The FDIC has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0% of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. Cardinal Bankshares had a ratio of total capital to risk-weighted assets of 21.71% at December 31, 2006 and a ratio of Tier 1 capital to risk-weighted assets of 20.54%. Both of these ratios well exceed the capital requirements adopted by the federal regulatory agencies and continue to be equal to or above most of our peer group.
In addition, a minimum leverage ratio of Tier I capital to average total assets for the previous quarter is required by federal bank regulators, ranging from 3% to 5%, subject to the regulator’s evaluation of the Company’s overall safety and soundness. As of December 31, 2006, Cardinal Bankshares had a ratio of year-end Tier I capital to average total assets, as defined, of 14.23%.
Table 11 below sets forth summary information with respect to the capital ratios for Cardinal and the Bank at December 31, 2006. All capital ratio levels indicate that Cardinal Bankshares and Bank of Floyd are well capitalized.
Table 11. Year-end Risk-based Capital
* Tier I capital divided by average total assets for the quarter ended December 31.
Management’s Discussion and Analysis
Nonperforming and Problem Assets
Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and strives to manage them effectively. The Bank seeks to use shorter-term loans and, although a portion of the loans may be made based upon the value of collateral, it relies primarily on the cash flow of the borrower as the source of repayment rather than the value of the collateral.
The Bank also manages its repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow-up on exceptions to credit policies.
Nonperforming assets, as shown in Table 12 below, increased to $869 thousand at December 31, 2006 from $467 thousand at December 31, 2005. The nonaccrual loan at the end of 2006 is a non-farm, non-residential property loan that has been in the portfolio since 2003. The loan has had periods of delinquencies and non-satisfactory performance, however, weekly payments have been made on the loan since August 2006. At year-end 2006, loans past due 90 days or more and still accruing had decreased to zero from $49 thousand a year earlier. Foreclosed assets decreased to $212 thousand from $418 thousand a year earlier. Foreclosed assets at the end of 2006 consisted of commercial property listed with an agent to be sold. Management does not intend to retain the property.
Table 12. Nonperforming Assets
Analysis of the Allowance for Loan Losses
The allowance for loan losses represents the amount available for credit losses inherent in the Company’s loan portfolio. The Company performs periodic systematic reviews of its portfolio to identify these inherent losses, and to assess the overall probability of collection of the portfolio. These reviews result in the identification and quantification of loss factors, which are used in determining the amount of the allowance for loan losses. In addition, the Company also evaluates the prevailing economic and business conditions affecting individual borrowers, changes in the size and characteristics of the loan portfolio and other pertinent factors. The allowance is also subject to annual review by external auditors and regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance, and the size of the allowance in comparison to peer companies identified by regulatory agencies. The most recent regulatory reviews were completed in March 2005 and July 2006.
The Company is committed to the early recognition of problem loans and to a conservative allowance. The Company believes the current allowance is adequate to cover inherent losses in the loan portfolio. However, the allowance may be increased or decreased in the future based upon management’s assessment of the factors outlined above. The allowance for loan losses was $1.6 million at December 31, 2006 and $1.4 million at December 31, 2005. The allowance as a percentage of period end loans was 1.33% at year-end 2006 and 1.10% at year-end 2005.
The provision for loan losses for the year ended December 31, 2006 was $208 thousand, an increase of $160 thousand from the previous year. Based upon management’s periodic reviews of the loan portfolio using the previously mentioned factors, the current year decrease in the provision was considered appropriate. Management believes the provision recorded in 2006 maintains the allowance at a level adequate to cover potential losses.
The provision for loan losses, net charge-offs and the activity in the allowance for loan losses is detailed in Table 13.
Management’s Discussion and Analysis
Table 13. Loan Losses
The Company has allocated the allowance for loan losses based on estimates of the allowance needed for each component of the loan portfolio. The allocation of the allowance as shown in Table 14 below should not be interpreted as an indication that loan losses in future years will occur in the same proportions or that the allocation indicates future loan loss trends. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since the total allowance is a general allowance applicable to the entire portfolio.
Table 14. Allocation of the Allowance for Loan Losses
(1)
Represents the percentage of loans in each category to the total loans outstanding.
Liquidity and Interest Rate Sensitivity
The principal goals of the Company’s asset and liability management strategy are the maintenance of adequate liquidity and the management of interest rate risk. Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss. Interest rate risk management seeks to balance the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Company from wide fluctuations in its net interest income.
Management’s Discussion and Analysis
Management must insure that adequate funds are available at all times to meet the needs of its customers. On the asset side of the balance sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity. On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates, federal funds lines from correspondent banks, borrowings from the Federal Reserve Bank and the Federal Home Loan Bank, as well as the ability to generate funds through the issuance of long-term debt and equity.
The liquidity ratio, the level of liquid assets divided by total deposits plus short-term liabilities, is considered to be adequate by management.
Table 15. Interest Rate Sensitivity
Interest rate risk is the effect that changes in interest rates would have on interest income and interest expense as interest-sensitive assets and interest-sensitive liabilities either reprice or mature. Management attempts to maintain the portfolios of earning assets and interest-bearing liabilities with maturities or repricing opportunities at levels that will afford protection from erosion of net interest margin, to the extent practical, from changes in interest rates. Table 15 above shows the sensitivity of the Company’s balance sheet on December 31, 2006. This table reflects the sensitivity of the balance sheet as of that specific date and is not necessarily indicative of the position on other dates. At December 31, 2006, the Company appeared to be liability-sensitive with interest-bearing liabilities exceeding earning assets, subject to changes in interest rates, for the first five years, excluding the first three months. The balance in interest-bearing deposits in banks puts the Company in an asset-sensitive position for the first three months. The Company also appears to be asset-sensitive after the first five years.
Matching sensitive positions alone does not ensure that Cardinal has no interest rate risk. The repricing characteristics of assets are different from the repricing characteristics of funding sources. Thus, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.
Management’s Discussion and Analysis
Earnings and Balance Sheet Analysis
2005 Compared to 2004 - Net interest income, on a taxable equivalent basis, was $7.5 million, higher by $400 thousand from $7.1 million in 2004. This increase was driven primarily by the 17 basis point increase in average rates earned on the Company’s loan portfolio. Noninterest income declined by 1.3% to $759 thousand for 2005 compared to $769 thousand for 2004 primarily due to lower service charges on deposits and other noninterest income. Noninterest expense increased by 10.0% to $5.1 million compared to $4.6 million in 2004.
Earning assets averaged $177.4 million, compared to $173.9 million in 2004, the increase driven primarily by an overall increase in average loans of 6.5%. Average securities declined $3.4 million in 2005, due largely to issuer calls of U.S. Government Agency securities and paydowns on mortgage-backed securities. The federal funds sold average balance decreased $3.8 million in 2005.
Interest-bearing liabilities averaged $137.1 million, up approximately $2.4 million from 2004. Savings deposits reflected an average decrease of $4.8 million from 2004, while average time deposits and average large denomination deposits increased $5.6 million and $3.2 million, respectively.
Stockholders’ equity grew 5.1% to an average of $26.7 million in 2005 from $25.4 million in 2004. The return on average assets and average equity decreased to 1.15% and 8.26%, respectively for 2005 compared to 1.21% and 8.84%, respectively, for 2004. Book value per share was $17.62 at December 31, 2005, compared to $16.83 at year-end 2004, representing an increase of 4.7%.
The allowance for loan losses at December 31, 2005 was $1.4 million compared to $1.6 million a year earlier. The allowance for loan losses as a percentage of period end loans was 1.10% compared to 1.31% at year-end 2004. The Company had charge-offs, net of recoveries, in the amount of $252 thousand for 2005. This compared to net charge offs of $121 thousand for 2004. Nonperforming loans totaled $49 thousand at December 31, 2005, a decrease of $366 thousand from 2004.
A Warning About Forward-Looking Statements
This annual report contains forward-looking statements. The Company may also make written forward-looking statements in periodic reports to the Securities and Exchange Commission, proxy statements, offering circulars and prospectuses, press releases and other written materials and oral statements made by Cardinal Bankshares’ officers, directors or employees to third parties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward-looking statements. These statements are based on beliefs and assumptions of the Company’s management, and on information currently available to such management. Forward-looking statements include statements preceded by, followed by or that include the words “believes,” “expects,” “estimates,” “anticipates,” “plans,” or similar expressions. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update publicly any of them in light of new information or future events.
Management’s Discussion and Analysis
A Warning About Forward-Looking Statements, continued
Forward-looking statements involve inherent risks and uncertainties. Management cautions the readers that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, but are not limited to, the following: competitive pressures among depository and other financial institutions may increase significantly; changes in the interest rate environment may reduce margins; general economic or business conditions may lead to a deterioration in credit quality or a reduced demand for credit; legislative or regulatory changes, including changes in accounting standards, may adversely affect the business in which Cardinal Bankshares is engaged; changes may occur in the securities markets; and competitors of the Company may have greater financial resources and develop products that enable such competitors to compete more successfully than Cardinal Bankshares.
Other factors that may cause actual results to differ from the forward-looking statements include the following: the timely development of competitive new products and services by the Company and the acceptance of such products and services by customers; changes in consumer spending and savings habits; the effects of competitors’ pricing policies; the Company’s success in managing the costs associated with the expansion of existing distribution channels and developing new ones, and in realizing increased revenues from such distribution channels, including cross-selling initiatives; and mergers and acquisitions and their integration into the Company and management’s ability to manage these other risks.
Management of Cardinal Bankshares believes these forward-looking statements are reasonable; however undue reliance should not be placed on such forward-looking statements, which are based on current expectations.
Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. The future results and stockholder values of Cardinal Bankshares may differ materially from those expressed in forward-looking statements contained in this report. Many of the factors that will determine these results and values are beyond the Company’s ability to control or predict.