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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

 

Commission file number: 0-20293

 


 

UNION BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 


 

VIRGINIA   54-1598552

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employee

Identification No.)

 

212 North Main Street, P.O. Box 446, Bowling Green, Virginia 22427

(Address or principal executive offices) (Zip code)

 

(804) 633-5031

(Registrant’s telephone number including area code)

 


 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $2 par value

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b – 2 of the Act).    Yes  x    No  ¨

 

The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2004 was approximately $251,418,890.

 

The number of shares of common stock outstanding as of February 18, 2005 was 8,744,446.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement to be used in conjunction with the registrant’s 2005 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 



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UNION BANKSHARES CORPORATION

FORM 10-K

INDEX

 

PART I

 

         Page

Item 1.

 

Business

   1

Item 2.

 

Properties

   7

Item 3.

 

Legal Proceedings

   8

Item 4.

 

Submission of Matters to a Vote of Security Holders

   8
PART II

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   9

Item 6.

 

Selected Financial Data

   10

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   11

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

   30

Item 8.

 

Financial Statements and Supplementary Data

   31

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   63

Item 9A.

 

Controls and Procedures

   63

Item 9B.

 

Other Information

   63
PART III

Item 10.

 

Directors and Executive Officers of the Registrant

   64

Item 11.

 

Executive Compensation

   64

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management

   64

Item 13.

 

Certain Relationships and Related Transactions

   64

Item 14.

 

Principal Accounting Fees and Services

   64
PART IV

Item 15.

 

Exhibits and Financial Statement Schedules

   65

 

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PART I

 

Item 1. - Business

 

GENERAL

 

Union Bankshares Corporation (the “Company” or “Union”) is a multi-bank holding company organized under Virginia law and registered under the Bank Holding Company Act of 1956. The Company is headquartered in Bowling Green, Virginia. The Company is committed to the delivery of financial services through its four community bank subsidiaries (the “Community Banks”) and three non-bank financial services affiliates:

 

Community Banks    
      

Union Bank & Trust Company

 

Bowling Green, Virginia

      

Northern Neck State Bank

 

Warsaw, Virginia

      

Rappahannock National Bank

 

Washington, Virginia

      

Bank of Williamsburg

 

Williamsburg, Virginia

Financial Services Affiliates    
      

Mortgage Capital Investors, Inc.

 

Springfield, Virginia

      

Union Investment Services, Inc.

 

Bowling Green, Virginia

      

Union Insurance Group, LLC

 

Bowling Green, Virginia

 

The Company was formed in connection with the July 1993 merger of Northern Neck Bankshares Corporation and Union Bancorp, Inc. and their bank subsidiaries Union Bank & Trust Company and Northern Neck State Bank into Union Bankshares Corporation. Although Union Bankshares was founded in 1993, its subsidiary banks are among the oldest in Virginia. Union Bank and Trust and Rappahannock National Bank began business in 1902 and Northern Neck State Bank dates back to 1907. On September 1, 1996, King George State Bank and on July 1, 1998, Rappahannock National Bank became wholly-owned subsidiaries of the Company. On February 22, 1999, the Bank of Williamsburg began business as a newly organized bank. In June 1999, after the retirement of its president, King George State Bank was merged into Union Bank & Trust Company (“Union Bank”) and ceased to be a subsidiary bank. The Company acquired Guaranty Financial Corporation and its wholly owned subsidiary, Guaranty Bank (“Guaranty”) on May 1, 2004 which it operated as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank and Trust Company.

 

Each of the Community Banks is a full service retail commercial bank offering consumers and businesses a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, and loans for commercial, industrial, residential mortgage and consumer purposes. The Community Banks also issue credit cards and deliver automated teller machine services through the use of reciprocally shared ATMs in the major ATM networks. All of the Community Banks offer Internet banking access for banking services and online bill payment for both consumers and commercial companies.

 

Union Bankshares is one of the largest community banking organizations based in Virginia, providing full service banking to the Central, Rappahannock, Williamsburg and Northern Neck regions of Virginia through 44 locations of its bank subsidiaries, Union Bank & Trust (31 locations in the counties of Albemarle, Caroline, Chesterfield, Fluvanna, Hanover, Henrico, King George, King William, Nelson, Spotsylvania, Stafford, Westmoreland and the Cities of Charlottesville and Fredericksburg), Northern Neck State Bank (9 locations in the counties of Essex, Lancaster, Northumberland, Richmond and Westmoreland), Rappahannock National Bank in Washington, Virginia and Bank of Williamsburg ( 2 locations in Williamsburg and 1 in Newport News). Union Bank & Trust also operates a loan production office in Manassas. The Company provides other financial services through its non-banking affiliates, Union Investment Services, Inc., Mortgage Capital Investors, Inc. and Union Insurance Group, LLC. The Bank of Williamsburg also owns a non-controlling interest in Johnson Mortgage Company, LLC.


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Union Investment Services has provided securities, brokerage and investment advisory services since its formation in February 1993. It is a full service investment company handling all aspects of wealth management including stocks, bonds, annuities, mutual funds and financial planning.

 

On February 11, 1999, the Company acquired CMK Corporation t/a “Mortgage Capital Investors,” a mortgage loan brokerage company headquartered in Springfield, Virginia, by merger of CMK Corporation into Mortgage Capital Investors, Inc., a wholly owned subsidiary of Union Bank (“MCII”). MCII has nine offices located in Virginia (5) and Maryland (3) and South Carolina (1), and is also licensed to do business in Washington, D.C. MCII provides a variety of mortgage products to customers in those states. The mortgage loans originated by MCII are generally sold in the secondary market through purchase agreements with institutional investors.

 

On August 31, 2003, the Company formed Union Insurance Group, LLC (“UIG”) an insurance agency in which each of the subsidiary banks owns a proportionate stake based on asset size. This agency operates in a joint venture with Bankers Insurance, LLC, a large insurance agency owned by community banks across Virginia and managed by the Virginia Bankers Association. UIG generates revenue through sales of various insurance products, including long term care insurance and business owner policies.

 

Union Bankshares Corporation had assets of $1.7 billion, deposits of $1.3 billion and stockholders’ equity of $162.8 million at December 31, 2004. The Community Banks range in asset size from $57.3 million to $1.2 billion at December 31, 2004.

 

SEGMENTS

 

The Company has two reportable segments: traditional full service community banks and a mortgage loan origination business, each as described above. See Note 18 in the Notes to Consolidated Financial Statements contained in Item 8, Financial Statement and Supplementary Data, of this Form 10-K and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this Form 10-K, for certain financial and other information about each of the Company’s operating segments.

 

ACQUISITION PROGRAM

 

The Company expands its market area and increases its market share through internal growth, de novo expansion and strategic acquisitions. Strategic acquisitions by the Company to date have included whole bank acquisitions and financial affiliations, as well as branch and deposit acquisitions and purchases of former bank branch facilities. The Company generally considers acquisitions of companies in strong growth markets or with unique products or services that might benefit the entire organization. Targeted acquisitions are priced to be economically feasible with minimal short term drag to achieve positive long term benefits. These acquisitions may be paid for in the form of cash, stock or a combination thereof. The amount and type of consideration and deal charges paid could have a dilutive effect on the Company earnings per share or book value, however cost savings and revenue enhancements are also anticipated to provide long term economic benefit to the Company.

 

During 2004, Union Bank opened five branches in the greater Richmond market. These branches compliment the existing operations of Union Bank and Trust in the Richmond area and further its expansion in the Richmond market. The Company acquired Guaranty on May 1, 2004 which it operated as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank and Trust Company.

 

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EMPLOYEES

 

As of December 31, 2004, the Company had 566 full-time equivalent employees, including executive officers, loan and other banking officers, branch personnel, operations personnel and other support personnel. None of the Company’s employees is represented by a union or covered under a collective bargaining agreement. Management of the Company considers their employee relations to be excellent.

 

COMPETITION

 

The financial services industry remains highly competitive and constantly evolving. The Company experiences strong competition in all aspects of its business. In its market areas, the Company competes with large national and regional financial institutions, savings and loans and other independent community banks, as well as credit unions, consumer finance companies, mortgage companies, loan production offices, mutual funds and life insurance companies. Competition has increasingly come from out-of-state banks through their acquisitions of Virginia-based banks. Competition for deposits and loans is affected by various factors including interest rates offered, the number and location of branches and types of products offered, as well as the reputation of the institution. In addition, credit unions have been allowed to increasingly expand their membership definitions and to offer more attractive loan and deposit pricing due to their favorable tax status. The Company’s non-bank financial services affiliates also operate in highly competitive environments.

 

Union Bankshares Corporation is one of the largest independent bank holding companies headquartered in Virginia. The Company believes its community bank framework and philosophy provide a competitive advantage, particularly with regards to larger national and regional institutions, allowing the Company to compete effectively in the markets it serves. The Company’s Community Banks generally have strong and growing market shares within the markets they serve. Due to the significant presence of out of state banks and the Company’s absence in many Virginia markets, the Company’s deposit market share in Virginia as of June 2004 is only 0.86% of the total banking deposits in Virginia. This is up from 0.74% in June 2003 and shows the impact of the Guaranty acquisition and our penetration in existing and new markets in the state.

 

SUPERVISION AND REGULATION

 

Bank holding companies and banks are extensively regulated under both federal and state law. The following description briefly addresses certain provisions of federal and state laws and certain regulations and proposed regulations and the potential impact of such provisions on the Company and the Community Banks. To the extent statutory or regulatory provisions or proposals are described herein, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

 

Bank Holding Companies

 

As a bank holding company registered under the Bank Holding Company Act of 1956 (the “BHCA”), the Company is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is so closely related to banking or to managing or controlling banks as to be a proper incident thereto.

 

Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks are also able to branch across state lines, provided certain conditions are met, including that applicable state law must expressly permit such interstate branching.

 

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Virginia has adopted legislation that permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based. The Company has no plans to branch outside of the Commonwealth of Virginia.

 

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation (the “FDIC”) insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by either the Savings Association Insurance Fund (“SAIF”) or the Bank Insurance Fund (“BIF”) as a result of the default of a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the SAIF or the BIF or both. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

 

The Federal Deposit Insurance Act (the “FDIA”) also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of the bank.

 

The Company is registered under the bank holding company laws of Virginia. Accordingly, the Company and the Community Banks (other than Rappahannock National Bank, which is federally regulated) are subject to regulation and supervision by the State Corporation Commission of Virginia (the “SCC”) and the Federal Reserve Bank. Rappahannock National Bank is subject to regulation and supervision by the Office of the Comptroller of the Currency (the “OCC”).

 

Capital Requirements

 

The Federal Reserve Board, the OCC and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and each of the Subsidiary Banks are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity (including Trust Preferred Securities), less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2004 were 10.41% and 11.63%, respectively, exceeding the minimum requirements.

 

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average adjusted assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2004, was 8.60%, which is above

 

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the minimum requirements. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

 

Limits on Dividends and Other Payments

 

The Company is a legal entity, separate and distinct from its subsidiary institutions. A significant portion of the revenues of the Company result from dividends paid to it by the Community Banks. There are various legal limitations applicable to the payment of dividends by the Community Banks to the Company, as well as the payment of dividends by the Company to its respective shareholders.

 

The Community Banks are subject to various statutory restrictions on their ability to pay dividends to the Company. Under the current supervisory practices of the Community Banks’ regulatory agencies, prior approval from those agencies is required if cash dividends declared in any given year exceed net income for that year, plus retained net profits of the two preceding years. The payment of dividends by the Community Banks or the Company may also be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Community Banks or the Company from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of the Community Banks, or the Company, could be deemed to constitute such an unsafe or unsound practice.

 

Under the FDIA, insured depository institutions such as the Community Banks are prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the statute). Based on the Community Banks’ current financial condition, the Company does not expect that this provision will have any impact on its ability to obtain dividends from the Community Banks. Nonbank subsidiaries pay the parent company dividends periodically on a nonregulated basis.

 

In addition to dividends it receives from the Community Banks, the Company receives management fees from its affiliated companies for various services provided to them including: data processing, item processing, customer accounting, financial accounting, human resources, funds management, credit administration, credit support, sales and marketing, collections, facilities management, call center, legal, compliance and internal audit. These fees are charged to each subsidiary based upon various specific allocation methods measuring the estimated usage of such services by that subsidiary. The fees are eliminated from the financial statements in the consolidation process.

 

Under federal law, the Community Banks may not, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, the Company or take securities of the Company as collateral for loans to any borrower. The Community Banks are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.

 

The Community Banks

 

The Community Banks are supervised and regularly examined by the Federal Reserve Board and the SCC, and in the case of Rappahannock National Bank, the OCC. The various laws and regulations administered by the regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt and acquisition of financial institutions and other companies, and affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices.

 

The Community Banks are also subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low- and moderate-income neighborhoods, consistent with

 

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the safe and sound operation of those institutions. Each financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to twelve assessment factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Many of the banks’ competitors, such as credit unions, are not subject to the requirements of CRA.

 

As institutions with deposits insured by the BIF, the Community Banks also are subject to insurance assessments imposed by the FDIC. There is a base assessment for all institutions. In addition, the FDIC has implemented a risk-based assessment schedule, imposing assessments ranging from zero (with a $2,000 minimum assessment) to 0.27% of an institution’s average assessment base. The actual assessment to be paid by each BIF member is based on the institution’s assessment risk classification, which is determined based on whether the institution is considered “well capitalized,” “adequately capitalized” or “undercapitalized,” as such terms have been defined in applicable federal regulations, and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. In 2004, the Company paid only the base assessment rate for “well capitalized” institutions which amounted to $169 thousand in deposit insurance premiums.

 

Other Safety and Soundness Regulations

 

The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” All such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies. The Community Banks each meet the definition of being “well capitalized” as of December 31, 2004.

 

The Gramm-Leach-Bliley Act

 

Effective on March 11, 2001, the Gramm Leach Bliley Act (the “GLB Act”) allows a bank holding company or other company to certify status as a financial holding company, which will allow such company to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker, underwriting, dealing in or making markets in securities, and engaging in merchant banking under certain restrictions. It also authorizes the Federal Reserve Board to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.

 

Filings with the SEC

 

The Company files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission (“SEC”). These reports are posted and are available at no cost on the Company’s website, www.ubsh.com, through the Investor Relations link, as soon as reasonably practicable after the Company files such documents with the SEC. Union’s filings are also available through the SEC’s website at www.sec.gov.

 

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Item 2. – Properties

 

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The corporate headquarters is located at 212 N. Main Street, Bowling Green, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, Financial Statement and Supplementary Data, of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.

 

Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2004.

 

Locations

Corporate Headquarters    

212 North Main Street

 

Bowling Green, Virginia

Banking Offices - Union Bank & Trust Company    

211 North Main Street

 

Bowling Green, Virginia

Route 1

 

Ladysmith, Virginia

Route 301

 

Port Royal, Virginia

4540 Lafayette Boulevard

 

Fredericksburg, Virginia

Route 1 and Ashcake Road

 

Ashland, Virginia

4210 Plank Road

 

Fredericksburg, Virginia

10415 Courthouse Road

 

Spotsylvania, Virginia

9665 Sliding Hill Road

 

Ashland, Virginia

700 Kenmore Avenue

 

Fredericksburg, Virginia

Route 360

 

Manquin, Virginia

9534 Chamberlayne Road

 

Mechanicsville, Virginia

Cambridge and Layhill Road

 

Fredericksburg, Virginia (leased)

Massaponax Church Road and Route 1

 

Spotsylvania, Virginia (leased)

Brock Road and Route 3

 

Spotsylvania, Virginia (leased)

2811 Fall Hill Avenue

 

Fredericksburg, Virginia

610 Mechanicsville Turnpike

 

Mechanicsville, Virginia

10045 Kings Highway

 

King George, Virginia

840 McKinney Blvd.

 

Colonial Beach, Virginia

5510 Morris Road

 

Thornburg, Virginia

4690 Pouncey Tract Road

 

Glen Allen, Virginia (leased)

8300 Bell Creek Road

 

Mechanicsville, Virginia

1773 Parham Road

 

Richmond, Virginia

11101 Hull Street

 

Midlothian, Virginia

13644 Hull Street

 

Midlothian, Virginia

400 East Main Street

 

Charlottesville, Virginia (leased)

1700 Seminole Trail

 

Charlottesville, Virginia (leased)

124 Main Street

 

Lovingston, Virginia

1924 Arlington Boulevard

 

Charlottesville, Virginia (leased)

1658 State Farm Boulevard

 

Charlottesville, Virginia

Route 53

 

Palmyra, Virginia

3290 Worth Crossing

 

Charlottesville, Virginia

Loan Production Office – Union Bank & Trust Company    

9282 Corporate Circle, Building 7

   
        Ashton Professional Center  

Manassas, Virginia (leased)

 

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Banking Offices - Northern Neck State Bank    

5839 Richmond Road

 

Warsaw, Virginia

4256 Richmond Road

 

Warsaw, Virginia

Route 3, Kings Highway

 

Montross, Virginia

1649 Tappahannock Blvd

 

Tappahannock, Virginia

1660 Tappahannock Blvd (Wal-Mart)

 

Tappahannock, Virginia (leased)

15043 Northumberland Highway

 

Burgess, Virginia

284 North Main Street

 

Kilmarnock, Virginia

876 Main Street

 

Reedville, Virginia

485 Chesapeake Drive

 

White Stone, Virginia

Banking Office - Rappahannock National Bank    

7 Bank Road

 

Washington, Virginia

Banking Offices – Bank of Williamsburg    

5125 John Tyler Highway

 

Williamsburg, Virginia

603 Pilot House Drive

 

Newport News, Virginia (leased)

171 Monticello Avenue (opened January 2005)

 

Williamsburg, Virginia (leased)

Union Investment Services, Inc.    

111 Davis Court

 

Bowling Green, Virginia

9665 Sliding Hill Road

 

Ashland, Virginia

2811 Fall Hill Avenue

 

Fredericksburg, Virginia

5125 John Tyler Highway

 

Williamsburg, Virginia

Mortgage Capital Investors, Inc. (All leased)    

5440 Jeff Davis Highway, #103

 

Fredericksburg, Virginia

3 Hillcrest Drive #A100

 

Frederick, Maryland

7501 Greenway Center, #140

 

Greenbelt, Maryland

7901 N. Ocean Boulevard

 

Myrtle Beach, South Carolina

6330 Newtown Road, #211

 

Norfolk, Virginia

6571 Edsall Road

 

Springfield, Virginia

12741 Darby Brooke Court, Suite 102

 

Woodbridge, Virginia

1658 State Farm Boulevard

 

Charlottesville, Virginia

11426 Rockville Pike

 

Rockville, Maryland

 

Item 3. - Legal Proceedings

 

In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

 

Item 4. - Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2004.

 

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PART II

 

Item 5. - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Union Bankshares Corporation’s common stock is traded on the NASDAQ National Market under the symbol “UBSH”. The Company’s common stock began trading on the Nasdaq National Market in October 1993.

 

There were 8,744,176 shares of the Company’s common stock outstanding at the close of business on December 31, 2004, which were held by 2,422 shareholders of record. The closing price of the Company’s stock on December 31, 2004 was $38.43 per share as compared to $30.50 on December 31, 2003.

 

The following table summarizes the high and low closing sales prices and dividends declared for quarterly periods during the two years ended December 31, 2004.

 

     Market Values

   Dividends
Declared


     2004

   2003

   2004

   2003

     High

   Low

   High

   Low

         

First Quarter

   $ 34.30    $ 30.90    $ 28.99    $ 23.26    $ —      $ —  

Second Quarter

     33.09      27.50      28.91      25.05      0.33      0.29

Third Quarter

     33.50      27.98      32.64      26.72      —        —  

Fourth Quarter

     40.07      30.70      34.25      30.13      0.35      0.31
                                

  

                                 $ 0.68    $ 0.60
                                

  

 

Regulatory restrictions on the ability of the Community Banks to transfer funds to the Company at December 31, 2004, are set forth in Note 17 of the Notes to the Consolidated Financial Statements contained in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. A discussion of certain limitations on the ability of the Community Banks to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the headings “Supervision and Regulation - Limits on Dividends and Other Payments” and “Supervision and Regulation - The Community Banks.”

 

The dividend amount on the Company’s common stock is established by the Board of Directors semi-annually and dividends are typically paid on May 1st and November 1st of each year. In making its decision on the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns and other factors.

 

On June 24, 2004, the Board of Directors authorized the Company to buy up to 150,000 shares of the Company’s outstanding common stock in the open market at prices that management and the Board of Directors determine to be prudent. This authorization expires May 31, 2005. The Company considers current market conditions and the Company’s current capital level, in addition to other factors, when deciding whether to repurchase stock. It is anticipated that any repurchased shares will be used primarily for general corporate purposes, including the dividend reinvestment plan, incentive stock option plan and other employee benefit plans. No shares have been purchased under this authorization to date.

 

Under prior authorization from the Board of Directors which expired in November 2003, the Company repurchased 1,000 shares of its common stock during the first nine months of 2003 in the open market at an average cost of $24.07.

 

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Item 6. - Selected Financial Data

 

The following table sets forth selected financial data for the Company for the last five years:

 

     2004

    2003

    2002

    2001

    2000

 
     (in thousands, except per share amounts)  

RESULTS OF OPERATIONS

                                        

Interest income

   $ 80,544     $ 67,017     $ 65,205     $ 65,576     $ 64,867  

Interest expense

     25,652       23,905       24,627       32,483       33,530  
    


 


 


 


 


Net interest income

     54,892       43,112       40,578       33,093       31,337  

Provision for loan losses

     2,154       2,307       2,878       2,126       2,101  
    


 


 


 


 


Net interest income after provision for loan losses

     52,738       40,805       37,700       30,967       29,236  

Noninterest income

     23,302       22,840       17,538       16,092       12,011  

Noninterest expenses

     51,221       40,725       35,922       32,447       32,424  
    


 


 


 


 


Income before income taxes

     24,819       22,920       19,316       14,612       8,823  

Income tax expense

     6,894       6,256       4,811       2,933       1,223  
    


 


 


 


 


Net income

   $ 17,925     $ 16,664     $ 14,505     $ 11,679     $ 7,600  
    


 


 


 


 


KEY PERFORMANCE RATIOS

                                        

Return on average assets (ROA)

     1.19 %     1.42 %     1.41 %     1.27 %     0.88 %

Return on average equity (ROE)

     12.18 %     14.88 %     14.91 %     13.55 %     10.69 %

Efficiency ratio

     65.51 %     61.75 %     58.90 %     62.13 %     71.18 %

PER SHARE DATA

                                        

Net income per share - basic

   $ 2.13     $ 2.19     $ 1.92     $ 1.55     $ 1.01  

Net income per share - diluted

     2.11       2.17       1.90       1.55       1.01  

Cash dividends declared

     0.68       0.60       0.52       0.46       0.40  

Book value at period-end

     18.61       15.54       13.92       11.82       10.42  

FINANCIAL CONDITION

                                        

Total assets

   $ 1,672,210     $ 1,234,732     $ 1,115,725     $ 983,097     $ 881,961  

Total deposits

     1,314,317       999,771       897,642       784,084       692,472  

Total loans, net of unearned income

     1,264,841       878,267       714,764       600,164       580,790  

Stockholders’ equity

     162,758       118,501       105,492       88,979       78,352  

ASSET QUALITY

                                        

Allowance for loan losses

   $ 16,384     $ 11,519     $ 9,179     $ 7,336     $ 7,389  

Allowance as % of total loans

     1.30 %     1.31 %     1.28 %     1.22 %     1.27 %

OTHER DATA

                                        

Market value per share at period-end

   $ 38.43     $ 30.50     $ 27.25     $ 16.24     $ 10.25  

Price to earnings ratio

     18.2       14.1       14.3       10.5       10.1  

Price to book value ratio

     207 %     196 %     196 %     137 %     98 %

Equity to assets

     9.7 %     9.6 %     9.5 %     9.1 %     8.9 %

Dividend payout ratio

     31.92 %     27.40 %     27.08 %     29.68 %     39.60 %

Weighted average shares outstanding, basic

     8,402,791       7,602,872       7,555,906       7,523,566       7,508,238  

Weighted average shares outstanding, diluted

     8,482,142       7,675,437       7,623,169       7,541,572       7,513,000  

Cash basis EPS fully diluted (1)

   $ 2.19     $ 2.22     $ 1.95     $ 1.59     $ 1.05  

Cash basis return on average tangible assets (1)

     1.26 %     1.45 %     1.46 %     1.31 %     0.92 %

Cash basis return on average tangible equity (1)

     15.78 %     16.08 %     16.43 %     14.99 %     12.16 %

(1) Refer to Item 7, page 16 for a reconciliation of Non GAAP measures.

 

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Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Union Bankshares Corporation and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.

 

FORWARD-LOOKING STATEMENTS

 

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” or other statements concerning opinions or judgment of the Company and its management about future events. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

 

CRITICAL ACCOUNTING POLICIES

 

General

 

The accounting and reporting policies of Union Bankshares Corporation and its subsidiaries are in accordance with U. S. generally accepted accounting principles (“GAAP”) and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.

 

The more critical accounting and reporting policies include Union’s accounting for the allowance for loan losses, goodwill and intangibles, and income taxes. Union’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations. Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 in the “Notes to Consolidated Financial Statements”.

 

The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions and judgments.

 

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Allowance for Loan Losses

 

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when occurrence is probable and estimatable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

 

The Company’s allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. All components of the allowance represent an estimation performed pursuant to either SFAS No. 5 or SFAS No. 114. Management’s estimate of each SFAS No. 5 component is based on certain observable data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; loan volumes; geographic, borrower and industry concentrations; seasoning of the loan portfolio; the findings of internal credit quality assessments and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

 

The Company adopted SFAS No. 114, which has been amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures. SFAS No. 114, as amended, requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. SFAS No. 114, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

 

Reserves for commercial loans are determined by applying estimated loss factors to the portfolio based on management’s evaluation and “risk grading” of the commercial loan portfolio. Reserves are provided for noncommercial loan categories using estimated loss factors applied to the total outstanding loan balance of each loan category. Specific reserves are determined on a loan-by-loan basis based on management’s evaluation the Company’s exposure for each credit, given the current payment status of the loan and the net market value of any underlying collateral.

 

While management uses the best information available to establish the allowance for loan and lease losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

 

Goodwill and Intangibles

 

SFAS No. 141, Business Combinations, requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, Union is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review, and more frequently if certain impairment indicators are in evidence.

 

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Goodwill totaled $31.0 million and $864 thousand at December 31, 2004 and 2003, respectively. Based on the testing for goodwill impairment, there were no impairment charges for 2004, 2003 or 2002. Core deposit intangible assets are being amortized over the period of expected benefit, which ranges from 8 to 15 years. Core deposit intangibles, net of amortization, amounted to $9.7 million and $4.9 million at December 31, 2004 and 2003, respectively. Amortization expense of core deposit intangibles for the years ended December 31, 2004, 2003 and 2002 totaled $1.0 million, $571 thousand and $571 thousand, respectively. The Company adopted SFAS 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over their estimated useful lives.

 

Mergers and Acquisitions

 

On May 1, 2004, Union Bankshares completed its acquisition of Guaranty, headquartered in Charlottesville, Virginia. This acquisition was accounted for using the purchase method of accounting. The total consideration paid to Guaranty stockholders in connection with the acquisition was approximately $54.9 million comprised of approximately $23.2 million in cash and 1,023,000 shares of Union’s common stock. Guaranty transactions have been included in Union’s financial results since May 1, 2004. Acquired assets on May 1, 2004 totaled $248 million, including $165 million in loans and $184 million in deposits. As part of the purchase price allocation at May 1, 2004, Union recorded $5.8 million in core deposit intangibles and goodwill of approximately $30.1 million.

 

The acquisition of Guaranty falls under the guidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring.) Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. “Exit costs” are defined to include those costs recorded by Guaranty prior to the merger date and therefore are not included in Union’s Bankshares results of operations. Guaranty recorded exit costs of $1.3 million relating to severance and costs associated with terminating contracts.

 

Union’s exit costs, referred to herein as “merger-related” costs, are defined to include those costs for combining operations such as systems conversions, integration planning consultant fees and marketing consultant fees incurred by Union prior to and after the merger date and are included in Union’s results of operations. Union expensed merger-related costs which totaled approximately $343 thousand for year ended December 31, 2004. The costs associated with these activities are included in noninterest expenses.

 

Income Taxes

 

The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.

 

The Company must also evaluate the likelihood that deferred tax assets will be recovered from future taxable income. If any such assets are not likely to be recovered, a valuation allowance must be recognized. The Corporation has determined that a valuation allowance is not required for deferred tax assets as of December 31, 2004. The assessment of the carrying value of deferred tax assets is based on certain assumptions, changes in which could have a material impact on the Corporation’s financial statements.

 

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OVERVIEW

 

Net income for the year 2004 was $17.9 million, up 7.6% from $16.7 million for the same period in 2003. Over this same period, earnings per share on a diluted basis decreased from $2.17 to $2.11 largely as a result of new shares issued in the Company’s acquisition of Guaranty. Return on average equity for the year ended December 31, 2004 was 12.18%, while return on average assets for the same period was 1.19%, compared to 14.88% and 1.42% respectively, for the year ended December 31, 2003.

 

Operating results for the year ended December 31, 2004 reflect the impact on earnings from the Company’s acquisition activity. The Company acquired Guaranty on May 1, 2004 which it operated as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank and Trust Company. Guaranty-related charges include approximately $439 thousand in amortization of core deposit intangibles for the year. In addition, interest expense for the year included $755 thousand on the Trust Preferred Security Pool used to fund the Guaranty acquisition. Other merger-related expenses, including data and systems conversion, marketing, communications and other integration costs totaled approximately $343 thousand for the year ended December 31, 2004.

 

In addition, the expansion of the Company’s branch network has impacted results for the year. Five branches were opened in 2004, and one of the Company’s convenience store branches was relocated to a larger traditional banking facility. The costs associated with these branches will typically be greater than the revenue generated in the first 18-24 months. The estimated direct cost, net of revenue generated on these branches in 2004, was approximately $604 thousand, net of applicable income taxes.

 

Loan demand during the year was strong, increasing by 25.2%, or approximately $221.5 million, excluding loans acquired during the Guaranty acquisition, principally in commercial real estate, construction and commercial business lending. Management believes this is reflective of the growth and the economic strength of the markets the Company serves, though such growth is expected to moderate in response to rising interest rates.

 

At December 31, 2004 total assets were $1.67 billion, up 35.4%, or $437 million from $1.23 billion at December 31, 2003. The Guaranty acquisition represents $248.1 million (at acquisition) of this growth. Loans at December 31, 2004 increased 44% or $386.6 million from December 31, 2003. The acquisition of Guaranty represents $165.1 million of the growth from December 31, 2003. The remaining growth during the year of $221.5 million, up 25.2% from 2003 year end totals, is attributable largely to increases in commercial and construction real estate loans, as well as commercial business loans. This loan growth occurred principally within the Richmond, Charlottesville, and Fredericksburg markets. Securities decreased to $233.5 million at December 31, 2004 compared to $240.1 million a year earlier. Deposit levels increased $314.5 million, or 31.5%, from December 31, 2003. The acquisition of Guaranty represents $184.5 million (at acquisition) of the growth in deposits from December 31, 2003. The remaining growth in deposits of $130.0 million represents a 13% increase from a year earlier. Since the May 1, 2004 acquisition, loans and deposits attributable to the former Guaranty operations have increased to $198.0 million and $192.8 million, respectively. The Company’s capital position remains strong with an equity-to-assets ratio of 9.73 %.

 

Non GAAP Measures

 

SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Prior to the issuance of SFAS No. 141, the Company accounted for most of its acquisition activity using the pooling method of accounting. The recent acquisition of Guaranty is the Company’s most significant business combination to be accounted for using the purchase method of accounting. At December 31, 2004, core deposit intangibles totaled $9.7 million, up from $4.9 million a year earlier and goodwill totaled $31.0 million, up from $864 thousand at December 31, 2003. Amortization of core deposit intangibles increased during 2004 as a result of the core deposit intangibles recorded in the Guaranty transaction.

 

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Table of Contents

In reporting the results of 2004, the Company has provided supplemental performance measures on an operating or tangible basis. Such measures exclude amortization expense related to intangible assets, such as core deposit intangibles. The Company believes these measures are useful to investors as they exclude non-operating adjustments resulting from acquisition activity and allow investors to see the combined economic results of the organization. Cash basis operating earnings per share was $2.19 per share for the year ended December 31, 2004 as compared to $2.22 per share a year earlier. Cash basis return on average tangible equity for 2004 was 15.78% as compared to 16.08% a year earlier, and cash basis return on average tangible assets was 1.26% as compared to 1.45% for 2003.

 

These measures are a supplement to GAAP used to prepare the Company’s financial statements and should not be viewed as a substitute for GAAP measures. In addition, UBSH’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. A reconciliation of these non-GAAP measures from their respective GAAP basis measures can be found in the following table:

 

     Years ended December 31,

 
     2004

    2003

 
     (in thousands)  

Net income

   $ 17,925     $ 16,664  

Plus amortization of core deposit intangibles, net of tax

     657       374  
    


 


Cash basis operating earnings

     18,582       17,038  
    


 


Average assets

     1,504,857       1,177,657  

Less average goodwill

     (21,039 )     (864 )

Less average core deposit intangibles

     (8,368 )     (5,217 )
    


 


Average tangible assets

     1,475,450       1,171,576  
    


 


Average equity

     147,166       112,013  

Less average goodwill

     (21,039 )     (864 )

Less average core deposit intangibles

     (8,368 )     (5,217 )
    


 


Average tangible equity

   $ 117,759     $ 105,932  
    


 


Weighted average shares outstanding

     8,482,142       7,675,437  

Cash basis EPS fully diluted

   $ 2.19     $ 2.22  

Cash basis return on average tangible assets

     1.26 %     1.45 %

Cash basis return on average tangible equity

     15.78 %     16.08 %

 

Community Bank Segment

 

Net income for the community bank segment was $16.5 million, an increase of $2.3 million, or 16.4% over 2003. Earnings from increased loan volumes contributed to a 28.3% increase in income from interest and fees on loans, which was partially offset by a 7.1% decrease in investment income. Deposit interest expense benefited from relatively low interest rates as a $237.6 million increase in average deposit balances resulted in only a 0.8% increase in interest expense on deposits. However, interest expense on borrowings increased 39.5% because of a 51.7% increase in the average balance of borrowings in 2004 compared to 2003, driven primarily from the issuance of trust preferred capital notes related to the acquisition of Guaranty. Net interest income before provision was up 29.5% or $12.2 million. Provision expense decreased $153

 

15


Table of Contents

thousand largely as a result of recoveries of prior charge-offs and higher overall asset quality. Noninterest income in the community bank segment grew by $1.9 million, or 19.4%, in 2004 with service charges on deposit accounts, the primary component of noninterest income, increasing 22.0%. Noninterest expense in the community bank segment increased $10.6 million, or 35.4%, while average assets grew by 27.8%. Noninterest expenses related to the operation of the seven former Guaranty branches amounted to approximately $4.7 million for the year. In addition, expenses due to branch expansion efforts totaled approximately $893 thousand for the year.

 

Mortgage Segment

 

The mortgage segment’s loan originations in 2004 totaled $496.2 million versus $535.5 million in 2003 and the gains on the sales of loans in 2004 totaled $11.8 million, a 10.9% decrease from 2003. Net income for the mortgage banking segment was $1.4 million, a decrease of $1.1 million compared to $2.5 million in 2003. Mortgage loan production for the year was down 7%, but decreasing profit margins in the mortgage sector resulted in a 43% decrease in net income for the year. This margin tightening is due largely to a shift in product mix from fixed rate to adjustable rate products and from government to conventional loans, as well as increasing competitive pressures. The Company is focused on expanding its mortgage presence throughout its markets, particularly Charlottesville and Richmond, and continuing to strengthen operating efficiencies to enhance earnings in this segment.

 

NET INTEREST INCOME

 

Net interest income, which represents the principal source of earnings for the Company, is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest-earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income, the net interest margin and net income.

 

Interest rates in 2004 remained relatively low, even as the Federal Reserve began to increase short-term interest rates during the last half of the year. The Company is in an asset-sensitive repricing position. It is anticipated that as interest rates rise, the Company will benefit from an improved net interest margin.

 

During 2004, loan volumes generated interest income to more than offset the decline in volume and rates in other asset categories. This resulted in an increase in income from earning assets on a taxable equivalent basis of $13.4 million, or 19.2%. At the same time, volume increases in all interest-bearing liabilities were accompanied by rate declines in all categories resulting in an increase in liability interest expense of only $1.7 million, or 7.3%. As a result, net interest income increased $11.6 million, or 25.5%, compared to last year.

 

During 2004, net interest income, on a taxable equivalent basis (which reflects the tax benefits of nontaxable interest income) totaled $57.3 million, an increase of 25.5% from $45.7 million in 2003. The Company’s net interest margin was 4.11% in 2004, the same as in 2003. The yield on earning assets decreased to 5.96% from 6.27% in 2003 while the cost of interest-bearing liabilities decreased to 2.23% from 2.62% over the same period. Average interest-bearing liabilities increased by $237.5 million, or 26.0% while average earning assets grew by $283.3 million, or 25.5%. In 2004, much of the growth in earning assets and interest-bearing liabilities resulted from the acquisition of Guaranty, however, there was also significant internal growth, especially in the loan volume.

 

During 2003, net interest income, on a taxable equivalent basis, totaled $45.7 million, an increase of 5.4% from $43.3 million in 2002. The Company’s net interest margin decreased to 4.11% in 2003, as compared to 4.49% in 2002. The yield on earning assets decreased to 6.27% from 7.04% in 2002 while the cost of interest-bearing liabilities decreased to 2.62% in 2003 from 3.05% in 2002. Average interest-bearing liabilities increased by $106.6 million, or 13.2% while average earning assets grew by $144.5 million, or 15.0%.

 

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Table of Contents

The following table shows interest income on earning assets and related average yields, as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated. Nonaccrual loans are included in average loans outstanding.

 

    

AVERAGE BALANCES (1), INCOME AND EXPENSES, YIELDS AND RATES (TAXABLE EQUIVALENT BASIS)

YEARS ENDED DECEMBER 31,


 
     2004

    2003

    2002

 
     Average
Balance


    Interest
Income/
Expense


   Yield/
Rate


    Average
Balance


    Interest
Income/
Expense


   Yield/
Rate


    Average
Balance


    Interest
Income/
Expense


   Yield/
Rate


 
     (in thousands)  

ASSETS:

                                                               

Securities:

                                                               

Taxable

   $ 159,709     $ 7,709    4.83 %   $ 168,022     $ 8,171    4.86 %   $ 168,787     $ 9,619    5.70 %

Tax-exempt (2)

     80,224       6,049    7.54 %     85,506       6,594    7.71 %     91,814       7,015    7.64 %
    


 

        


 

        


 

      

Total securities

     239,933       13,758    5.73 %     253,528       14,765    5.82 %     260,601       16,634    6.38 %

Loans, net

     1,104,942       67,114    6.07 %     789,934       52,266    6.62 %     658,836       49,403    7.50 %

Loans held for sale

     34,326       1,917    5.58 %     45,890       2,351    5.12 %     27,606       1,663    6.02 %

Federal funds sold

     8,090       102    1.26 %     16,241       138    0.85 %     14,153       206    1.46 %

Money market investments

     101       1    0.99 %     1,913       22    1.15 %     2,778       40    1.44 %

Interest-bearing deposits in other banks

     3,645       29    0.80 %     2,137       22    1.03 %     1,146       17    1.48 %

Other interest-bearing deposits

     1,889       33    1.75 %     —         —              —         —         
    


 

        


 

        


 

      

Total earning assets

     1,392,926       82,954    5.96 %     1,109,643       69,564    6.27 %     965,120       67,963    7.04 %

Allowance for loan losses

     (14,167 )                  (10,279 )                  (8,370 )             

Total non-earning assets

     126,098                    78,293                    71,684               
    


              


              


            

Total assets

   $ 1,504,857                  $ 1,177,657                  $ 1,028,434               
    


              


              


            

LIABILITIES & STOCKHOLDERS’ EQUITY

                                                               

Interest-bearing deposits:

                                                               

Checking

   $ 175,659       488    0.28 %   $ 136,621       567    0.42 %   $ 120,878       1,028    0.85 %

Money market savings

     159,111       1,555    0.98 %     97,368       967    0.99 %     84,623       1,193    1.41 %

Regular savings

     112,953       726    0.64 %     90,208       746    0.83 %     78,497       1,014    1.29 %

Certificates of deposit:

                                                               

$100,000 and over

     190,506       6,582    3.46 %     163,330       6,277    3.84 %     135,429       5,718    4.22 %

Under $100,000

     352,589       10,678    3.03 %     322,111       11,316    3.51 %     286,076       11,506    4.02 %
    


 

        


 

        


 

      

Total interest-bearing deposits

     990,818       20,029    2.02 %     809,638       19,873    2.45 %     705,503       20,459    2.90 %

Other borrowings

     160,213       5,623    3.51 %     103,866       4,032    3.88 %     101,385       4,168    4.11 %
    


 

        


 

        


 

      

Total interest-bearing liabilities

     1,151,031       25,652    2.23 %     913,504       23,905    2.62 %     806,888       24,627    3.05 %

Noninterest bearing liabilities:

                                                               

Demand deposits

     196,520                    140,526                    115,552               

Other liabilities

     10,140                    11,614                    8,734               
    


              


              


            

Total liabilities

     1,357,691                    1,065,644                    931,174               

Stockholders’ equity

     147,166                    112,013                    97,260               
    


              


              


            

Total liabilities and stockholders’ equity

   $ 1,504,857                  $ 1,177,657                  $ 1,028,434               
    


              


              


            

Net interest income

           $ 57,302                  $ 45,659                  $ 43,336       
            

                

                

      

Interest rate spread

                  3.73 %                  3.65 %                  3.99 %

Interest expense as a percent of average earning assets

                  1.84 %                  2.15 %                  2.55 %

Net interest margin

                  4.11 %                  4.11 %                  4.49 %

(1) Includes Guaranty from acquisition date of 5/1/2004.
(2) Income and yields are reported on a taxable equivalent basis.

 

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The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates.

 

VOLUME AND RATE ANALYSIS* (TAXABLE EQUIVALENT BASIS)

(in thousands)

 

     Years Ended December 31,

 
    

2004 vs. 2003

Increase (Decrease)

Due to Changes in:


   

2003 vs. 2002

Increase (Decrease)

Due to Changes in:


 
     Volume

    Rate

    Total

    Volume

    Rate

    Total

 

EARNING ASSETS:

                                                

Securities:

                                                

Taxable

   $ (402 )   $ (60 )   $ (462 )   $ (43 )   $ (1,405 )   $ (1,448 )

Tax-exempt

     (401 )     (144 )     (545 )     (485 )     64       (421 )

Loans, net

     19,424       (4,576 )     14,848       9,103       (6,240 )     2,863  

Loans held for sale

     (631 )     197       (434 )     967       (279 )     688  

Federal funds sold

     (86 )     50       (36 )     26       (94 )     (68 )

Money market investments

     (19 )     (2 )     (21 )     (11 )     (7 )     (18 )

Interest-bearing deposits in other banks

     12       (5 )     7       12       (7 )     5  

Other interest-bearing deposits

     33       —         33       —         —         —    
    


 


 


 


 


 


Total earning assets

     17,930       (4,540 )     13,390       9,569       (7,968 )     1,601  
    


 


 


 


 


 


INTEREST-BEARING LIABILITIES:

                                                

Checking

     137       (216 )     (79 )     119       (580 )     (461 )

Money market savings

     603       (15 )     588       162       (388 )     (226 )

Regular savings

     165       (185 )     (20 )     135       (403 )     (268 )

CDs $100,000 and over

     978       (673 )     305       1,104       (545 )     559  

CDs < $100,000

     1,010       (1,648 )     (638 )     1,357       (1,547 )     (190 )
    


 


 


 


 


 


Total interest-bearing deposits

     2,893       (2,737 )     156       2,877       (3,463 )     (586 )

Other borrowings

     2,009       (418 )     1,591       100       (236 )     (136 )
    


 


 


 


 


 


Total interest-bearing liabilities

     4,902       (3,155 )     1,747       2,977       (3,699 )     (722 )
    


 


 


 


 


 


Change in net interest income

   $ 13,028     $ (1,385 )   $ 11,643     $ 6,592     $ (4,269 )   $ 2,323  
    


 


 


 


 


 



* The change in interest, due to both rate and volume, has been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each.

 

INTEREST SENSITIVITY

 

An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap and liquidity gap. The interest sensitivity gap is the difference between interest-sensitive assets and interest-sensitive liabilities in a specific time interval. This gap can be managed by repricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

 

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies and practices governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the state of the national, regional and local economy, and other financial and business risk factors. The Company uses computer simulations to measure the effect of various interest rate scenarios and business strategies on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

 

At December 31, 2004 and 2003, the Company had $56.6 million and $36.2 million, respectively, more liabilities than assets subject to repricing within one year based on static gap modeling and was, therefore, in a liability-sensitive position. An asset-sensitive company generally will be impacted favorably by increasing interest rates while a liability-sensitive company’s net interest margin and net interest income generally will be impacted favorably by declining interest rates.

 

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Although the static gap report shows the Company to be liability-sensitive, computer simulation modeling shows the Company’s net interest income tends to increase when interest rates rise and fall when interest rates decline. The explanation for this is that interest rate changes affect bank products differently. For example, if the prime rate changes by 1.00% (100 basis points or bps), the change on certificates of deposit may only be 0.75% (75 bps), while other interest bearing deposit accounts may only change 0.10% (10 bps). Also, despite their fixed terms, loan products are often refinanced as rates decline, but rarely refinanced as rates rise. Assets and liabilities reprice throughout the year resulting in changes in the earning asset rate, the cost of funds rate, and the net interest margin.

 

EARNINGS SIMULATION ANALYSIS

 

Management uses simulation analysis to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis, such as the static gap analysis discussed above.

 

Assumptions used in the model are derived from historical trends and management’s outlook and include loan and deposit growth rates and projected yields and rates. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are reflected in the different rate scenarios.

 

The Company uses its simulation model to estimate earnings in rate environments where rates ramp up or down around a “most likely” rate scenario, based on implied forward rates. The analysis assesses the impact on net interest income over a 12 month time horizon by applying 12-month ramps versus the implied forward rates in intervals of 50 basis points up to a total of 200 basis points. The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled:

 

Change in Yield Curve


   % Change in
Net Interest Income


    $ Change in
Net Interest Income


           (in thousands)

+200 basis points

   5.63 %   $ 4,108

+50 basis points

   1.40 %     1,019

Most likely

   0.00 %     —  

-50 basis points

   -1.46 %     -1,063

-200 basis points

   -5.89 %     -4,296

 

ECONOMIC VALUE SIMULATION

 

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantanious rate shocks to the balance sheet where the earnings simulation uses rate ramps over 12 months. The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation:

 

     Change in Economic Value of Equity

Change in Yield Curve


   (percent)

    (in thousands)

+200 basis points

   1.76 %   $ 5,203

+50 basis points

   1.08 %     3,188

Most likely

   0.00 %     —  

-50 basis points

   -1.56 %     -4,625

-200 basis points

   -9.15 %     -27,114

 

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NONINTEREST INCOME

 

Noninterest income increased by $462 thousand, or 2%, from $22.8 million in 2003 to $23.3 million in 2004. This increase is relatively small due to a $1.4 million decrease in gains on sales of loans, which declined from $13.3 million in 2003 to $11.8 million in 2004. Mortgage loan originations were $496.2 million in 2004, down from $535.5 million in 2003, but there was also margin tightening attributable largely to a shift in product mix from fixed rate to adjustable rate products and increasing competitive pressures. Service charges on deposits rose 22.0% from $5.6 million to $6.8 million largely as a result of a new overdraft privilege service which the Community Banks began offering in June, 2003. Other service charges, commissions and fee income increased from $2.5 million in 2003 to $3.4 million in 2004 as net brokerage commissions were up $278 thousand, debit card income was up $218 thousand, and ATM-related fees were up $306 thousand. In addition, other operating income decreased from $1.2 million in 2003 to $1.1 million in 2004. This decrease was the result of a reduction of $205 thousand in income from the Bank of Williamsburg’s investment in Johnson Mortgage Company, LLC, partially offset by an increase in income from Bank-owned life insurance of $126 thousand.

 

Noninterest income increased by $5.3 million or 30.2%, from $17.5 million in 2002 to $22.8 million in 2003. This increase is primarily due to a $3.2 million increase in gains on sales of loans, which rose from $10.1 million in 2002 to $13.3 million in 2003. Stimulated by continued low mortgage interest rates, the mortgage originations growth carried through the third quarter of 2003. Service charges on deposits rose 36.9% from $4.1 million to $5.6 million as a result of a new overdraft privilege service which the Community Banks began offering in June, 2003. Other service charges, commissions and fee income were down slightly from $2.6 million in 2002 to $2.5 million in 2003 as net brokerage commissions were down $119,000. A securities gain of $113,000 represents a $272,000 change from a loss of $159,000 a year ago. Such sales of securities are typically related to minor adjustments in the structure of the portfolio. The Company also recorded a gain of $156,000 on the disposal of other real estate owned. In addition, other operating income was up from $800,000 in 2002 to $1.2 million in 2003. This increase was the result of a full years contribution of $189,000 from the Bank of Williamsburg’s investment in Johnson Mortgage Company, LLC, rental income of $69,000 from the Richmond LPO building and a one time death benefit of $125,000 from a subsidiary director’s life insurance.

 

NONINTEREST EXPENSES

 

Noninterest expenses were up $10.5 million or 25.8% to $51.2 million in 2004, compared to $40.7 million in 2003. Salaries and benefits were $29.1 million in 2004, up $4.0 million or 15.9% compared to $25.1 million in 2003. Compensation expense related to the operation of the seven former Guaranty branches amounted to $1.9 million of the increase, and includes amounts related to positions which have been eliminated with the integration of the former Guaranty operation into Union. The community bank segment’s salaries and benefits, excluding the impact of the Guaranty acquisition, were up $2.4 million from 2003 to 2004. This was the result of a full year of expenses from the addition of one new branch opened in 2003, five new branches opened in 2004, higher cost of group insurance, expanded staffing in the retail locations and merit increases. Occupancy expenses were $3.4 million, up $743 thousand over $2.7 million in 2003. The Guaranty acquisition and the five new branches accounted for $554 thousand of this

 

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increase. Equipment expense was $3.4 million versus $2.6 million in 2003, an increase of $835 thousand, of which $493 thousand was related to Guaranty ($349 thousand) and the new branches ($144 thousand). Other operating expense was $15.2 million, up $4.9 million from $10.3 million in 2003. Consulting expenses related to the overdraft privilege service represented $576 thousand of the increase, but will not recur in future years. Director expenses also increased by $231 thousand as the Company enhanced its director compensation structure and responded to the additional requirements of Sarbanes-Oxley. This included implementation of a director certification program and engagement of compensation consultants to review executive compensation. The outsourcing of data processing services in September 2003 also contributed approximately $626 thousand to the increase in other expenses in 2004. The Company’s decision to outsource this function reflects the changing face of technology and the Company’s commitment to maintain the appropriate operating foundation for future growth. Amortization of core deposit intangibles increased $439 thousand due to the Guaranty merger, and there were approximately $343 thousand in merger-related expenses including data and systems conversion, marketing, communications, and other integration costs. Marketing and advertising expense increased by $463 thousand over last year, and other expenses including telephone expense, courier and armored car expense and postage expense were up $497 thousand compared to a year ago.

 

Noninterest expenses were up $4.8 million or 13.4% to $40.7 million in 2003, compared to $35.9 million in 2002. Salaries and benefits were $25.1 million in 2003, up $3.8 million or 17.9% compared to $21.3 million in 2002. The increase in mortgage loan originations and gains on loan sales within the mortgage segment resulted in an increase of $2.1 million in salaries and benefits of which $1.5 million was commission based compensation. The community bank segment’s salaries and benefits were up $1.7 million from 2002 to 2003. This was the result of a full year of expenses from the two new branches opened during 2002 and the addition of one new branch in 2003, a full year from the loan production office in Manassas, Virginia opened in 2002, the loan production office in Richmond for 2003, higher group insurance, expanded staffing in the retail locations and merit increases. Occupancy expenses were $2.7 million, up $366,000 over $2.3 million in 2002. This was the result of a new main office at the Rappahannock National Bank, building improvements to the operations center and various branches and the relocation of the Newport News office. Equipment expense was down slightly at $2.6 million versus $2.7 million in 2002. Other operating expense was $10.3 million, up $759,000 compared to $9.5 million in 2002. This was the result of increases in operating expense, data processing fees from outsourcing this service, marketing, other taxes and other expenses. Much of these increased costs were related to the new locations, new product advertising and general operating costs. In addition, during 2003, the Company elected to outsource its data processing function to its core processing vendor. This decision was based on analysis of the costs to upgrade and administer the existing internal system versus migration to the vendor’s cost effective platform.

 

LOAN PORTFOLIO

 

Loans, net of unearned income, totaled $1.3 billion at December 31, 2004, an increase of $386.5 million, or 44%, over $878.3 million at December 31, 2003. The acquisition of Guaranty includes $165.1 million in loans. Loans secured by real estate continue to represent the Company’s largest category, comprising 78.4% of the total loan portfolio at December 31, 2004. Of this total, 1-4 family residential loans, not including home equity lines, comprised 21.4% of the total loan portfolio at December 31, 2004, down from 25.9% in 2003. Loans secured by commercial real estate comprised 29.2% of the total loan portfolio at December 31, 2004, as compared to 27.3% in 2003, and consist of income producing properties, as well as commercial and industrial loans where real estate constitutes a secondary source of collateral. Real estate construction loans accounted for 17.5% of total loans outstanding at December 31, 2004, up significantly from 12% in 2003. Home equity lines were up in 2004, comprising 7.1% of the total loan portfolio compared to 5.5% in 2003 The Company’s charge-off rate for all loans secured by real estate has historically been low.

 

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Table of Contents

LOAN PORTFOLIO

 

     DECEMBER 31,

     2004

   2003

   2002

   2001

   2000

     (in thousands)

Commercial

   $ 135,907    $ 112,760    $ 78,289    $ 70,739    $ 74,261

Loans to finance agriculture production and other loans to farmers

     1,591      818      1,128      4,075      2,793

Real estate:

                                  

Real estate construction

     221,190      105,417      85,335      57,940      33,560

Real estate mortgage:

                                  

Residential (1-4 family)

     288,358      227,450      190,427      169,426      177,282

Home equity lines

     90,042      48,034      32,320      24,474      20,049

Multi-family

     18,287      11,075      3,066      3,418      4,666

Commercial

     368,816      239,804      200,125      155,093      139,737

Agriculture

     5,530      6,745      4,466      2,497      2,859
    

  

  

  

  

Total real estate

     992,223      638,525      515,739      412,848      378,153

Loans to individuals:

                                  

Consumer

     113,841      110,285      102,528      94,620      107,876

Credit card

     8,655      7,004      5,350      4,140      4,958
    

  

  

  

  

Total loans to individuals

     122,496      117,289      107,878      98,760      112,834

All other loans

     12,628      8,901      11,836      14,048      13,507
    

  

  

  

  

Total loans

     1,264,845      878,293      714,870      600,470      581,548

Less unearned income

     4      26      106      306      758
    

  

  

  

  

Total net loans

   $ 1,264,841    $ 878,267    $ 714,764    $ 600,164    $ 580,790
    

  

  

  

  

 

Despite growth of $23.2 million in 2004, commercial loans, secured by non-real estate business assets comprised 10.7% of total loans at the end of 2004, a decrease from 12.8% at the end of 2003. The Company’s consumer loan portfolio consists principally of installment loans. Such loans to individuals for household, family and other personal expenditures totaled 9.7% of total loans at December 31, 2004, down from 12.6% in 2003. This continues a trend as increased competition for automobile loans and the internet financing companies continued to impact this portfolio significantly in 2004. Loans to the agricultural industry totaled less than 1.0% of the loan portfolio in each of the last five years.

 

REMAINING MATURITIES OF SELECTED LOANS

 

          VARIABLE RATE:

   FIXED RATE:

    

At December 31, 2004

(in thousands)


   Within 1 year

   1 to 5
years


   After 5
years


   Total

   1 to 5
years


   After 5
years


   Total

   Total maturities

Commercial

   $ 92,748    3,005    784    3,789    34,409    4,961    39,370    $ 135,907

Real Estate Construction

   $ 215,017    1,156    —      1,156    1,832    3,185    5,017    $ 221,190

 

The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade area. The Company maintains a policy not to originate or purchase loans to foreign entities or loans classified by regulators as highly leveraged transactions. To manage the growth of the real estate loans in the loan portfolio, facilitate asset/liability management and generate additional fee income, the Company sells a portion of conforming first mortgage residential real estate loans to the secondary market as they are originated. Mortgage Capital Investors, Inc. serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to the affiliated banks that meet the banks’ current asset/liability management needs. This venture has provided the banks’ customers with enhanced mortgage products and the Company with improved efficiencies through the consolidation of this function.

 

ASSET QUALITY - ALLOWANCE/PROVISION FOR LOAN LOSSES

 

The allowance for loan losses represents management’s estimate of the amount deemed adequate to provide for potential losses inherent in the loan portfolio. Among other factors, management considers the Company’s historical loss experience, the size and composition of the loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits and current and anticipated economic

 

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conditions. There are additional risks of future loan losses, which cannot be precisely quantified nor attributed to particular loans or classes of loans. Because those risks include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The allowance is also subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and size of the allowance in comparison to peer companies identified by regulatory agencies.

 

Management maintains a list of loans which have a potential weakness that may need special attention. This list is used to monitor such loans and is used in the determination of the sufficiency of the Company’s allowance for loan losses. As of December 31, 2004, the allowance for loan losses was $16.4 million or 1.30% of total loans as compared to $11.5 million, or 1.31% in 2003. The provision for loan losses was $2.2 million in 2004 and $2.3 million in 2003. This modest decline in the provision expense reflects stronger asset quality and the fact that recoveries exceeded charge-offs due largely to recoveries associated with a large loan charged-off in prior years. The Company has recovered all principal related to the prior year charge-off which will reduce future years’ recoveries to the allowance for loan losses. The Company anticipates collection of as much as $600 thousand in interest income related to this credit in 2005.

 

ALLOWANCE FOR LOAN LOSSES

 

     DECEMBER 31,

 
     2004

    2003

    2002

    2001

    2000

 
                 (in thousands)              

Balance, beginning of year

   $ 11,519     $ 9,179     $ 7,336     $ 7,389     $ 6,617  

Allowance from acquired bank

     2,040       —         —         —         —    

Loans charged-off:

                                        

Commercial

     167       77       310       1,716       777  

Real estate

     5       1       —         3       48  

Consumer

     1,002       877       1,271       880       825  
    


 


 


 


 


Total loans charged-off

     1,174       955       1,581       2,599       1,650  
    


 


 


 


 


Recoveries:

                                        

Commercial

     1,388       684       245       154       16  

Real estate

     42       —         33       15       10  

Consumer

     415       304       268       251       295  
    


 


 


 


 


Total recoveries

     1,845       988       546       420       321  
    


 


 


 


 


Net charge-offs (recoveries)

     (671 )     (33 )     1,035       2,179       1,329  

Provision for loan losses

     2,154       2,307       2,878       2,126       2,101  
    


 


 


 


 


Balance, end of year

   $ 16,384     $ 11,519     $ 9,179     $ 7,336     $ 7,389  
    


 


 


 


 


Ratio of allowance for loan losses to total loans outstanding at end of year

     1.30 %     1.31 %     1.28 %     1.22 %     1.27 %

Ratio of net charge-offs to average loans outstanding during year

     -0.06 %     0.00 %     0.16 %     0.37 %     0.23 %

 

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The table below shows an allocation among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors and the ratio of the related outstanding loan balances to total loans.

 

(Percent is loans in category divided by total loans.)

 

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

 

December 31:


   2004

    2003

    2002

    2001

    2000

 
     Allowance

   Percent

    Allowance

   Percent

    Allowance

   Percent

    Allowance

   Percent

    Allowance

   Percent

 
     (in thousands)  

Commercial, financial and agriculture

   $ 4,971    10.8 %   $ 4,500    12.9 %   $ 3,249    11.1 %   $ 2,846    12.5 %   $ 3,369    13.3 %

Real estate construction

     7,998    17.5 %     4,176    12.0 %     3,492    11.9 %     2,205    9.7 %     1,467    5.8 %

Real estate mortgage

     518    61.0 %     493    60.7 %     426    60.2 %     383    59.1 %     406    59.3 %

Consumer & other

     2,897    10.7 %     2,350    14.4 %     2,012    16.8 %     1,902    18.7 %     2,147    21.6 %
    

  

 

  

 

  

 

  

 

  

     $ 16,384    100.0 %   $ 11,519    100.0 %   $ 9,179    100.0 %   $ 7,336    100.0 %   $ 7,389    100.0 %
    

        

        

        

        

      

 

NONPERFORMING ASSETS

 

Nonperforming assets were $11.2 million at December 31, 2004, up from $9.6 million at December 31, 2003. Nonaccrual loans increased to $11.2 million in 2004 from $9.2 million in 2003 and foreclosed properties were down from $444 thousand in 2003 to $14 thousand in 2004.

 

NONPERFORMING ASSETS

 

     DECEMBER 31,

 
     2004

    2003

    2002

    2001

    2000

 
     (in thousands)  

Nonaccrual loans

   $ 11,169     $ 9,174     $ 136     $ 915     $ 830  

Foreclosed properties

     14       444       774       639       844  

Real estate investment

     —         —         —         129       867  
    


 


 


 


 


Total nonperforming assets

   $ 11,183     $ 9,618     $ 910     $ 1,683     $ 2,541  
    


 


 


 


 


Loans past due 90 days and accruing interest

   $ 822     $ 957     $ 896     $ 2,757     $ 1,531  
    


 


 


 


 


Nonperforming assets to year-end loans, foreclosed properties and real estate investment

     0.88 %     1.09 %     0.13 %     0.28 %     0.44 %

Allowance for loan losses to nonaccrual loans

     146.69 %     125.56 %     6749.26 %     801.75 %     890.24 %

 

Most of the nonperforming assets are secured by real estate within the Company’s trade area. Based on the estimated fair values of the related real estate, management considers these amounts to be recoverable, with any individual deficiency considered in the allowance for loan losses. At December 31, 2004, nonperforming assets totaled $11.2 million, including a single credit relationship totaling $10.9 million. These loans are secured by real estate, but based on the information currently available management has allocated $1.2 million in reserves. In 2004, the Company has entered into a workout agreement with the borrower. This agreement has matured, and management anticipates that it will be renewed in the first quarter of 2005. Under the terms of the workout, the Company extended further credit of approximately $2.9 million secured by additional property with significant equity to enhance the Company’s collateral position. The Company anticipates that this workout will result in a reduction of overall exposure to the borrower.

 

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SECURITIES AVAILABLE FOR SALE

 

At December 31, 2004, the Company had securities available for sale in the amount of $233.5 million, as compared to $240.1 million at December 31, 2003. The Company seeks to diversify its portfolio to minimize risk and to maintain a large amount of securities issued by states and political subdivisions due to the tax benefits such securities provide. It also purchases mortgage-backed securities because of the reinvestment opportunities from the cash flows and the higher yield offered from these securities. The investment portfolio has a high percentage of municipals and mortgage-backed securities, which is the main reason for the high taxable equivalent yield the portfolio attains compared to its peers. The Company does not engage in structured derivative or hedging activities. The following table sets forth a summary of the securities available for sale:

 

     As of December 31,

     2004

   2003

   2002

     (in thousands)

Available-for sale securities, at fair value:

                    

U.S. government and agency securities

   $ 8,020    $ 11,709    $ 17,455

Obligations of states and political subdivisions

     83,338      91,027      101,713

Corporate and other bonds

     38,673      57,219      67,625

Mortgage-backed securities

     92,923      75,023      80,886

Federal Reserve Bank stock

     2,153      688      648

Federal Home Loan Bank stock

     7,474      3,678      3,758

Other securities

     886      780      670
    

  

  

     $ 233,467    $ 240,124    $ 272,755
    

  

  

 

The following table summarizes the contractual maturity of securities available for sale and their weighted average yields:

 

     DECEMBER 31, 2004

 
     1 YEAR
OR LESS


    1-5
YEARS


    5-10
YEARS


    OVER 10
YEARS &
EQUITY
SECURITIES


    TOTAL

 
     (in thousands)  

U.S. government and agency securities:

                                        

Amortized cost

   $ 1,002     $ 1,970     $ 5,044     $ —       $ 8,016  

Fair value

     1,004       1,973       5,043       —         8,020  

Weighted average yield(1)

     3.80 %     3.66 %     2.76 %     —         3.11 %

Mortgage backed securities:

                                        

Amortized cost

   $ —       $ 3,737     $ 30,920     $ 57,768     $ 92,425  

Fair value

     —         3,773       31,144       58,006       92,923  

Weighted average yield(1)

     —         4.28 %     4.29 %     4.65 %     4.52 %

Municipal bonds:

                                        

Amortized cost

   $ 2,312     $ 18,524     $ 39,081     $ 20,134     $ 80,051  

Fair value

     2,337       19,002       40,794       21,205       83,338  

Weighted average yield(1)

     4.98 %     5.01 %     4.83 %     4.96 %     4.91 %

Other securities:

                                        

Amortized cost

   $ 2,379     $ 6,090     $ —       $ 36,668     $ 45,137  

Fair value

     2,411       6,214       —         40,561       49,186  

Weighted average yield(1)

     6.33 %     5.21 %     —         8.25 %     7.74 %

Total securities:

                                        

Amortized cost

   $ 5,693     $ 30,321     $ 75,045     $ 114,570     $ 225,629  

Fair value

     5,752       30,962       76,981       119,772       233,467  

Weighted average yield(1)

     5.34 %     4.87 %     4.47 %     5.86 %     5.25 %

(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.

 

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Contractual maturity of mortgage-backed securities is not a reliable indicator of their expected life because borrowers have the right to prepay the obligations at any time.

 

DEPOSITS

 

Total deposits grew $314.5 million, or 31.5%, in 2004 with deposits acquired in the Guaranty merger accounting for $184.5 million of that growth at acquisition. The Company also opened five new branches through Union Bank in 2004.

 

Total deposits increased from $1.0 billion at December 31, 2003 to $1.3 billion at December 31, 2004. Over this same period, average interest-bearing deposits were $990.8 million or 22.4% over the 2003 average of $809.6 million. Average NOW accounts and money market accounts continued to rise with increases of $39.0 million and $61.7 million, respectively. Average certificates of deposits rose $57.7 million with customers moving to longer term investments to improve their returns. In 2004, the average balance of the Company’s lowest-cost funding source, noninterest-bearing demand deposits, increased by a total of $56.0 million over 2003. The Company has no brokered deposits.

 

AVERAGE DEPOSITS AND RATES PAID

 

     YEARS ENDED DECEMBER 31,

 
     2004

    2003

    2002

 
     AMOUNT

   RATE

    AMOUNT

   RATE

    AMOUNT

   RATE

 
     (in thousands)  

Noninterest-bearing demand deposits

   $ 196,520    —       $ 141,228    —       $ 115,552    —    

Interest-bearing deposits:

                                       

NOW accounts

     175,659    0.28 %     136,621    0.42 %     120,878    0.85 %

Money market accounts

     159,111    0.98 %     97,368    0.99 %     84,623    1.41 %

Savings accounts

     112,953    0.64 %     90,208    0.83 %     78,497    1.29 %

Time deposits of $100,000 and over

     190,506    3.46 %     163,330    3.84 %     135,429    4.22 %

Other time deposits

     352,589    3.03 %     322,111    3.51 %     286,076    4.02 %
    

        

        

      

Total interest-bearing

     990,818    2.02 %     809,638    2.45 %     705,503    2.90 %
    

        

        

      

Total average deposits

   $ 1,187,338          $ 950,866          $ 821,055       
    

        

        

      

 

MATURITIES OF CERTIFICATES OF DEPOSIT OF $100,000 AND OVER

 

     WITHIN
3 MONTHS


   3 - 6
MONTHS


   6 - 12
MONTHS


   OVER 12
MONTHS


   TOTAL

  

PERCENT

OF TOTAL

DEPOSITS


 
     (in thousands)  

At December 31, 2004

   $ 40,677    $ 24,707    $ 27,717    $ 116,828    $ 209,929    15.97 %

 

CAPITAL RESOURCES

 

Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

 

The Federal Reserve Board, along with the OCC and 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 assets is 8.0%, of which 4.0% must be Tier 1 capital, consisting of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The Company had a ratio of total capital to risk-weighted assets of 11.63% and 11.88% on December 31, 2004 and 2003, respectively. The Company’s ratio of Tier 1 capital to risk-weighted assets was 10.41% and 10.71% at December 31, 2004 and 2003, respectively, allowing the

 

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Company to meet the definition of “well-capitalized” for regulatory purposes. Both of these ratios exceeded the fully phased-in capital requirements in 2004 and 2003. The Company’s current strategic plan includes a targeted equity to asset ratio between 8% and 9%. As of December 31, 2004, that ratio was 9.7%.

 

In connection with the acquisition of Guaranty, the Company issued trust preferred capital notes to fund the cash portion of that acquisition, which approximated $22.5 million. These debt instruments qualify for regulatory treatment as Tier 1 capital and will allow the Company to maintain its categorization as well-capitalized for regulatory purposes.

 

ANALYSIS OF CAPITAL

 

     DECEMBER 31,

 
     2004

    2003

    2002

 
     (in thousands)  

Tier 1 capital:

                        

Common stock

   $ 17,488     $ 15,254     $ 15,159  

Surplus

     33,716       2,401       1,442  

Retained earnings

     106,460       94,102       81,997  
    


 


 


Total equity

     157,664       111,757       98,598  

Plus: qualifying trust preferred capital notes

     22,500       —         —    

Less: core deposit intangibles/goodwill

     (40,714 )     (5,779 )     (6,342 )
    


 


 


Total Tier 1 capital

     139,450       105,978       92,256  
    


 


 


Tier 2 capital:

                        

Allowance for loan losses

     16,384       11,519       9,179  
    


 


 


Total Tier 2 capital

     16,384       11,519       9,179  
    


 


 


Total risk-based capital

   $ 155,834     $ 117,497     $ 101,435  
    


 


 


Risk-weighted assets

   $ 1,339,900     $ 989,236     $ 834,560  
    


 


 


Capital ratios:

                        

Tier 1 risk-based capital ratio

     10.41 %     10.71 %     11.05 %

Total risk-based capital ratio

     11.63 %     11.88 %     12.15 %

Tier 1 capital to average adjusted total assets

     8.60 %     8.72 %     8.49 %

Equity to total assets

     10.77 %     9.60 %     9.46 %

 

OFF BALANCE SHEET OBLIGATIONS

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

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 may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

 

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The Company evaluates each customer’s creditworthiness on a case-by-case basis. At December 31, 2004 and 2003, the Company had outstanding loan commitments approximating $571.6 million and $318.8 million, respectively.

 

Letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The amount of standby letters of credit whose contract amounts represent credit risk totaled approximately $28.2 million and $17.1 million at December 31, 2004 and 2003, respectively.

 

At December 31, 2004, the mortgage company had rate lock commitments to originate mortgage loans amounting to approximately $15.1 million and loans held for sale of $42.7 million. The mortgage company has entered into corresponding mandatory commitments, on a best-efforts basis, to sell loans of approximately $57.8 million. These commitments to sell loans are designed to eliminate the mortgage company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

 

LIQUIDITY

 

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, Federal funds sold, securities available for sale and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates determines its liability liquidity. As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity, which is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

 

At December 31, 2004, cash and cash equivalents and securities classified as available for sale comprised 15.9% of total assets, compared to 22.8% at December 31, 2003. Asset liquidity is also provided by managing loan and securities maturities and cash flows.

 

Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary. The subsidiary banks maintain Federal funds lines with several regional banks totaling approximately $65.4 million at December 31, 2004. At year-end 2004, the banks had outstanding $45.0 million of borrowings pursuant to securities sold under agreements to repurchase transactions with a maturity of one day. The Company also had a line of credit with the Federal Home Loan Bank of Atlanta for $503.8 million at December 31, 2004.

 

The following table presents the Company’s contractual obligations and scheduled payment amounts due at the various intervals over the next five years and beyond as of December 31, 2004.

 

(in thousands)    Payments due by Period

Contractual Obligations and Commitments


   Total

   Less than a
year


   1 -3
years


  

3-5

years


   More than 5
years


Long term debt

   $ 113,467    $ 671    $ 100    $ 52,500    $ 60,196

Operating leases

     4,869      817      1,483      1,269      1,300

Repurchase agreements

     45,024      45,024      —        —        —  
    

  

  

  

  

Total Contractual obligations and commitments

   $ 163,360    $ 46,512    $ 1,583    $ 53,769    $ 61,496
    

  

  

  

  

 

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QUARTERLY RESULTS

 

The following table presents the Company’s quarterly performance for the years ended December 31, 2004 and 2003:

 

     2004

     FOURTH

   THIRD

   SECOND

   FIRST

   TOTAL

     (in thousands, except per share amounts)

Interest and dividend income

   $ 22,718    $ 21,582    $ 19,354    $ 16,890    $ 80,544

Interest expense

     6,985      6,705      6,188      5,774      25,652
    

  

  

  

  

Net interest income

     15,733      14,877      13,166      11,116      54,892

Provision for loan losses

     520      895      308      431      2,154
    

  

  

  

  

Net interest income after provision for loan losses

     15,213      13,982      12,858      10,685      52,738

Noninterest income

     6,247      6,098      6,274      4,683      23,302

Noninterest expenses

     13,964      13,992      12,755      10,510      51,221
    

  

  

  

  

Income before income taxes

     7,496      6,088      6,377      4,858      24,819

Income tax expense

     2,199      1,631      1,816      1,248      6,894
    

  

  

  

  

Net income

   $ 5,297    $ 4,457    $ 4,561    $ 3,610    $ 17,925
    

  

  

  

  

Net income per share

                                  

Basic

   $ 0.62    $ 0.51    $ 0.53    $ 0.47    $ 2.13
    

  

  

  

  

Diluted

   $ 0.60    $ 0.51    $ 0.53    $ 0.47    $ 2.11
    

  

  

  

  

 

     2003

     FOURTH

   THIRD

   SECOND

   FIRST

   TOTAL

     (in thousands, except per share amounts)

Interest and dividend income

   $ 16,795    $ 16,945    $ 16,751    $ 16,526    $ 67,017

Interest expense

     5,854      5,967      6,020      6,064      23,905
    

  

  

  

  

Net interest income

     10,941      10,978      10,731      10,462      43,112

Provision for loan losses

     372      903      645      387      2,307
    

  

  

  

  

Net interest income after provision for loan losses

     10,569      10,075      10,086      10,075      40,805

Noninterest income

     5,270      6,683      6,211      4,676      22,840

Noninterest expenses

     10,222      10,959      10,264      9,280      40,725
    

  

  

  

  

Income before income taxes

     5,617      5,799      6,033      5,471      22,920

Income tax expense

     1,428      1,604      1,697      1,527      6,256
    

  

  

  

  

Net income

   $ 4,189    $ 4,195    $ 4,336    $ 3,944    $ 16,664
    

  

  

  

  

Net income per share

                                  

Basic

   $ 0.55    $ 0.55    $ 0.57    $ 0.52    $ 2.19
    

  

  

  

  

Diluted

   $ 0.53    $ 0.55    $ 0.57    $ 0.52    $ 2.17
    

  

  

  

  

 

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Table of Contents

Item 7A. - Quantitative and Qualitative Disclosures About Market Risk

 

This information is incorporated herein by reference from Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, on pages 18 through 20 of this Form 10-K.

 

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Table of Contents

Item 8. – Financial Statements and Supplementary Data

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders

Union Bankshares Corporation

Bowling Green, Virginia

 

We have audited the accompanying consolidated balance sheets of Union Bankshares Corporation and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004. We also have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Union Bankshares Corporation and subsidiaries’ management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Union Bankshares Corporation and subsidiaries’ internal control over financial reporting based on our audits. We did not audit the financial statements or management’s assessment of internal control over financial reporting of Mortgage Capital Investors, Inc., a consolidated subsidiary which reflects total assets and revenue constituting 3% and 13%, respectively, in 2004, 3% and 17%, respectively, in 2003, 4% and 14%, respectively, in 2002, of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Mortgage Capital Investors, Inc. and management’s assessment and the effectiveness of Mortgage Capital Investors, Inc. internal control over financial reporting, is based solely on the report of the other auditors.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the corporation; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the corporation are being made only in accordance with authorizations of

 

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management and directors of the corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the corporation’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Union Bankshares Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, based on our audit and the report of other auditors, management’s assessment that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, based on our audit and the report of other auditors, Union Bankshares Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

LOGO

 

Winchester, Virginia

February 18, 2005

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2004 and 2003

(in thousands)

 

     2004

   2003

ASSETS

             

Cash and cash equivalents:

             

Cash and due from banks

   $ 29,920    $ 28,708

Interest-bearing deposits in other banks

     523      2,077

Money market investments

     130      137

Other interest-bearing deposits

     2,598      —  

Federal funds sold

     73      10,050
    

  

Total cash and cash equivalents

     33,244      40,972
    

  

Securities available for sale, at fair value

     233,467      240,124
    

  

Loans held for sale

     42,668      28,683
    

  

Loans, net of unearned income

     1,264,841      878,267

Less allowance for loan losses

     16,384      11,519
    

  

Net loans

     1,248,457      866,748
    

  

Bank premises and equipment, net

     40,945      26,528

Other real estate owned

     14      444

Core deposit intangibles, net

     9,721      4,925

Goodwill

     30,992      864

Other assets

     32,702      25,444
    

  

Total assets

   $ 1,672,210    $ 1,234,732
    

  

LIABILITIES AND STOCKHOLDERS’ EQUITY

             

Noninterest-bearing demand deposits

   $ 230,055    $ 146,423

Interest-bearing deposits:

             

NOW accounts

     195,309      149,168

Money market accounts

     197,617      104,911

Savings accounts

     117,851      93,374

Time deposits of $100,000 and over

     209,929      177,458

Other time deposits

     363,556      328,437
    

  

Total interest-bearing deposits

     1,084,262      853,348
    

  

Total deposits

     1,314,317      999,771
    

  

Securities sold under agreements to repurchase

     45,024      42,602

Other short-term borrowings

     24,514      —  

Trust preferred capital notes

     23,196      —  

Long-term borrowings

     90,271      66,208

Other liabilities

     12,130      7,650
    

  

Total liabilities

     1,509,452      1,116,231
    

  

Commitments and contingencies

             

Stockholders’ equity:

             

Common stock, $2 par value. Authorized 24,000,000 shares; issued and outstanding, 8,744,176 shares in 2004 and 7,627,248 shares in 2003

     17,488      15,254

Surplus

     33,716      2,401

Retained earnings

     106,460      94,102

Accumulated other comprehensive income

     5,094      6,744
    

  

Total stockholders’ equity

     162,758      118,501
    

  

Total liabilities and stockholders’ equity

   $ 1,672,210    $ 1,234,732
    

  

 

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31, 2004, 2003 and 2002

(in thousands, except per share amounts)

 

     2004

   2003

   2002

 

Interest and dividend income :

                      

Interest and fees on loans

   $ 68,738    $ 54,312    $ 50,693  

Interest on Federal funds sold

     102      138      206  

Interest on deposits in other banks

     29      22      17  

Interest on money market investments

     1      22      40  

Interest on other interest-bearing deposits

     33      —        —    

Interest and dividends on securities:

                      

Taxable

     7,709      8,171      9,619  

Nontaxable

     3,932      4,352      4,630  
    

  

  


Total interest and dividend income

     80,544      67,017      65,205  
    

  

  


Interest expense:

                      

Interest on deposits

     20,029      19,873      20,459  

Interest on short-term borrowings

     697      325      475  

Interest on long-term borrowings

     4,926      3,707      3,693  
    

  

  


Total interest expense

     25,652      23,905      24,627  
    

  

  


Net interest income

     54,892      43,112      40,578  

Provision for loan losses

     2,154      2,307      2,878  
    

  

  


Net interest income after provision for loan losses

     52,738      40,805      37,700  
    

  

  


Noninterest income:

                      

Service charges on deposit accounts

     6,826      5,597      4,088  

Other service charges, commissions and fees

     3,431      2,509      2,563  

Gains (losses) on securities transactions, net

     49      113      (159 )

Gains on sales of loans

     11,836      13,260      10,089  

Gains on sales of other real estate owned and bank premises, net

     29      165      157  

Other operating income

     1,131      1,196      800  
    

  

  


Total noninterest income

     23,302      22,840      17,538  
    

  

  


Noninterest expenses:

                      

Salaries and benefits

     29,128      25,137      21,326  

Occupancy expenses

     3,427      2,684      2,318  

Furniture and equipment expenses

     3,444      2,609      2,742  

Other operating expenses

     15,222      10,295      9,536  
    

  

  


Total noninterest expenses

     51,221      40,725      35,922  
    

  

  


Income before income taxes

     24,819      22,920      19,316  

Income tax expense

     6,894      6,256      4,811  
    

  

  


Net income

   $ 17,925    $ 16,664    $ 14,505  
    

  

  


Earnings per share, basic

   $ 2.13    $ 2.19    $ 1.92  
    

  

  


Earnings per share, diluted

   $ 2.11    $ 2.17    $ 1.90  
    

  

  


 

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2004, 2003 and 2002

(in thousands, except per share amounts)

 

     Common
Stock


    Surplus

    Retained
Earnings


    Accumulated
Other
Comprehensive
Income (Loss)


    Comprehensive
Income (Loss)


    Total

 

Balance - December 31, 2001

   $ 15,052     $ 446     $ 71,419     $ 2,062             $ 88,979  

Comprehensive income:

                                                

Net income - 2002

                     14,505             $ 14,505       14,505  

Unrealized holding gains arising during the period (net of tax, $2,435)

                                     4,727          

Reclassification adjustment for losses included in net income (net of tax, $54)

                                     105          
                                    


       

Other comprehensive income (net of tax, $2,489)

                             4,832       4,832       4,832  
                                    


       

Total comprehensive income

                                   $ 19,337          
                                    


       

Cash dividends - 2002 ($.52 per share)

                     (3,927 )                     (3,927 )

Issuance of common stock under Dividend Reinvestment Plan (18,389 shares)

     37       387                               424  

Issuance of common stock under Incentive Stock Option Plan (16,850 shares)

     33       274                               307  

Issuance of common stock for services rendered (1,400 shares)

     3       36                               39  

Issuance of common stock in exchange for net assets in acquisition (17,156 shares)

     34       299                               333  
    


 


 


 


         


Balance - December 31, 2002

   $ 15,159     $ 1,442     $ 81,997     $ 6,894             $ 105,492  

Comprehensive income:

                                                

Net income - 2003

                     16,664             $ 16,664       16,664  

Unrealized holding losses arising during the period (net of tax, $39)

                                     (75 )        

Reclassification adjustment for gains included in net income (net of tax, $38)

                                     (75 )        
                                    


       

Other comprehensive income (loss) (net of tax, $77)

                             (150 )     (150 )     (150 )
                                    


       

Total comprehensive income

                                   $ 16,514          
                                    


       

Cash dividends - 2003 ($.60 per share)

                     (4,559 )                     (4,559 )

Issuance of common stock under Dividend Reinvestment Plan (16,501 shares)

     33       426                               459  

Issuance of common stock under Incentive Stock Option Plan (26,703 shares)

     54       395                               449  

Issuance of common stock for services rendered (8,196 shares)

     16       248                               264  

Stock repurchased under Stock Repurchase Plan and option exchange (3,859 shares)

     (8 )     (110 )                             (118 )
    


 


 


 


         


Balance - December 31, 2003

   $ 15,254     $ 2,401     $ 94,102     $ 6,744             $ 118,501  

Comprehensive income:

                                                

Net income - 2004

                     17,925             $ 17,925     $ 17,925  

Unrealized holding losses arising during the period (net of tax, $871)

                                     (1,618 )        

Reclassification adjustment for gains included in net income (net of tax, $17)

                                     (32 )        
                                    


       

Other comprehensive income (loss) (net of tax, $888)

                             (1,650 )     (1,650 )     (1,650 )
                                    


       

Total comprehensive income

                                   $ 16,275          
                                    


       

Cash dividends - 2004 ($.68 per share)

                     (5,567 )                     (5,567 )

Issuance of common stock under Dividend Reinvestment Plan (18,678 shares)

     37       529                               566  

Issuance of common stock under Incentive Stock Option Plan (66,586 shares)

     134       860                               994  

Issuance of common stock for services rendered (8,908 shares)

     17       292                               309  

Issuance of common stock in exchange for net assets in acquisition (1,022,756 shares)

     2,046       29,634                               31,680  
    


 


 


 


         


Balance - December 31, 2004

   $ 17,488     $ 33,716     $ 106,460     $ 5,094             $ 162,758  
    


 


 


 


         


 

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDING DECEMBER 31, 2004, 2003 and 2002

( in thousands)

 

     2004

    2003

    2002

 

Operating activities:

                        

Net income

   $ 17,925     $ 16,664     $ 14,505  

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:

                        

Depreciation of bank premises and equipment

     2,994       2,041       2,062  

Amortization, net

     1,679       2,237       1,879  

Provision for loan losses

     2,154       2,307       2,878  

(Gains) losses on securities transactions, net

     (49 )     (113 )     159  

Origination of loans held for sale

     (496,153 )     (535,482 )     (384,511 )

Proceeds from sales of loans held for sale

     482,168       546,570       388,225  

Gains on sales of other real estate owned and fixed assets, net

     (29 )     (165 )     (157 )

Deferred income tax benefit

     (335 )     (655 )     (304 )

Other, net

     (594 )     (232 )     (1,219 )
    


 


 


Net cash and cash equivalents provided by operating activities

     9,760       33,172       23,517  
    


 


 


Investing activities:

                        

Purchases of securities available for sale

     (76,574 )     (71,065 )     (63,043 )

Proceeds from sales of securities available for sale

     12,354       9,775       6,118  

Proceeds from maturities of securities available for sale

     87,806       92,455       47,724  

Net increase in loans

     (218,801 )     (163,470 )     (116,134 )

Cash paid in bank acquisition

     (23,235 )     —         —    

Cash acquired in bank acquisition

     16,701       —         —    

Purchases of bank premises and equipment

     (9,483 )     (7,678 )     (5,045 )

Proceeds from sales of bank premises and equipment

     —         15       347  

Proceeds from sales of other real estate owned

     494       486       459  
    


 


 


Net cash and cash equivalents used in investing activities

     (210,738 )     (139,482 )     (129,574 )
    


 


 


Financing activities:

                        

Net increase in noninterest-bearing deposits

     45,129       12,957       23,259  

Net increase in interest-bearing deposits

     84,933       89,878       90,299  

Net increase (decrease) in short-term borrowings

     19,936       (2,175 )     3,694  

Proceeds from long-term borrowings

     37,500       5,000       400  

Repayment of long-term borrowings

     (13,437 )     (1,011 )     (912 )

Proceeds from trust preferred capital notes

     23,196       —         —    

Cash dividends paid

     (5,567 )     (4,559 )     (3,927 )

Issuance of common stock

     1,560       908       731  

Stock repurchased under Stock Repurchase Plan and option exchange

     —         (118 )     —    
    


 


 


Net cash and cash equivalents provided by financing activities

     193,250       100,880       113,544  
    


 


 


Increase (decrease) in cash and cash equivalents

     (7,728 )     (5,430 )     7,487  

Cash and cash equivalents at beginning of year

     40,972       46,402       38,915  
    


 


 


Cash and cash equivalents at end of year

   $ 33,244     $ 40,972     $ 46,402  
    


 


 


Supplemental Disclosure of Cash Flow Information

                        

Cash payments for:

                        

Interest

   $ 25,404     $ 23,965     $ 24,895  

Income taxes

     6,896       7,211       4,833  

Supplemental schedule of noncash investing and financing activities:

                        

Loan balances transferred to foreclosed properties

     —         —         499  

Unrealized gain (loss) on securities available for sale

     (2,381 )     (227 )     7,321  

Issuance of common stock in exchange for net assets in acquisition

     31,680       —         333  

Issuance of common stock for services rendered

     309       264       39  

Transactions related to the acquisition of subsidiary:

                        

Increase in assets and liabilities

                        

Loans

   $ 165,062                  

Securities

     19,931                  

Other assets

     39,220                  

Non-interest bearing deposits

     38,503                  

Interest bearing deposits

     145,981                  

Borrowings

     7,000                  

Other liabilities

     2,130                  

Issuance of common stock

     31,680                  

 

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2004, 2003, and 2002

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

The accounting policies and practices of Union Bankshares Corporation and subsidiaries (the “Company” or “Union”) conform to U. S. generally accepted accounting principles and to general practice within the banking industry. Major policies and practices are described below:

 

(A) Principles Of Consolidation

 

The consolidated financial statements include the accounts of Union Bankshares Corporation and its wholly owned subsidiaries. Union Bankshares Corporation is a bank holding company that owns all of the outstanding common stock of its banking subsidiaries, Union Bank and Trust Company, Northern Neck State Bank, Rappahannock National Bank, Bank of Williamsburg and of Union Investment Services. Mortgage Capital Investors is a wholly owned subsidiary of Union Bank and Trust Company. The Bank of Williamsburg has a non-controlling interest in Johnson Mortgage Company, which is accounted for under the equity method of accounting. FASB Interpretation No. 46R requires the Company to no longer consolidate Statutory Trust I, an unconsolidated subsidiary. The subordinated debt owed to the trust is reported as a liability of the Company. All significant intercompany balances and transactions have been eliminated. The accompanying consolidated financial statements for prior periods reflect certain reclassifications in order to conform to the current presentation.

 

(B) Investment Securities

 

Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. The Company has no securities in this category.

 

Securities classified as available for sale are those debt and equity securities that management intends to hold for an indefinite period of time, including securities used as part of the Company’s asset/liability strategy, and that may be sold in response to changes in interest rates, liquidity needs or other similar factors. Securities available for sale are reported at fair value, with unrealized gains or losses on, net of deferred taxes, included in accumulated other comprehensive income (loss) in stockholders’ equity.

 

Securities classified as held for trading are those debt and equity securities that are bought and held principally for the purpose of selling them in the near term and reported at fair value, with unrealized gains and losses included in earnings.

 

Purchased premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

 

(C) Loans Held For Sale

 

Loans originated and intended for sale in the secondary market are sold servicing released and carried at the lower of cost or estimated fair value which is determined in the aggregate based on sales commitments to permanent investors or on current market rates for loans of similar quality and type. In addition, the

 

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Company requires a firm purchase commitment from a permanent investor before a loan can be closed, thus limiting interest rate risk. As a result, loans held for sale are stated at fair value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

 

(D) Loans

 

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout its market area. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

 

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

 

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on nonaccrual status or charged-off at an earlier date if collection of principal and interest is considered doubtful.

 

All interest accrued but not collected for loans that are placed on nonaccrual status or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

(E) Allowance For Loan Losses

 

The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance that management considers adequate to absorb potential losses in the portfolio. Loans are charged against the allowance when management believes the collectibility of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the composition of the loan portfolio, the value and adequacy of collateral, current economic conditions, historical loan loss experience, and other risk factors. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions, particularly those affecting real estate values. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

 

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as 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.

 

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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.

 

(F) Bank Premises And Equipment

 

Bank premises and equipment is stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using either the straight-line or accelerated method based on the type of asset involved. It is the policy of the Company to capitalize additions and improvements and to depreciate the cost thereof over their estimated useful lives ranging from 3 to 40 years. Maintenance, repairs and renewals are expensed as they are incurred.

 

(G) Goodwill and Intangible Assets

 

SFAS No. 141, Business Combinations, requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, Union is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. The Company adopted SFAS 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over the estimated useful life.

 

(H) Income Taxes

 

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

 

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(I) Other Real Estate Owned

 

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the carrying amount or fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are 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 net expenses from foreclosed assets.

 

(J) Consolidated Statements of Cash Flows

 

For purposes of reporting cash flows, the Company defines cash and cash equivalents as cash due from banks, interest-bearing deposits in other banks, money market investments, other interest-bearing deposits, and Federal funds sold.

 

(K) Earnings Per Share

 

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

 

(L) Comprehensive Income (Loss)

 

Comprehensive income (loss) represents all changes in equity that result from recognized transactions and other economic events of the period. Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under accounting principles generally accepted in the United States of America are included in comprehensive income but excluded from net income, such as unrealized gains and losses on certain investments in debt and equity securities.

 

(M) Use of Estimates

 

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of goodwill and intangible assets, foreclosed real estate and deferred tax assets and liabilities.

 

(N) Advertising Costs

 

The Company follows a policy of charging the cost of advertising to expense as incurred. Total advertising costs included in other operating expenses for 2004, 2003 and 2002 were $2.0 million, $1.5 million and $1.4 million, respectively.

 

(O) Off Balance Sheet Credit Related Financial Instruments

 

In the ordinary course of business, the Company has entered into commitments to extend credit and standby letters of credit. Such financial instruments are recorded when they are funded.

 

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(P) Rate Lock Commitments

 

The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 120 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. As a result, the Company is not exposed to losses nor will it realize significant gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitments and the best efforts contracts is very high due to their similarity.

 

The market value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments.

 

(Q) Variable Interest Entities

 

In January 2003, the FASB issued FIN 46 which states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This interpretation explains how to identify variable interest entities and how an enterprise assesses its interest in a variable interest entity to decide whether to consolidate the entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to the significant implementation concerns, the FASB revised Interpretation No. 46 (“FIN 46R”) in December 2003. Management has evaluated the Company’s investment in variable interest entities and potential variable interest entities or transactions, particularly in trust preferred securities structures because these entities constitute the Company’s primary exposure.

 

Currently, other than the impact described above from the deconsolidation of the trust preferred capital notes, the adoption of FIN 46 and FIN 46R has not had a material impact on the financial condition or the operating results of the Company.

 

(R) Asset Prepayment Rates

 

The Company purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from the borrowers’ election to refinance the underlying mortgage based on market and other conditions. The purchase premiums and discounts associated with these assets are amortized or accreted to interest income over the estimated life of the related assets. The estimated life is calculated by projecting future prepayments and the resulting principal cash flows until maturity. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums and discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.

 

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(S) Stock Compensation Plan

 

The Company accounts for the Incentive Stock Option Plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the Plan have an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.

 

     Years Ended December 31,

 

(in thousands except per share data)

 

   2004

    2003

    2002

 

Net income, as reported

   $ 17,925     $ 16,664     $ 14,505  

Total stock-based compensation expense determined under fair value based method for all awards

     (378 )     (338 )     (201 )
    


 


 


Pro forma net income

   $ 17,547     $ 16,326     $ 14,304  
    


 


 


Earning per share:

                        

Basic - as reported

   $ 2.13     $ 2.19     $ 1.92  
    


 


 


Basic - pro forma

   $ 2.09     $ 2.15     $ 1.90  
    


 


 


Diluted - as reported

   $ 2.11     $ 2.17     $ 1.90  
    


 


 


Diluted - pro forma

   $ 2.07     $ 2.13     $ 1.88  
    


 


 


 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 

     2004

    2003

    2002

 

Dividend yield

   2.39 %   2.43 %   2.51 %

Expected life

   10 years     10 years     10 years  

Expected volatility

   34.54 %   35.54 %   36.91 %

Risk-free interest rate

   4.23 %   4.03 %   5.13 %

 

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(T) Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). This Interpretation provides guidance with respect to the identification of variable interest entities when the assets, liabilities, non-controlling interests, and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. An entity is deemed a variable interest entity, subject to the interpretation, if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or in cases in which the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity’s activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. Due to significant implementation issues, the FASB modified the wording of FIN 46 and issued FIN 46R in December of 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities (“SPEs”) until financial statements issued for periods ending after March 15, 2004. SPEs were subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. Management has evaluated the Company’s investments in variable interest entities and potential variable interest entities or transactions, particularly in limited liability partnerships involved in low-income housing development and trust preferred securities structures because these entities or transactions constitute the Company’s primary FIN 46 and FIN 46R exposure. The adoption of FIN 46 and FIN 46R did not have a material effect on the Company’s consolidated financial position or consolidated results of operations.

 

In December 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The scope of the SOP applies to unhealthy “problem” loans that have been acquired, either individually in a portfolio, or in a business acquisition. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. The SOP does not apply to loans originated by the Company. The Company intends to adopt the provisions of SOP 03-3 effective January 1, 2005, and does not expect the initial implementation to have a significant effect on the Company’s consolidated financial position or consolidated results of operations.

 

On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (“SAB 105”). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (“IRLC”), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, this guidance did not have a material adverse effect on either the Company’s consolidated financial position or consolidated results of operations.

 

Emerging Issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”) was issued and is effective March 31, 2004. EITF 03-1 provides guidance for determining the meaning of “other-than-temporarily impaired” and its

 

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application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS No. 115”) and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired. On September 30, 2004, the Financial Accounting Standards Board (“FASB”) decided to delay the effective date for the measurement and recognition guidance contained in EITF 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in EITF 03-1 was not delayed and it is provided in Footnote 3 of the consolidated financial statements in Item 8 of this Form 10-K.

 

EITF No. 03-16, Accounting for Investments in Limited Liability Companies (“EITF 03-16”) was ratified by the Board and is effective for reporting periods beginning after June 15, 2004. APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, (“Opinion 18”) prescribes the accounting for investments in common stock of corporations that are not consolidated. AICPA Accounting Interpretation 2, Investments in Partnerships Ventures, of Opinion 18, indicates that “many of the provisions of the Opinion would be appropriate in accounting” for partnerships. In EITF Abstracts, Topic No. D-46, Accounting for Limited Partnership Investments, the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (LLCs) have characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs. The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting. This guidance did not have a material adverse effect on either the Company’s consolidated financial position or consolidated results of operations.

 

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period (usually the vesting period). The entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be re-measured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available). If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. This Statement is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. Under the transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service

 

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has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures. For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123. The Company currently measures compensation costs related to stock-based payments under APB Opinion No. 25 as allowed under SFAS No. 123, and provides disclosure in the notes to the consolidated financial statements as required by SFAS No. 123. Management is currently in the process of evaluating the extent of the impact.

 

U. Business Combination

 

On May 1, 2004, Union Bankshares completed its acquisition of Guaranty headquartered in Charlottesville, Virginia. This acquisition was accounted for using the purchase method of accounting. The total consideration paid to Guaranty stockholders in connection with the acquisition was approximately $54.9 million with approximately $23.2 million in cash and 1,023,000 shares of Union’s common stock. The Company operated Guaranty as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank and Trust Company. Guaranty transactions have been included in Union’s financial results since May 1, 2004. Acquired assets on May 1, 2004 totaled $248 million, including $165 million in loans and $184 million in deposits. As part of the purchase price allocation at May 1, 2004, Union recorded $5.8 million in core deposit intangibles, and goodwill totaled approximately $30.1 million. The core deposit intangible assets are being amortized over 12.9 years.

 

The acquisition of Guaranty falls under the guidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring.) Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. “Exit costs” are defined to include those costs recorded by Guaranty prior to the merger date and therefore are not included in Union’s Bankshares results of operations. Guaranty recorded exit costs of $1.3 million relating to severance and costs associated with terminating contracts.

 

Union’s exit costs, referred to herein as “merger-related” costs, are defined to include those costs for combining operations such as systems conversions, integration planning consultant fees and marketing consultant fees incurred by Union prior to and after the merger date and are included in Union’s results of operations. Union expensed merger-related costs which totaled approximately $343 thousand for year ended December 31, 2004. The costs associated with these activities are included in noninterest expenses.

 

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2. SECURITIES AVAILABLE FOR SALE

 

The amortized cost, gross unrealized gains and losses and estimated fair value of securities available for sale at December 31, 2004 and 2003 are summarized as follows (i