Edgar Filing: AMERICAN NATIONAL BANKSHARES INC

dec312007_10k.htm

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from______________________ to ___________________

Commission file number 0-12820

AMERICAN NATIONAL BANKSHARES INC.

(Exact name of registrant as specified in its charter)

Virginia		54-1284688
(State or other jurisdiction of incorporation organization)		(I.R.S. Employer Identification No.)
628 Main Street, Danville, VA		24541
(Address of principal executive offices)		(Zip Code)

434-792-5111

Registrant’s telephone number, including area code

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

Title of Each Class		Name of Exchange on Which Registered
Common Stock, $1 par value		The Nasdaq Stock Market L.L.C.
		(Nasdaq Global Select Market)

Securities registered pursuant to section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer þ Non-accelerated filer oSmaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes o No þ

The aggregate market value of the voting stock held by non-affiliates of the Registrant at June 30, 2007, based on the closing price, was $120,255,792.

The number of shares of the Registrant’s Common Stock outstanding on March 7, 2008 was 6,103,085.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement of the Registrant for the Annual Meeting of Shareholders to be held on April 22, 2008, are incorporated by reference in Part III of this report.

CROSS REFERENCE INDEX

PART I		PAGE
ITEM 1	Business	3
ITEM 1A	Risk Factors	7
ITEM 1B	Unresolved Staff Comments	None
ITEM 2	Properties	9
ITEM 3	Legal Proceedings	10
ITEM 4	Submission of Matters to a Vote of Security Holders	10

PART II
ITEM 5	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	10
ITEM 6	Selected Financial Data	13
ITEM 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
ITEM 7A	Quantitative and Qualitative Disclosures About Market Risk	20
ITEM 8	Financial Statements and Supplementary Data
	Quarterly Financial Results for 2007 and 2006	32
	Management’s Report on Internal Control over Financial Reporting	33
	Report of Independent Registered Public Accounting Firm	34
	Consolidated Balance Sheets at December 31, 2007 and 2006	36
	Consolidated Statements of Income for each of the years in the three-year period ended December 31, 2007	37
	Consolidated Statements of Changes in Shareholders’ Equity for each of the years in the three-year period ended December 31, 2007	38
	Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2007	39
	Notes to Consolidated Financial Statements	40
ITEM 9	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	None
ITEM 9A	Controls and Procedures	33
ITEM 9B	Other Information	None

PART III
ITEM 10	Directors, Executive Officers and Corporate Governance	*
ITEM 11	Executive Compensation	*
ITEM 12	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	*
ITEM 13	Certain Relationships and Related Transactions, and Director Independence	*
ITEM 14	Principal Accounting Fees and Services	*

PART IV
ITEM 15	Exhibits and Financial Statement Schedules	64

_______________________________

*The information required by Item 10 is incorporated herein by reference to the information that appears under the headings “Election of Directors – Board of Directors and Committees - The Audit and Compliance Committee,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Report of the Audit and Compliance Committee,” and “Code of Conduct” in the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders.

Certain information required by Item 11 is incorporated herein by reference to the information that appears under the heading “Compensation Discussion and Analysis,” “Compensation Committee Interlocks and Insider Participation,” and “Compensation Committee Report” in the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders.

The information required by Item 12 is incorporated herein by reference to the information that appears under the headings “Security Ownership” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders. The information required by Item 201(d) of Regulation S-K is disclosed herein. See Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”

Index

The information required by Item 13 is incorporated herein by reference to the information that appears under the heading “Related Party Transactions,” and “Election of Directors – Board Independence” in the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders.

The information required by Item 14 is incorporated herein by reference to the information that appears under the heading “Independent Public Accountants” in the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders.

PART I

Forward-Looking Statements

This report contains forward-looking statements with respect to the financial condition, results of operations and business of American National Bankshares Inc. and its wholly owned subsidiary, American National Bank and Trust Company (collectively referred to as the “Company”). These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on information available to management at the time these statements and disclosures were prepared. Forward-looking statements are subject to numerous assumptions, estimates, risks, and uncertainties that could cause actual conditions, events, or results to differ materially fro those stated or implied by such forward-looking statements.

A variety of factors, some of which are discussed in more detail in Item 1A – Risk Factors, may affect the operations, performance, business strategy, and results of the Company. Those factors include but are not limited to the following:

·	Financial market volatility including the level of interest rates could affect the values of financial instruments and the amount of net interest income earned;

·	General economic or business conditions, either nationally or in the market areas in which the Company does business, may be less favorable than expected, resulting in deteriorating credit quality, reduced demand for credit, or a weakened ability to generate deposits;

·	Competition among financial institutions may increase and competitors may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than the Company;

·	Businesses that the Company is engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards;

·	The ability to retain key personnel; and

·	The failure of assumptions underlying the allowance for loan losses.

ITEM 1 – BUSINESS

American National Bankshares Inc. is a one-bank holding company organized under the laws of the Commonwealth of Virginia in 1984. On September 1, 1984, American National Bankshares Inc. acquired all of the outstanding capital stock of American National Bank and Trust Company, a national banking association chartered in 1909 under the laws of the United States. American National Bank and Trust Company is the only banking subsidiary of American National Bankshares Inc. In April 2006, AMNB Statutory Trust I, a Delaware statutory trust (the “Trust”) and a wholly owned subsidiary of American National Bankshares Inc., was formed for the purpose of issuing preferred securities (the “Trust Preferred Securities”) in a private placement pursuant to an applicable exemption from registration. Proceeds from the securities were used to fund the acquisition of Community First Financial Corporation (“Community First”). In April 2006, the Company finalized the acquisition of Community First and acquired 100% of its preferred and common stock through a merger transaction. Community First was a bank holding company headquartered in Lynchburg, Virginia, and through its subsidiary, Community First Bank, operated four banking offices serving the city of Lynchburg and Bedford, Nelson, and Amherst Counties. The Company entered into the merger agreement with Community First because it believed the merger to be consistent with its expansion strategy to target entry into strong markets that logically extend its existing footprint. The Company had previously opened a full service banking office in the Lynchburg area and was considering opening additional offices in that area.

The operations of the Company are conducted at twenty banking offices and one loan production office serving Southern and Central Virginia and the northern portion of Central North Carolina. American National Bank and Trust Company provides a full array of financial products and services, including commercial, mortgage, and consumer banking; trust and investment services; and insurance. Services are also provided through twenty-three ATMs, “AmeriLink” Internet banking, and 24-hour “Access American” telephone banking.

Index

Competition and Markets

Vigorous competition exists in the Company’s service area. The Company competes not only with national, regional, and community banks, but also with many other types of financial institutions, including without limitation, savings banks, finance companies, mutual and money market fund providers, brokerage firms, insurance companies, credit unions, and mortgage companies. The Company has the largest deposit market share in the City of Danville, as well as in the City of Danville and Pittsylvania County, combined.

The Southern Virginia market, in which the Company has a significant presence, is under economic pressure. The region’s economic base has historically been weighted toward the manufacturing sector. Increased global competition has negatively impacted the local textile industry and several manufacturers have closed plants due to competitive pressures or the relocation of some operations to foreign countries. Other important industries include farming, tobacco processing and sales, food processing, furniture manufacturing and sales, specialty glass manufacturing, and packaging tape production. Additional declines in manufacturing production and unemployment could negatively impact the ability of certain borrowers to repay loans.

Supervision and Regulation

The Company is extensively regulated under both federal and state law. The following information describes certain aspects of that regulation applicable to the Company and does not purport to be complete. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to determine with any certainty. A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations, and earnings of the Company.

American National Bankshares Inc.

American National Bankshares Inc. is qualified as a bank holding company (“BHC”) within the meaning of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is registered as such with the Board of Governors of the Federal Reserve System (the “FRB”). As a bank holding company, American National Bankshares Inc. is required to file various reports and additional information with the FRB and is also subject to examinations by the FRB.

The BHC Act prohibits, with certain exceptions, a BHC from acquiring beneficial ownership or control of more than 5% of the voting shares of any company, including a bank, without the FRB’s prior approval and from engaging in any activity other than those of banking, managing or controlling banks or other subsidiaries authorized under the BHC Act, or furnishing services to or performing services for its subsidiaries. Among the permitted activities is the ownership of shares of any company the activities of which the FRB determines to be so closely related to banking or managing or controlling banks as to be proper incident thereto.

Under FRB policy, a BHC is expected to serve as a source of financial and managerial strength to its subsidiary banks and to commit resources to support those banks. This support may be required at times when the BHC may not have the resources to provide it. Under this policy, a BHC is expected to stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial adversity and to maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks.

Under the Gramm-Leach-Bliley Act, a BHC may elect to become a financial holding company and thereby engage in a broader range of financial and other activities than are permissible for traditional BHC’s. In order to qualify for the election, all of the depository institution subsidiaries of the BHC must be well capitalized, well managed, and have achieved a rating of “satisfactory” or better under the Community Reinvestment Act (the “CRA”). Financial holding companies are permitted to engage in activities that are “financial in nature” or incidental or complementary thereto as determined by the FRB. The Gramm-Leach-Bliley Act identifies several activities as “financial in nature,” including insurance underwriting and sales, investment advisory services, merchant banking and underwriting, and dealing or making a market in securities. American National Bankshares Inc. has not elected to become a financial holding company.

American National Bank and Trust Company

American National Bank and Trust Company is a federally chartered national bank and is a member of the Federal Reserve System. It is subject to federal regulation by the Office of the Comptroller of the Currency (the “OCC”), the FRB, and the Federal Deposit Insurance Corporation (“FDIC”).

Index

Depository institutions, including American National Bank and Trust Company, are subject to extensive federal and state regulations that significantly affect their business and activities. Regulatory bodies have broad authority to implement standards and initiate proceedings designed to prohibit deposit institutions from engaging in unsafe and unsound banking practices. The standards relate generally to operations and management, asset quality, interest rate exposure, and capital. The agencies are authorized to take action against institutions that fail to meet such standards.

As with other financial institutions, the earnings of American National Bank and Trust Company are affected by general economic conditions and by the monetary policies of the FRB. The FRB exerts a substantial influence on interest rates and credit conditions, primarily through open market operations in U.S. Government securities, setting the reserve requirements of member banks, and establishing the discount rate on member bank borrowings. The policies of the FRB have a direct impact on loan and deposit growth and the interest rates charged and paid thereon. They also impact the source and cost of funds and the rates of return on investments. Changes in the FRB’s monetary policies have had a significant impact on the operating results of American National Bank and Trust Company and other financial institutions and are expected to continue to do so in the future; however, the exact impact of such conditions and policies upon the future business and earnings cannot accurately be predicted.

Dividend Restrictions and Capital Requirements

For information regarding the limitation on bank dividends and risk-based capital requirements, refer to Note 18 of the consolidated financial statements. Additional information may be found in the Shareholder’s Equity section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

FDIC Insurance

American National Bank and Trust Company’s deposits are insured up to $100,000 per insured depositor by the Deposit Insurance Fund of the FDIC. Under federal law, deposits and certain claims for administrative expenses and employee compensation against insured depository institutions are afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the liquidation or other resolution of such an institution by any receiver appointed by regulatory authorities. Such priority creditors would include the FDIC.

In February 2006, the Federal Deposit Insurance Reform Act of 2005 was adopted by Congress. This legislation increased FDIC coverage for retirement accounts to $250,000 and indexed insurance levels for inflation.

The Federal Deposit Insurance Corporation Improvement Act

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the federal banking agencies possess broad powers to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” as defined by the law. Under regulations established by the federal banking agencies a “well capitalized” institution must have a Tier 1 capital ratio of at least 6%, a total capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a capital directive order. An “adequately capitalized” institution must have a Tier 1 capital ratio of a least 4%, a total capital ratio of at least 8%, and a leverage ratio of at least 4%, or 3% in some cases. Management believes, as of December 31, 2007 and 2006, that the Company met the requirements for being classified as “well capitalized.”

As required by FDICIA, the federal banking agencies also have adopted guidelines prescribing safety and soundness standards relating to, among other things, internal controls and information systems, internal audit systems, loan documentation, credit underwriting, and interest rate exposure. In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. In addition, the agencies adopted regulations that authorize, but do not require, an institution which has been notified that it is not in compliance with safety and soundness standard to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the prompt corrective action provisions described above.

Community Reinvestment and Consumer Protection Laws

In connection with its lending activities, the Company is subject to a number of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. These include the Equal Credit Opportunity Act, the Truth-in-Lending Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, and the Community Reinvestment Act.

Index

The CRA requires the appropriate federal banking agency, in connection with its examination of a bank, to assess the bank’s record in meeting the credit needs of the communities served by the bank, including low and moderate income neighborhoods. Furthermore, such assessment is also required of banks that have applied, among other things, to merge or consolidate with or acquire the assets or assume the liabilities of an insured depository institution, or to open or relocate a branch. In the case of a BHC applying for approval to acquire a bank or BHC, the record of each subsidiary bank of the applicant BHC is subject to assessment in considering the application. Under the CRA, institutions are assigned a rating of “outstanding,” “satisfactory,” “needs to improve,” or “substantial non-compliance.” The Company was rated “outstanding” in its most recent CRA evaluation.

Anti-Money Laundering Legislation

The Company is subject to the Bank Secrecy Act and other anti-money laundering laws and regulations, including the USA Patriot Act of 2001. Among other things, these laws and regulations require the Company to take steps to prevent the use of the Company for facilitating the flow of illegal or illicit money, to report large currency transactions, and to file suspicious activity reports. The Company is also required to carry out a comprehensive anti-money laundering compliance program. Violations can result in substantial civil and criminal sanctions. In addition, provisions of the USA Patriot Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and BHC acquisitions.

Employees

At December 31, 2007, the Company employed 263 full-time equivalent persons. The relationship with employees is considered to be good.

Internet Access to Company Documents

The Company provides access to its Securities and Exchange Commission (the “SEC”) filings through a link on the Investor Relations page of the Company’s website at www.amnb.com. Reports available include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are filed electronically with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

Executive Officers of the Registrant

The following lists, as of December 31, 2007, the named executive officers of the registrant, their ages, and their positions.

Name Age Position

Charles H. Majors

President and Chief Executive Officer of the Company.

R. Helm Dobbins

Senior Vice President of American National Bankshares Inc.; Executive Vice President and Chief Credit Officer of American National Bank and Trust Company since November 2005; prior thereto, Senior Vice President and Chief Credit Officer of American National Bank and Trust Company since June 2003; Executive Vice President and Chief Credit Officer of Citizens Bank and Trust Co. from 1998 to 2003.

Jeffrey V. Haley

Senior Vice President of American National Bankshares Inc.; Executive Vice President and Chief Operating Officer of American National Bank and Trust Company since November 2005; prior thereto, Senior Vice President and Chief Administrative Officer of American National Bank and Trust Company.

Neal A. Petrovich

Senior Vice President, Chief Financial Officer, Treasurer and Secretary of American National Bankshares Inc.; Executive Vice President, Chief Financial Officer, and Cashier of American National Bank and Trust Company since November 2005; prior thereto, Senior Vice President, Chief Financial Officer and Cashier of American National Bank and Trust Company since May 2004; Senior Vice President of SouthTrust Bank from 2002 to May 2004; Executive Vice President and Chief Financial Officer of Bank of Tidewater from 1995 to 2002.

Index

ITEM 1A – RISK FACTORS

The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect financial performance.

Changes in the interest rate environment may reduce the Company’s profits. It is expected that the Company will continue to realize income from the differential or “spread” between the interest earned on loans, securities, and other interest earning assets, and interest paid on deposits, borrowings and other interest bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest earning assets and interest bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. Management cannot ensure that it can minimize the Company’s interest rate risk. While an increase in the general level of interest rates may increase the loan yield and the net interest margin, it may adversely affect the ability of certain borrowers with variable rate loans to pay the interest and principal of their obligations. Accordingly, changes in levels of market interest rates could materially and adversely affect the net interest spread, asset quality, loan origination volume, and overall profitability of the Company.

The Company faces strong competition from financial services companies and other companies that offer banking services which could negatively affect the Company’s business.

Increased competition may result in reduced business for the Company. Ultimately, the Company may not be able to compete successfully against current and future competitors. Many competitors offer the same banking services that the Company offers in its service area. These competitors include national, regional, and community banks. The Company also faces competition from many other types of financial institutions, including without limitation, savings banks, finance companies, mutual and money market fund providers, brokerage firms, insurance companies, credit unions, and mortgage companies. In particular, competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and ATMs and conduct extensive promotional and advertising campaigns.

Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain loans and deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services. If the Company is unable to attract and retain banking customers, it may be unable to continue to grow loan and deposit portfolios and its results of operations and financial condition may otherwise be adversely affected.

Changes in economic conditions could materially and negatively affect the Company’s business.

The Company’s business is directly impacted by factors such as economic, political, and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies, and inflation, all of which are beyond the Company’s control. A deterioration in economic conditions, whether caused by national or local concerns, especially within the Company’s market area, could result in the following consequences, any of which could hurt business materially: loan delinquencies may increase; problem assets and foreclosures may increase; demand for products and services may decrease; low cost or noninterest bearing deposits may decrease; and collateral for loans, especially real estate, may decline in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans.

Trust and Investment Services fee revenue is largely dependent on the fair market value of assets under care and on trading volumes in the brokerage business. General economic conditions and their subsequent effect on the securities markets tend to act in correlation. When general economic conditions deteriorate, consumer and corporate confidence in securities markets erodes, and Trust and Investment Service revenues are negatively impacted as asset values and trading volumes decrease.

Index

A downturn in the real estate market could materially and negatively affect the Company’s business.

A downturn in the real estate market could negatively affect the Company’s business because significant portions (approximately 82% as of December 31, 2007) of its loans are secured by real estate. The ability to recover on defaulted loans by selling the real estate collateral could then be diminished and the Company would be more likely to suffer losses on defaulted loans.

Substantially all of the Company’s real property collateral is located in its market area. If there is a significant decline in real estate values, especially in our market area, the collateral for loans would provide less security. Real estate values could be affected by, among other things, an economic slowdown and an increase in interest rates.

The Company is dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect the Company’s prospects.

The Company currently depends heavily on the services of a number of key management personnel. The loss of key personnel could materially and adversely affect the results of operations and financial condition. The Company’s success also depends in part on the ability to attract and retain additional qualified management personnel. Competition for such personnel is strong in the banking industry and the Company may not be successful in attracting or retaining the personnel it requires.

The Company is subject to extensive regulation which could adversely affect its business.

The Company’s operations are subject to extensive regulation by federal, state, and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of the Company’s operations. Because the Company’s business is highly regulated, the laws, rules, and regulations applicable to it are subject to regular change. There are currently proposed laws, rules, and regulations that, if adopted, would impact the Company’s operations. There can be no assurance that these proposed laws, rules, and regulations, or any other laws, rules, or regulations, will not be adopted in the future, which could (i) make compliance much more difficult and expensive, (ii) restrict the ability to originate, broker or sell loans, or accept certain deposits, (iii) further limit or restrict the amount of commissions, interest, or other charges earned on loans originated by the Company, or (iv) otherwise adversely affect the Company’s business or prospects for business.

The primary source of the Company’s income from which it pays dividends is the receipt of dividends from its subsidiary bank.

The availability of dividends from the Company is limited by various statutes and regulations. It is possible, depending upon the financial condition of the subsidiary bank and other factors, that the Office of the Comptroller of the Currency could assert that payment of dividends or other payments is an unsafe or unsound practice. In the event American National Bank and Trust Company was unable to pay dividends to American National Bankshares Inc., the holding company would likely have to reduce or stop paying common stock dividends. The Company’s failure to pay dividends on its common stock could have a material adverse effect on the market price of the common stock.

A limited trading market exists for the Company’s common stock which could lead to price volatility.

The Company’s common stock is approved for quotation on the NASDAQ Global Select Market, but the trading volume has generally been modest. The limited trading market for the common stock may cause fluctuations in the stock’s market value to be exaggerated, leading to price volatility in excess of that which would occur in a more active trading market. In addition, even if a more active market in the Company’s common stock develops, management cannot ensure that such a market will continue or that shareholders will be able to sell their shares.

The allowance for loan losses may not be adequate to cover actual losses.

In accordance with accounting principles generally accepted in the United States, an allowance for loan losses is maintained to provide for loan losses. The allowance for loan losses may not be adequate to cover actual credit losses, and future provisions for credit losses could materially and adversely affect operating results. The allowance for loan losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating, and other conditions, including changes in interest rates that may be beyond control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Company’s loans and allowance for loan losses. While management believes that the allowance for loan losses is adequate to cover current losses, it cannot make assurances that it will not further increase the allowance for loan losses or that regulators will not require it to increase this allowance. Either of these occurrences could adversely affect earnings.

Index

The allowance for loan losses requires management to make significant estimates that affect the financial statements. Due to the inherent nature of this estimate, management cannot provide assurance that it will not significantly increase the allowance for loan losses which could materially and adversely affect earnings.

The Company is exposed to operational risk.

The Company is exposed to many types of operational risks, including reputation, legal, and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, clerical or record-keeping errors, and errors resulting from faulty or disabled computer or telecommunications systems.

Negative public opinion can result from the actual or alleged conduct in any number of activities, including lending practices, corporate governance, and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect the Company’s ability to attract and retain customers and can expose it to litigation and regulatory action.

Certain errors may be repeated or compounded before they are discovered and successfully rectified. The Company’s necessary dependence upon automated systems to record and process its transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. The Company may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is the Company) and to the risk that the Company’s (or its vendors’) business continuity and data security systems prove to be inadequate.

Changes in accounting standards could impact reported earnings.

From time to time there are changes in the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can materially impact how the Company records and reports its financial condition and results of operations. In some instances, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.

The Company’s information systems may experience an interruption or breach in security.

The Company relies heavily on communications and information systems to conduct business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in the Company’s relationship management, general ledger, deposit, loan, and other systems. While the Company has policies and procedures designed to prevent or limit the effect of such failure, interruption, or security breach, there can be no assurance that they will not occur or, if they do occur, that they will be adequately addressed. Any such occurrences could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the company to civil litigation and possible financial liability, any of which could have a material adverse affect on the Company’s financial condition and results of operations.

ITEM 2 – PROPERTIES

As of December 31, 2007, the Company maintained twenty banking offices located in Danville, Pittsylvania County, Martinsville, Henry County, Halifax County, Lynchburg, Bedford County, Campbell County, and Nelson County in Virginia and Caswell County in North Carolina. The Company also operates a loan production office in Greensboro, North Carolina.

The principal executive offices of the Company are located at 628 Main Street in the business district of Danville, Virginia. This building, owned by the Company, was originally constructed in 1973 and has three floors totaling approximately 27,000 square feet.

The Company owns a building located at 103 Tower Drive in Danville, Virginia. This three-story facility serves as a retail banking office and houses certain of the Company’s finance, administrative, and operations staff.

The Company owns an office building on 203 Ridge Street, Danville, Virginia, which is leased to Bankers Insurance, LLC. The Company has a minority ownership interest in Bankers Insurance, LLC.

Index

The Company owns eleven other retail office locations for a total of fourteen owned buildings. There are no mortgages or liens against any of the properties owned by the Company. The Company operates twenty-three Automated Teller Machines (“ATMs”) on owned or leased facilities. The Company leases seven of the retail office locations and a storage warehouse.

ITEM 3 – LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party or to which the property of the Company is subject.

ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders of the Company through a solicitation of proxies or otherwise.

PART II

ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company’s common stock is traded on the NASDAQ Global Select Market under the symbol “AMNB.” At December 31, 2007, the Company had 1,694 shareholders of record. The following table presents the high and low closing sales prices for the Company’s common stock and dividends declared for the past two years.

Market Price of the Company’s Common Stock

	Closing Price				Dividends
2007	High		Low		Per Share
4th quarter	$	22.76	$	19.40	$	0.23
3rd quarter		22.96		20.50		0.23
2nd quarter		23.08		22.15		0.23
1st quarter		23.68		22.02		0.22
					$	0.91


	Closing Price				Dividends
2006	High		Low		Per Share
4th quarter	$	23.87	$	22.81	$	0.22
3rd quarter		24.00		22.45		0.22
2nd quarter		24.02		22.50		0.22
1st quarter		24.07		22.30		0.21
					$	0.87

The table below presents share repurchase activity during the quarter ended December 31, 2007.

	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Program		Maximum Number of Shares That May Yet Be Purchased Under the Program

October 1-31, 2007		6,200	$	22.66		6,200		112,200
November 1-30, 2007		200		20.35		200		112,000
December 1-31, 2007		2,300		20.11		2,300		109,700
		8,700	$	21.93		8,700

Index

Stock Option Plan

The Company maintained a stock option plan (the “Plan”) designed to attract and retain qualified personnel in key positions, provide employees with a proprietary interest in the Company as an incentive to contribute to the success of the Company, and reward employees for outstanding performance and the attainment of targeted goals. The Plan was approved by the shareholders at the 1997 Annual Meeting, and options were eligible to be granted under the Plan through December 31, 2006. The Plan provided for the granting of incentive stock options intended to comply with the requirements of Section 422 of the Internal Revenue Code of 1986 (“incentive stock options”), as well as non-qualified stock options.

The Plan is administered by a committee of the Board of Directors of the Company comprised of independent Directors. Under the Plan, the committee determines which employees will be granted options, whether such options will be incentive or non-qualified options, the number of shares subject to each option, whether such options may be exercised by delivering other shares of common stock, and when such options became exercisable. In general, the per share exercise price of an incentive stock option must be at least equal to the fair market value of a share of common stock on the date the option is granted.

Stock options became vested and exercisable in the manner specified by the committee. Each stock option or portion thereof shall be exercisable at any time on or after it vests and is exercisable until ten years after its date of grant. There were no stock options awarded in 2007.

	December 31, 2007
	Number of Shares to be Issued Upon Exercise of Outstanding Options		Weighted-Average Per Share Exercise Price of Outstanding Options		Number of Shares Remaining Available for Future Issuance Under Stock Option Plan

Equity compensation plans approved by shareholders		174,871	$	21.15		-
Equity compensation plans not approved by shareholders		-		-		-
Total		174,871	$	21.15		-

Index

Comparative Stock Performance

The following graph compares the Company’s cumulative total return to its shareholders with the returns of three indexes for the five-year period ended December 31, 2007. The cumulative total return was calculated taking into consideration changes in stock price, cash dividends, stock dividends, and stock splits since December 31, 2002. The indexes are the NASDAQ Composite Index; the SNL Bank $500 Million-$1Billlion Index, which includes bank holding companies with assets of $500 million to $1 billion and is published by SNL Financial, LC; and the Independent Bank Index, which is provided by Carson Medlin Company and consists of 27 independent community banks located in the southeastern states of Alabama, Florida, Georgia, North Carolina, South Carolina, Tennessee, Virginia, and West Virginia.

		Period Ending
Index	12/31/02	12/31/03	12/31/04	12/31/05	12/31/06	12/31/07
American National Bankshares Inc.	$100.00	$103.32	$99.16	$98.63	$102.66	$91.66
NASDAQ Composite	100.00	150.01	162.89	165.13	180.85	198.60
SNL Bank $500M-$1B	100.00	144.19	163.41	170.41	193.81	155.31
Independent Bank Index	100.00	137.00	156.00	167.00	194.00	147.00

Index

ITEM 6 - Selected Financial Data

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

(in thousands, except per share amounts and ratios)
	2007		2006		2005		2004		2003
Results of Operations:
Interest income	$ 48,597		$ 45,070		$ 32,479		$ 30,120		$ 32,178
Interest expense	19,370		16,661		8,740		7,479		9,391
Net interest income	29,227		28,409		23,739		22,641		22,787
Provision for loan losses	403		58		465		3,095		920
Noninterest income	8,822		8,458		7,896		6,510		6,671
Noninterest expense	21,326		20,264		17,079		15,011		15,111
Income before income tax provision	16,320		16,545		14,091		11,045		13,427
Income tax provision	4,876		5,119		4,097		3,032		3,914
Net income	$ 11,444		$ 11,426		$ 9,994		$ 8,013		$ 9,513

Period-end Balances:
Securities	$157,149		$162,621		$165,629		$188,163		$207,479
Loans, net of unearned income	551,391		542,228		417,087		407,269		406,245
Deposits	581,221		608,528		491,651		485,272		501,688
Assets	772,288		777,720		623,503		619,065		644,302
Shareholders' equity	101,511		94,992		73,419		71,000		71,931
Shareholders' equity - tangible (a)	76,591		69,695		73,287		70,516		70,997

Per Share Information:
Earnings - basic	$ 1.86		$ 1.91		$ 1.83		$ 1.43		$ 1.67
Earnings - diluted	1.86		1.90		1.81		1.42		1.65
Dividends	0.91		0.87		0.83		0.79		0.75
Book value	16.59		15.42		13.49		12.86		12.71
Book value - tangible (a)	12.52		11.31		13.47		12.77		12.54

Ratios:
Return on average assets	1.48	%	1.51	%	1.61	%	1.26	%	1.52	%
Return on average shareholders' equity	11.69		12.72		13.95		11.15		13.52
Return on average tangible equity (b)	16.09		16.60		14.35		11.72		14.21
Net interest margin - taxable equivalent	4.24		4.20		4.17		3.90		3.98
Average shareholders' equity / average assets	12.65		11.85		11.57		11.34		11.27
Dividend payout ratio	48.82		45.58		45.39		55.13		44.96
Net charge-offs to average loans	0.05		0.10		0.56		0.10		0.30
Allowance for loan losses to period-end loans	1.34		1.34		1.46		1.96		1.30
Nonperforming assets to total assets	0.42		0.45		0.72		1.35		0.56

(a) - Excludes goodwill and other intangible assets
(b) - Excludes amortization expense, net of tax, of intangible assets

Index

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company during the past three years. The discussion and analysis are intended supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Annual Report on Form 10-K. Financial institutions acquired by the Company during the past three years and accounted for as purchases are reflected in the financial position and results of operations of the Company since the date of their acquisition.

RECLASSIFICIATION

In certain circumstances, reclassifications have been made to prior period information to conform to the 2007 presentation.

CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies followed by the Company conform with U.S. generally accepted accounting principles (“GAAP”) and they conform to general practices within the banking industry. The Company’s critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses and (2) goodwill impairment. A summary of the Company’s significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements.

The financial information contained within the Company’s financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset, or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method.

Allowance for Loan Losses and Reserve for Unfunded Lending Commitments

The allowance for loan losses is an estimate of the losses inherent in the loan portfolio at the balance sheet date. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standards (“SFAS”) 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows, or values observable in the secondary market, and the loan balance.

The Company’s allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change. The formula allowance uses a historical loss view as an indicator of future losses along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries; trends in volume and terms of loans; effects of changes in underwriting standards; experience of lending staff and economic conditions; and portfolio concentrations. In the formula allowance, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans. The adjusted loss factor is multiplied by the period-end balances for each risk-grade category. The formula allowance is calculated for a range of outcomes. The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. The unallocated allowance includes estimated losses whose impact on the portfolio has yet to be recognized in either the formula or specific allowance. The use of these values is inherently subjective and actual losses could be greater or less than the estimates.

The reserve for unfunded loan commitments is an estimate of the losses inherent in off-balance-sheet loan commitments at the balance sheet date. It is calculated by multiplying an estimated loss factor by an estimated probability of funding, and then by the period-end amounts for unfunded commitments. The reserve for unfunded loan commitments is included in other liabilities.

Goodwill Impairment

The Company tests goodwill on an annual basis or more frequently if events or circumstances indicate that there may have been impairment. If the carrying amount of goodwill exceeds its implied fair value, the Company would recognize an impairment loss in an amount equal to that excess. The goodwill impairment test requires management to make judgments in determining the assumptions used in the calculations. The goodwill impairment testing conducted by the Company in 2007 indicated that goodwill is not impaired and is properly recorded in the financial statements.

Index

NON-GAAP PRESENTATIONS

The analysis of net interest income in this document is performed on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets.

EXECUTIVE OVERVIEW

American National Bankshares Inc. is the holding company of American National Bank and Trust Company, a community bank serving Southern and Central Virginia and the northern portion of Central North Carolina with twenty banking offices and a loan production office.

American National Bank and Trust Company provides a full array of financial products and services, including commercial, mortgage, and consumer banking; trust and investment services; and insurance. Services are also provided through twenty-three ATMs, “AmeriLink” Internet banking, and 24-hour “Access American” telephone banking.

Additional information is available on the Company’s website at www.amnb.com. The shares of American National Bankshares Inc. are traded on the NASDAQ Global Select Market under the symbol “AMNB.”

The Company’s mission, vision, and guiding principles are as follows:

Mission

We provide quality financial services with exceptional customer service.

Vision

We will enhance the value of our shareholders’ investment by being our communities’ preferred provider of relationship-based financial services.

Guiding Principles

To achieve our vision and carry out our mission, we:

operate a sound, efficient, and highly profitable company,
identify and respond to our internal and external customers’ needs and expectations in an ever changing financial services environment,
provide quality sales and quality service to our customers,
produce profitable growth,
provide an attractive return for our shareholders,
furnish positive leadership for the well-being of all communities we serve,
continuously develop a challenging and rewarding work environment for our employees, and
conduct our work with integrity and professionalism.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits and other funding sources. Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income. The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities. A tax rate of 35% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis. Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the average rate earned on earning assets and the average rate paid on interest bearing liabilities.

Index

Net interest income increased $757,000, or 2.6% from 2006 to 2007, following a $4,670,000, or 19.7% increase in 2006 from 2005 levels. These increases were primarily due to balance sheet growth including the acquisition of Community First Financial Corporation in April 2006. Additionally, purchase accounting adjustments from the Community First acquisition had a positive impact on net interest income in 2007 and 2006. Payoffs of acquired loans accounted for under American Institute of Certified Public Accountants Statement of Position 03-3 resulted in $571,000 of interest income in 2007. Interest income related to the valuation of other loans acquired from Community First was $536,000 and $402,000 in 2007 and 2006, respectively. Similarly, interest expense related to the valuation of acquired deposits was $88,000 and $197,000 in 2007 and 2006, respectively. The net interest margin improved slightly from 4.20% in 2006 to 4.24% in 2007, after increasing from 4.17% in 2005, due generally to the fact that loans comprised an increasing portion of earning assets compared to lower-yielding investment securities and to the effect of the purchase accounting adjustments discussed above.

To meet its funding needs for the Community First acquisition, the Company issued $20,619,000 of trust preferred securities during the second quarter of 2006. Interest expense associated with these securities was $1,373,000 for 2007 and $1,007,000 for 2006.

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the years 2005 through 2007. Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.

Table 1 - Net Interest Income Analysis
(in thousands, except yields and rates)

			Average Balance			Interest Income/Expense			Average Yield/Rate

			2007	2006	2005	2007	2006	2005	2007		2006		2005
Loans:
	Commercial		$ 89,673	$ 84,676	$ 74,202	$ 6,980	$ 6,481	$ 4,627	7.78	%	7.65	%	6.24	%
	Real Estate		449,683	416,530	327,888	33,621	29,813	20,155	7.48		7.16		6.15
	Consumer		10,420	12,287	12,490	975	1,152	1,132	9.36		9.38		9.06
		Total loans	549,776	513,493	414,580	41,576	37,446	25,914	7.56		7.29		6.25

Securities:
	Federal agencies		68,521	94,589	77,609	3,032	3,745	2,414	4.42		3.96		3.11
	Mortgage-backed		25,406	21,197	25,614	1,255	988	1,099	4.94		4.66		4.29
	State and municipal		46,069	46,735	51,943	2,530	2,624	3,049	5.49		5.61		5.87
	Other		7,484	11,059	15,273	438	621	715	5.85		5.62		4.68
		Total securities	147,480	173,580	170,439	7,255	7,978	7,277	4.92		4.60		4.27

Deposits in other banks			13,431	12,922	9,782	679	620	376	5.06		4.80		3.84

Total interest earning assets			710,687	699,995	594,801	49,510	46,044	33,567	6.97		6.58		5.64

Nonearning assets			62,952	57,807	24,273

		Total assets	$773,639	$757,802	$619,074

Deposits:
	Demand		$107,834	$105,320	$ 82,121	1,550	1,513	539	1.44	%	1.44	%	0.66	%
	Money market		52,843	48,124	44,685	1,429	1,180	715	2.70		2.45		1.60
	Savings		66,246	77,445	81,641	845	963	629	1.28		1.24		0.77
	Time		261,286	255,856	189,467	11,711	9,693	5,019	4.48		3.79		2.65
		Total deposits	488,209	486,745	397,914	15,535	13,349	6,902	3.18		2.74		1.73

Repurchase agreements			48,088	40,970	42,757	1,841	1,384	901	3.83		3.38		2.11
Other borrowings			32,591	33,087	19,474	1,994	1,928	937	6.12		5.83		4.81
		Total interest bearing
		liabilities	568,888	560,802	460,145	19,370	16,661	8,740	3.40		2.97		1.90

Noninterest bearing
	demand deposits		102,003	102,117	84,670
Other liabilities			4,894	5,059	2,621
Shareholders' equity			97,854	89,824	71,638
		Total liabilities and
		shareholders' equity	$773,639	$757,802	$619,074

Interest rate spread									3.57	%	3.61	%	3.74	%
Net interest margin									4.24	%	4.20	%	4.17	%

Net interest income (taxable equivalent basis)						30,140	29,383	24,827
Less: Taxable equivalent adjustment						913	974	1,088
Net interest income						$29,227	$28,409	$23,739

Index

Table 2 presents the dollar amount of changes in interest income and interest expense, and distinguishes between changes resulting from fluctuations in average balances of interest earning assets and interest bearing liabilities (volume), and changes resulting from fluctuations in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionately.

Table 2 - Changes in Net Interest Income (Rate / Volume Analysis)
(in thousands)

				2007 vs. 2006			2006 vs. 2005
					Change			Change
				Increase	Attributable to		Increase	Attributable to
Interest income				(Decrease)	Rate	Volume	(Decrease)	Rate	Volume
	Loans:
		Commercial		$ 499	$ 111	$ 388	$ 1,854	$ 1,144	$ 710
		Real Estate		3,808	1,367	2,441	9,658	3,652	6,006
		Consumer		(177)	(2)	(175)	20	39	(19)
			Total loans	4,130	1,476	2,654	11,532	4,835	6,697
	Securities:
		Federal agencies		(713)	404	(1,117)	1,331	739	592
		Mortgage-backed		267	62	205	(111)	89	(200)
		State and municipal		(94)	(57)	(37)	(425)	(129)	(296)
		Other securities		(183)	25	(208)	(94)	126	(220)
			Total securities	(723)	434	(1,157)	701	825	(124)
	Deposits in other banks			59	34	25	244	106	138
			Total interest income	3,466	1,944	1,522	12,477	5,766	6,711

Interest expense
	Deposits:
		Demand		37	1	36	974	787	187
		Money market		249	127	122	465	406	59
		Savings		(118)	24	(142)	334	368	(34)
		Time		2,018	1,808	210	4,674	2,576	2,098
			Total deposits	2,186	1,960	226	6,447	4,137	2,310
	Repurchase agreements			457	198	259	483	522	(39)
	Other borrowings			66	95	(29)	991	230	761
			Total interest expense	2,709	2,253	456	7,921	4,889	3,032
Net interest income				$ 757	$ (309)	$ 1,066	$ 4,556	$ 877	$ 3,679

Noninterest Income

Noninterest income is generated from a variety of sources, including fee-based deposit services, trust and investment services, mortgage banking, and retail brokerage. Noninterest income also includes net gains or losses on sales or calls of investment securities.

Noninterest income was $8,822,000 in 2007, up 4.3% over 2006. Increases in trust fees, mortgage banking income, brokerage, and other fee income were partially offset by decreases in deposit account service charges and by a $362,000 impairment charge on securities (see the Securities section of this discussion and analysis).

Noninterest income was $8,458,000 in 2006, up 7.1% over 2005, largely due to an increase in trust fees, deposit account service charge income, mortgage banking revenue, and income from bank owned life insurance policies (“BOLI”) acquired from Community First.

Fees from the management of trusts, estates, and asset management accounts totaled $3,578,000 in 2007, up from $3,374,000 in 2006 and $3,012,000 in 2005. These increases were due primarily to new account activity and fee structure changes. Market value appreciation in the securities markets also contributed to the increase as a substantial proportion of these fees are earned as a percentage of the account balances.

Service charges on deposit accounts decreased 4.6% in 2007, primarily due to reduced customer overdraft activity. Deposit account service charges increased 8.5% in 2006, primarily as a result of the acquisition of Community First.

Index

Other fees and commissions primarily include income generated from the Company’s debit card, ATM, safe deposit box, merchant credit card, and wire transfer services. Insurance commission revenue is also included in this category. Other fees and commissions were $786,000 in 2007, $744,000 in 2006, and $693,000 in 2005. The increase in both 2007 and 2006 is primarily the result of growth in debit card revenue due to increased customer debit card activity.

Mortgage banking income represents fees from originating and selling residential mortgage loans. Mortgage banking income was $954,000 in 2007, $709,000 in 2006, and $665,000 in 2005. Changes in interest rates directly impact the volume of mortgage activity and, in turn, the amount of mortgage banking fee income earned.

Securities are sold from time to time for balance sheet management purposes or because an investment no longer meets the Company’s policy requirements. Net gains on sales or calls of securities were $135,000 in 2007, $62,000 in 2006, and $53,000 in 2005.

In December 2007, the Company recorded a $362,000 impairment charge relating to its holdings of Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) preferred stock. The market value of these two securities dropped significantly at the end of 2007, and any near-term recovery in value is uncertain. The Company’s recorded investment in these securities, after the write-down, is $1,346,000 at December 31, 2007. The impairment charge is recorded as a reduction of noninterest income.

Other noninterest income was $650,000 in 2007, $496,000 in 2006, and $642,000 in 2005. The 2007 increase was largely the result of increased dividend revenue from the Company’s investments in Bankers Insurance, LLC and Virginia Title Center, LLC. Additionally, a full year of revenue from the Company’s BOLI policies increased this income category by $34,000 in 2007. Other noninterest income growth in 2006 was impacted by increased dividend revenue from the Company’s investment in the two insurance companies, and by $100,000 of income generated from the BOLI policies acquired from Community First in April 2006. During 2005, the Company earned nonrecurring income of $375,000 from the sale of a bankcard processor, of which the Company was a member.

Table 3 - Noninterest income
(in thousands)

	Years Ended December 31,
	2007	2006	2005

Trust fees	$ 3,578	$ 3,374	$ 3,012
Service charges on deposit accounts	2,531	2,654	2,446
Other fees and commissions	786	744	693
Mortgage banking income	954	709	665
Brokerage fees	550	419	385
Securities gains, net	135	62	53
Impairment of securities	(362)	-	-
Investment in insurance companies	280	220	163
Bank owned life insurance	134	100	-
Check order charges	127	113	107
Gain from sale of bankcard processor	-	-	375
Other	109	63	(3)
	$ 8,822	$ 8,458	$ 7,896

Noninterest Expense

Noninterest expense consists primarily of personnel, occupancy, equipment, and other expenses. Noninterest expense was $21,326,000 in 2007, up 5.2% over 2006, due primarily to increased staff levels and a full year of expenses associated with the April 2006 Community First acquisition. Noninterest expense was $20,264,000 in 2006, up 18.6% over 2005, due largely to the impact of the Community First acquisition.

Personnel expenses comprise over half of the Company’s noninterest expense. Combined salary and benefits expense increased 3.4% in 2007 when compared to 2006. Higher staff levels and a full year of the expenses associated with Community First were partially offset by a reduction in profit sharing and incentive compensation expense. Profit sharing and incentive expense was $287,000 in 2007, $867,000 in 2006, and $866,000 in 2005. Personnel expenses rose 15.3% in 2006 over 2005, due primarily to the Community First acquisition.

Index

Occupancy and equipment expense increased from $2,977,000 in 2006 to $3,527,000 in 2007, an increase of 18.5%. The increase was due in large part to a full year of expenses associated with the Community First acquisition, increased building maintenance costs, the expenses of two new branch offices, and costs related to new technology for check processing and network security. Occupancy and equipment expense increased from $17,079,000 in 2005 to $20,264,000 in 2006. The increase was due primarily to the acquisition of Community First.

Bank franchise tax expense was $663,000 in 2007, compared with $651,000 in 2006 and $543,000 in 2005. This expense is based in large part on the level of shareholders’ equity.

Core deposit intangible expense was $377,000 in 2007, $414,000 in 2006, and $353,000 in 2005. The 2007 expense consists entirely of amortization of the core deposit intangible asset from the Community First acquisition; beginning April 2006, this asset is being amortized on a straight-line basis over ninety-nine months. Core deposit intangible expense in 2006 also includes amortization of the core deposit intangible asset arising from a 1996 branch purchase. The 2005 expense is comprised entirely of amortization of intangible assets related to the 1996 branch purchase as well as a 1995 branch purchase.

Other noninterest expense consists of a variety of expenses including those related to professional services, advertising and marketing, telephone systems, ATM and Internet banking services, trust services, supplies, and Federal Reserve services. Other noninterest expense totaled $4,322,000 in 2007, $4,196,000 in 2006, and $3,279,000 in 2005. Other noninterest expense increased 3.0% in 2007, and was largely the result of higher trust service costs and a full year of expenses associated with the acquisition of Community First. Other noninterest expense increased $917,000, or 28.0%, from 2005 to 2006. The increase for 2006 included $123,000 for the establishment of a reserve for unfunded lending commitments. The Company also experienced increases in Internet banking fees, external data processing expenses, advertising and marketing costs, and telephone fees, all related primarily to the acquisition of Community First. Trust expense increased $117,000 in 2006 related to costs of outside investment management services and increased trust operational activity.

Table 4 - Noninterest expense
(in thousands)

	Years Ended December 31,
	2007	2006	2005

Salaries	$ 9,688	$ 9,520	$ 8,453
Employee benefits	2,749	2,506	1,975
Occupancy and equipment	3,527	2,977	2,476
Bank franchise tax	663	651	543
Core deposit intangible amortization	377	414	353
Professional fees	733	689	744
Telephone	395	361	290
Stationery and printing supplies	335	395	312
ATM network fees	329	303	237
Advertising and marketing	300	267	174
Postage	273	240	210
Trust services contracted	237	187	70
Internet banking fees	194	173	133
Correspondent bank fees	161	161	141
Automobile	147	103	89
Contributions	120	138	114
Loan expenses	108	67	64
Courier service	106	97	82
FDIC assessment	87	84	65
Other	797	931	554
	$ 21,326	$ 20,264	$ 17,079

Index

Income Taxes

Income taxes on 2007 earnings amounted to $4,876,000, resulting in an effective tax rate of 29.9%, compared to 30.9% in 2006 and 29.1% in 2005. The Company was subject to a statutory, blended, Federal tax rate of 34.4% in 2007, 34.4% in 2006, and 34.3% in 2005. The major difference between the statutory rate and the effective rate results from income that is not taxable for Federal income tax purposes. The primary non‑taxable income is that of state and municipal securities and industrial revenue bonds or loans.

 Impact of Inflation and Changing Prices

The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. The most significant effect of inflation is on noninterest expenses that tend to rise during periods of inflation. Changes in interest rates have a greater impact on a financial institution’s profitability than do the effects of higher costs for goods and services. Through its balance sheet management practices, the Company has the ability to react to those changes and measure and monitor its interest rate and liquidity risk.

Market Risk Management

Effectively managing market risk is essential to achieving the Company’s financial objectives. Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. The Company is generally not subject to currency exchange risk or commodity price risk. The Company’s primary market risk exposure is interest rate risk; however, market risk also includes liquidity risk. Both are discussed below.

Interest Rate Risk Management

Interest rate risk and its impact on net interest income is a primary market risk exposure. The Company manages its exposure to fluctuations in interest rates through policies approved by its Asset/Liability Investment Committee (“ALCO”) and Board of Directors, both of which receive and review periodic reports of the Company’s interest rate risk position.

The Company uses simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation takes into account current balance sheet volumes and the scheduled repricing dates and maturities of assets and liabilities. It incorporates numerous assumptions including growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered asset sensitive when its earning assets (loans and securities) reprice faster or to a greater extent than its liabilities (deposits and borrowings). An asset sensitive balance sheet will produce more net interest income when interest rates rise and less net interest income when they decline. Based on the Company’s simulation analysis, management believes the Company’s interest sensitivity position at December 31, 2007 is asset sensitive.

Index

The interest rate sensitivity position at December 31, 2007 is illustrated in the following table. The carrying amounts of assets and liabilities are presented in the periods they are expected to reprice or mature.

Table 5 - Interest Rate Sensitivity Gap Analysis
December 31, 2007
(dollars in thousands)

	Within			> 1 Year			> 3 Year
	1 Year			to 3 Years			to 5 Years			> 5 Years			Total
Interest sensitive assets:
Interest bearing deposits
with other banks	$	149		$	-		$	-		$	-		$	149
Securities		8,836			42,628			34,191			71,494			157,149
Loans (1)		306,781			128,675			66,019			51,284			552,759

Total interest sensitive assets		315,766			171,303			100,210			122,778			710,057

Interest sensitive liabilities:
Checking and savings deposits		167,151			-			-			-			167,151
Money market deposits		50,254			-			-			-			50,254
Time deposits		203,919			39,313			21,198			155			264,585
Repurchase agreements		47,891			-			-			-			47,891
Federal Home Loan Bank advances		10,200			5,000						937			16,137
Trust preferred capital notes		-			-			20,619			-			20,619

Total interest sensitive liabilities		479,415			44,313			41,817			1,092			566,637

Interest sensitivity gap	$	(163,649	)	$	126,990		$	58,393		$	121,686		$	143,420

Cumulative interest sensitivity gap	$	(163,649	)	$	(36,659	)	$	21,734		$	143,420

Percentage cumulative gap
to total interest sensitive assets		(23.0	) %		(5.2	) %		3.1	%		20.2	%


(1) Loans include loans held for sale and are net of unearned income.

Using the Company’s simulation analysis, the following table shows the estimated impact of changes in interest rates on net interest income over a one year time horizon as of December 31, 2007. This analysis makes numerous assumptions including: modest increases in assets and liabilities, a 1.25% parallel change in interest rates in January 2008, a 1.25% parallel change in interest rates in February 2008, the Company’s estimated prepayment activity on loans and mortgage-backed securities, and the Company’s estimate of how interest bearing deposit accounts would reprice using current yield curves at December 31, 2007.

Index

Table 6 - Estimated Changes in Net Interest Income
        
        
(dollars in thousands)
        
        
              
        
      December 31, 2007
          
        
Change in
          Changes in
          
        
Interest
          Net interest Income (1)
          
        
Rates
          Amount
          Percent
          
        
              
        
Up  2.5%
           $     2,982 
          10.2  
        %
        
        
Up  1.25%
                  1,590 
          5.4  
          
        
Down 1.25%
             (2,192)
           (7.5)
          
        
Down 2.5%
          (3,962)
          (13.5)
          
        
              
        
             
        
  (1) Represents the difference between estimated net interest income for the next 12 months in the new interest rate environment and the current interest rate environment.

Management cannot predict future interest rates or their exact effect on net interest income. Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Certain limitations are inherent in such computations. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect the Company’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

Liquidity Risk Management

Liquidity is the ability of the Company to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities. Liquidity management involves maintaining the Company’s ability to meet the daily cash flow requirements of its customers, whether they are borrowers requiring funds to meet their credit needs or depositors desiring to withdraw funds. Additionally, the parent company requires cash for various operating needs including dividends to shareholders, stock repurchases, the servicing of debt, and the payment of general corporate expenses. The Company manages its exposure to fluctuations in interest rates through policies approved by the ALCO and Board of Directors, both of which receive periodic reports of the Company’s interest rate risk position. The Company uses a simulation and budget model to manage the future liquidity needs of the Company.

Liquidity sources include cash and amounts due from banks, deposits in other banks, loan repayments, increases in deposits, lines of credit from the FHLB, federal funds lines of credit from two correspondent banks, and maturities and sales of securities. Management believes that these sources provide sufficient and timely liquidity.

The Company has a line of credit with the FHLB, equal to 30% of the Company’s assets, subject to the amount of collateral pledged. Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans and home equity lines of credit. In addition, the Company pledges as collateral its capital stock in and deposits with the FHLB. Borrowings under the line were $16,137,000 at December 31, 2007 and $15,100,000 at December 31, 2006.

       The Company had fixed-rate term borrowing contracts with the FHLB as of December 31, 2007, with the following final maturities:

   Amount
          Expiration Date
        
        
$3,000,000
          2008
        
        
  5,000,000
          2009
        
        
     937,000
          2014
        
        
      
        
        
        
 
        The Company has federal funds lines of credit established with two other banks in the amounts of $15,000,000 and $5,000,000, and has access to the Federal Reserve Bank’s discount 
window.  There were no amounts outstanding under these facilities at December 31, 2007 or 2006.
         
 
Index
        
22

        
        
 
          
        
BALANCE SHEET ANALYSIS

Securities

The securities portfolio generates income, plays a primary role in the management of interest rate sensitivity, provides a source of liquidity, and is used to meet collateral requirements. The composition of the Company’s securities portfolio reflects the Company’s investment strategy of maximizing yields, maintaining adequate liquidity, and providing a tool to manage the Company’s interest rate sensitivity position.

The securities portfolio consists primarily of high quality investments for which an active market exists. Federal agency, mortgage-backed, and state and municipal securities comprise the majority of the portfolio.

In December 2007, the Company recorded a $362,000 impairment charge relating to its holdings of FHLMC and FNMA preferred stock. The market value of these two securities dropped significantly at the end of 2007, and any near-term recovery in value is uncertain. The Company’s recorded investment in these securities, after the write-down, is $1,346,000 at December 31, 2007. The impairment charge is recorded as a reduction of noninterest income.

The following table presents information on the amortized cost, maturities, and taxable equivalent yields of securities at the end of the last three years.

Table 7 - Securities Portfolio
(in thousands, except yields)

	December 31,
	2007					2006					2005

			Taxable					Taxable					Taxable
	Amortized		Equivalent			Amortized		Equivalent			Amortized		Equivalent
	Cost		Yield			Cost		Yield			Cost		Yield
Federal Agencies:
Within 1 year	$	4,000		3.46	%	$	36,969		3.92	%	$	27,005		2.77	%
1 to 5 years		45,170		4.79			45,432		4.62			44,353		3.49
5 to 10 years		6,180		5.46			6,706		4.67			10,905		4.55
Over 10 years		-		-			-		-			-		-
Total		55,350		4.77			89,107		4.34			82,263		3.40

Mortgage-backed:
Within 1 year		108		3.43			-		-			-		-
1 to 5 years		3,461		4.33			4,460		4.51			4,142		4.18
5 to 10 years		14,411		4.85			8,345		4.83			10,227		4.78
Over 10 years		27,674		5.34			6,805		5.06			6,908		4.11
Total		45,654		5.10			19,610		4.84			21,277		4.44

State and Municipal:
Within 1 year		4,025		5.60			1,330		6.69			3,395		6.30
1 to 5 years		24,443		4.97			23,036		5.15			23,321		5.65
5 to 10 years		11,679		5.63			16,550		5.16			19,446		5.06
Over 10 years		7,878		5.73			5,179		6.03			3,040		6.15
Total		48,025		5.31			46,095		5.30			49,202		5.49

Other Securities:
Within 1 year		-		-			1,005		6.06			4,511		6.09
1 to 5 years		1,485		3.32			1,485		3.32			3,514		4.91
5 to 10 years		-		-			-		-			-		-
Over 10 years		4,994		6.56			6,401		6.21			5,952		3.62
Total		6,479		5.82			8,891		5.71			13,977		4.74

Total portfolio	$	155,508		5.08	%	$	163,703		4.74	%	$	166,719		4.26	%

Index

Loans

The loan portfolio consists primarily of commercial and residential real estate loans, commercial loans to small and medium-sized businesses, construction and land development loans, and home equity loans. Average loans increased $36,283,000, or 7.1%, from 2006 to 2007. Average loans increased $98,913,000, or 23.9% from 2005 to 2006. This increase was due largely to the acquisition of Community First, which occurred in April 2006.

Period-end loans increased $9,163,000, or 1.7%, from December 31, 2006 to December 31, 2007. The increase was primarily due to growth in commercial real estate loans.

Loans held for sale are loans originated and in process of being sold to the secondary market. These loans are sold servicing released and totaled $1,368,000 at December 31, 2007, and $1,662,000 at December 31, 2006.

The following table provides loan balances, percentage of portfolio (excluding loans held for sale), and the percentage change since December 31, 2006 of loans outstanding by geographic region. The loans are allocated to the region in which they were originated. In some circumstances, loans may be originated in one region for borrowers located in other regions.

Table 8 - Loans by Geographic Region

		December 31, 2007
(dollars in thousands)		Balance	Percentage of Portfolio		Percentage Change in Balance Since December 31, 2006

Danville region		$206,037	37.4	%	(4.5	)%
Lynchburg region		151,018	27.4		3.8

Southside region:

Martinsville and Henry County		108,065	19.6		9.8
Halifax and Pittsylvania County		63,204	11.4		3.1
Greensboro area		23,067	4.2		8.7

	Total loans	$551,391	100.0	%

The Company does not participate in highly leveraged lending transactions, as defined by bank regulations, and there are no loans of this nature recorded in the loan portfolio. The Company has no foreign loans in its portfolio. While there were no concentrations of loans to any individual, group of individuals, business, or industry that exceeded 10% of total loans at December 31, 2007 or 2006, loans to lessors of nonresidential buildings represented 11.0% of total loans at December 31, 2007; the lessees and lessors are engaged in a variety of industries.

Index

Table 9 illustrates loans by type.

Table 9 - Loans

			December 31,
		(in thousands)	2007	2006	2005	2004	2003

Real estate:
	Construction and land development		$ 69,803	$ 69,404	$ 50,092	$ 34,101	$ 12,790
	Commercial real estate		198,332

Table 6 - Estimated Changes in Net Interest Income
(dollars in thousands)

		December 31, 2007
Change in		Changes in
Interest		Net interest Income (1)
Rates		Amount	Percent

Up 2.5%		$ 2,982	10.2	%
Up 1.25%		1,590	5.4
Down 1.25%		(2,192)	(7.5)
Down 2.5%		(3,962)	(13.5)


	(1) Represents the difference between estimated net interest income for the next 12 months in the new interest rate environment and the current interest rate environment.