Virginia National Bankshares Corp

RESULTS OF OPERATIONS

Industry events and economic environment

Management of the Company continually monitors the impact of various global and national events on the Company's results of operations and financial condition, including inflation, changes in interest rates, and the political environment in light of the upcoming U.S. presidential election and other elections. The timing and impact of inflation, fluctuations in and volatility of interest rates, and the competitive landscape of deposits on our business and results of operations will depend on future developments, which are uncertain and unpredictable. In an effort to combat inflation, the FOMC increased the Federal Funds target rates throughout 2022 and 2023 to its current range of 5.25% to 5.50%. These developments contributed to the increased deposit costs that banks are experiencing. While inflation eased in 2023 and into 2024, it remains elevated over the FOMC’s long-run target of 2%. The FOMC has noted that it will carefully assess incoming data, the evolving outlook, and the balance of risks in considering any adjustments to the target range for the Federal Funds rate and that its assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments. The FOMC further noted that it does not expect it will be appropriate to reduce the target range for the Federal Funds rate until the FOMC has gained greater confidence that inflation is moving sustainability toward 2%, but that the FOMC would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the FOMC’s goals. The higher-for-longer interest rate environment and heightened competition for deposits has led to a continued shift within deposit composition toward higher cost products, although the pace of movement has slowed in recent months.

Non-GAAP presentations

The accounting and reporting policies of the Company conform to GAAP and prevailing practices in the banking industry. However, certain non-GAAP measures are used by management to supplement the evaluation of the Company’s performance. These include tangible book value per share, tangible equity and the following fully-taxable equivalent measures: net interest income-FTE, efficiency ratio-FTE and net interest margin-FTE. Interest on tax-exempt loans and securities is presented on a taxable-equivalent basis (which converts the income on loans and investments for which no income taxes are paid to the equivalent yield as if income taxes were paid) using the federal corporate income tax rate of 21 percent that was applicable for all periods presented.

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Management believes that the use of these non-GAAP measures provides meaningful information about operating performance by enhancing comparability with other financial periods, other financial institutions, and between different sources of interest income. The non-GAAP measures used by management enhance comparability by excluding the effects of (1) items that do not reflect ongoing operating performance, (2) balances of intangible assets, including goodwill, that vary significantly between institutions, and (3) tax benefits that are not consistent across different opportunities for investment. These non-GAAP financial measures should not be considered an alternative to GAAP-basis financial statements, and other banks and bank holding companies may define or calculate these or similar measures differently. Net income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “non-GAAP.”

A reconcilement of the non-GAAP financial measures used by the Company to evaluate and measure the Company's performance to the most directly comparable GAAP financial measures is presented below (dollars in thousands, except for the per share data):

Net income

Net income for the three months ended June 30, 2024 was $4.2 million, a $1.5 million decrease compared to $5.7 million reported for the three months ended June 30, 2023. Net income per diluted share was $0.77 for the three months ended June 30, 2024 compared to $1.05 per diluted share for the same period in the prior year.

Net income for the six months ended June 30, 2024 was $7.8 million, compared to $11.4 million for the six months ended June 30, 2023. Net income per diluted share was $1.45 for the six months ended June 30, 2024, compared to $2.13 for the six months ended June 30, 2023.

The decline in net income for each of the periods noted above is primarily the result of increased cost of funds, as discussed in more detail below.

Net interest income

Net interest margin (FTE) is the ratio of net interest income (FTE) to average earning assets for the period. The level of interest rates, together with the volume and mix of earning assets and interest-bearing liabilities, impact net interest income (FTE) and net interest margin (FTE).

Quarterly overview -Net interest income (FTE) for the three months ended June 30, 2024 was $11.3 million, a $2.5 million decrease compared to net interest income (FTE) of $13.8 million for the three months ended June 30, 2023. The net interest margin (FTE) of 3.04% for the three months ended June 30, 2024 was 79 bps lower than the 3.83% realized during the three months ended June 30, 2023. Interest expense increased $2.9 million, negatively impacting net interest income (FTE)

and net interest margin (FTE), compared to the same period in the prior year. Overall, the cost of interest-bearing deposits increased 100 bps period over period, from 174 bps to 274 bps. A $143.9 million increase in average balances of time deposit products contributed to the higher interest expense during the second quarter of 2024. The increase in average loan balances, from $940.3 million for the three months ended June 30, 2023 to $1.1 billion for the three months ended June 30, 2024, positively impacted interest income by $3.1 million. This metric was however negatively impacted by the decrease in the average balances of securities, decreasing from $488.1 million in the three months ended June 30, 2023 to $327.7 in the three months ended June 30, 2024, negatively impacting interest income (FTE) by $1.2 million period over period.

Year-to-date overview -Net interest income (FTE) for the six months ended June 30, 2024 was $22.3 million, a $5.0 million decrease compared to net interest income (FTE) for the six months ended June 30, 2023. The net interest margin (FTE) of 2.98% for the six months ended June 30, 2024 was 79 bps lower than the 3.77% realized during the six months ended June 30, 2023. Interest expense increased $7.5 million, negatively impacting net interest income (FTE) and net interest margin (FTE), compared to the same period in the prior year. Overall, the cost of interest-bearing deposits increased 133 bps period over period, from 141 bps to 274 bps. A $178.6 million increase in average balances of time deposit products contributed to the higher interest expense during the first half of 2024. The increase in average loan balances, from $936.6 million for the six months ended June 30, 2023 to $1.1 billion for the six months ended June 30, 2024, positively impacted interest income by $5.4 million. This metric was however negatively impacted by the decrease in the average balances of securities, decreasing from $501.2 million in the six months ended June 30, 2023 to $349.0 in the six months ended June 30, 2024, negatively impacting interest income (FTE) by $2.2 million period over period.

For the quarterly and year-to-date periods of 2024, the shift in the composition of earnings assets was intentional to shift the mix to higher yielding assets.

Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP net interest margin.

The following tables detail the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest-bearing liabilities, for the three and six months ended June 30, 2024 and 2023. These tables also include rate/volume analyses for these same periods (dollars in thousands).

Consolidated Average Balance Sheet and Analysis of Net Interest Income

(1)

Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section.

(2)

Interest spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.

(3)

Net interest margin (FTE) is net interest income expressed as a percentage of average earning assets.

(4)

The impact on the net interest income (FTE) resulting from changes in average balances and average rates is shown for the period indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Consolidated Average Balance Sheet and Analysis of Net Interest Income

(1)

Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section.

(2)

Interest spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.

(3)

Net interest margin (FTE) is net interest income expressed as a percentage of average earning assets.

(4)

The impact on the net interest income (FTE) resulting from changes in average balances and average rates is shown for the period indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Provision for credit losses

A recovery of provision for credit losses of $338 thousand was recognized during the three months ended June 30, 2024 compared to a provision for loan losses of $261 thousand recognized during the three months ended June 30, 2023. The second quarter 2024 recovery of provision for credit losses was comprised of $519 thousand of recovery of provision for loan losses and $181 thousand of provision for losses on unfunded commitments.

A recovery of provision for credit losses of $360 thousand was recognized during the six months ended June 30, 2024 compared to a provision for loan losses of $13 thousand recognized during the six months ended June 30, 2023. The first half 2024 recovery of provision for credit losses was comprised of $508 thousand of recovery of provision for loan losses and $148 thousand of provision for losses on unfunded commitments.

An update to the peer data used in the Company's CECL model was performed during the three months ended June 30, 2024. This included a new group of peer banks, an adjustment to the k-factors used in the DCF models, and the election to mirror CRE non-owner occupied data for the multifamily pool based on the more appropriate and reasonable data fit. In addition, during the second quarter of 2024, a reallocation of qualitative factor weightings for each pool was performed based on assessment of applicability and significance in terms of anticipated effect of each factor on loss rates for each pool.

A significant portion of the increase in loan balances in the first half of 2024 was attributable to the purchase of government-guaranteed loans which do not require an ACL as they are 100% guaranteed, with balances increasing by $74.6 million from December 31, 2023 to June 30, 2024.

The increase in unfunded commitment reserve was almost entirely due to the increase in the reserve rate associated with the construction portfolio. In the second quarter of 2024, the construction pool was assigned a higher loss rate of 1.84%, compared to 1.22% in the first quarter of 2024. This increase was due to changes in economic data as well as qualitative factors. The increase is due to the inherent risks associated with construction, which have been elevated due to the interest rate environment and costs of labor and supplies associated with construction projects.

Further discussion of management’s assessment of the ACL is provided earlier in the report and in Note 5 – Allowance for Credit Losses, found in the Notes to the Consolidated Financial Statements. In management’s opinion, the ACL was adequately provided for at June 30, 2024. The ACL calculation, provision for credit losses, asset quality and collateral values may be significantly impacted by deterioration in economic conditions. Should economic conditions worsen, we could experience further increases in our required ACL and record additional provision for credit loss exposure.

Noninterest income

The components of noninterest income for the three months ended June 30, 2024 and 2023 are shown below (dollars in thousands):

Noninterest income for the three months ended June 30, 2024 of $1.7 million was $354 thousand or 17.3% less than the amount recorded for the three months ended June 30, 2023, due primarily to a reduction in wealth management and debit/credit card and ATM fees, as a result of a reduction in number of accounts. The decline in wealth management fees associated with Masonry was offset by a reduction in Masonry-related expenses.

The components of noninterest income for the six months ended June 30, 2024 and 2023 are shown below (dollars in thousands):

Noninterest income for the six months ended June 30, 2024 of $3.9 million was $452 thousand or 10.5% less than the amount recorded for the six months ended June 30, 2023, due primarily to the fact that the gain on the termination of the interest rate swap that occurred in the first quarter of 2023 was $81 thousand more than the gain on the early redemption of debt in the first quarter of 2024, coupled with the reduction in wealth management and debit/credit card and ATM fees, as noted above, as a result of a reduction in number of accounts.

Noninterest expense

The components of noninterest expense for the three months ended June 30, 2024 and 2023 are shown below (dollars in thousands):

Noninterest expense for the quarter ended June 30, 2024 of $8.1 million was $412 thousand or 4.8% lower than the quarter ended June 30, 2023. This decrease is primarily due to reduced compensation, occupancy and data processing costs, as a result of right-sizing the branch network from the Merger, and reduced marketing, advertising and promotion expense.

The components of noninterest expense for the six months ended June 30, 2024 and 2023 are shown below (dollars in thousands):

Noninterest expense for the six months ended June 30, 2024 of $16.9 million was $406 thousand or 2.3% lower than the six months ended June 30, 2023. This decrease is primarily due to reduced compensation, occupancy and data processing costs, as a result of right-sizing the branch network from the Merger, and reduced marketing, advertising and promotion expense.

The efficiency ratio (FTE) was 62.7% for the three months ended June 30, 2024 compared to 54.1% for the same quarter of 2023, due predominantly to the decrease in net interest income (FTE), as described above. The efficiency ratio of 64.8% for the six months ended June 30, 2024 deteriorated from the 55.1% realized in the six months ended June 30, 2023 for the same reason. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP efficiency ratio.

Provision for Income Taxes

For the three months ended June 30, 2024 and 2023, the Company provided $929 thousand and $1.3 million for Federal income taxes, respectively, resulting in effective income tax rates of 18.3% and 18.4%, respectively, declining due to the application of prior period tax adjustments. For the six months ended June 30, 2024 and 2023, the Company provided $1.6 million and $2.6 million for Federal income taxes, respectively, resulting in effective income tax rates of 17.0% and 18.3%, respectively. For each period, the effective income tax rate differed from the U.S. statutory rate of 21% due to the recognition of low-income housing tax credits and the effect of tax-exempt income from municipal bonds and bank owned life insurance policies.

OTHER SIGNIFICANT EVENTS

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