PNBI Pioneer Bankshares Inc (PK)

The discussion covers the consolidated balance sheet and statement of income of Pioneer Bankshares, Inc. (“Company”) and its subsidiary Pioneer Bank (“Bank”).

Forward-Looking Statements

This quarterly report on Form 10-QSB contains forward-looking statements with respect to the Company’s and the Bank’s financial condition, results of operations and business. These forward-looking statements involve certain risks and uncertainties. When used in this quarterly report or future regulatory filings, in press releases or other public shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” “believe,” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We caution the readers and users of this information not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and advise readers that various factors including regional and national economic conditions, changes in the levels of market rates of interest, credit risk and lending activities, and competitive and regulatory factors could affect the financial performance of the Company and the Bank and could cause actual results for future periods to differ materially from those anticipated or projected.

The Company and the Bank do not undertake and specifically disclaim any obligation to publicly release the result of any revisions, which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

Overview

For the nine month period ended September 30, 2007, net income including securities transactions was $1.25 million compared to $1.23 million for the same period in 2006. This represents an increase of $20,000 or approximately 1.62%. Earnings per share were $1.24 as of September 30, 2007, compared to $1.22 for the same period last year. The increase in earnings for the period is primarily attributed to increased interest income on loans and investment securities. These increases are primarily the result of the Company’s continued efforts to expand its loan portfolio, as well as; increased market yields on the Bank’s investment portfolio as compared to the prior year.

The Company’s net growth in assets for the nine month period ending September 30, 2007 was $6.4 million, which represents a 4.25% increase over that achieved in the comparable period for 2006. The loan portfolio grew by $7.2 million or 6.08% during the nine months ending September 30, 2007. The growth trends are attributed to the Company’s focus on increasing its loan portfolio primarily in the category of small to medium sized commercial loans.

Total liabilities for the Company as of September 30, 2007 were $142.1 million compared to $136.4 million at year-end 2006. This represents an increase of approximately $5.7 million or 4.18%. The deposit portfolio grew by $6.5 million or 5.24% during the same period. The primary increases in deposit accounts have been in a variety of categories, including non-interest bearing demand accounts, time deposits and savings accounts. Time deposits increased by approximately $4.0 million or 5.67% during the nine month period ending September 30, 2007.

The Company’s total capital position remains strong and exceeds regulatory guidelines. As of September 30, 2007, total capital was $16.0 million.

Management is not aware of any trends, events, or other uncertainties that would have a material effect on the Company’s liquidity, capital resources, or operational activities.

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Critical Accounting Policies

General

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within our 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 either when earning income, recognizing an expense, recovering an asset, or relieving a liability.

The Company uses historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basis principles of accounting: 1) Statement of Financial Accounting Standard (“SFAS”) 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and 2) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the market and the loan balance.

Management evaluates the loan portfolio in light of national and local economic trends, changes in the nature and value of the portfolio and industry standards. Specific factors considered by management in determining the adequacy of the level of the allowance include loan review reports, past due reports, historical loan loss experience and individual borrower’s financial condition. This review also considers concentrations of loans in terms of geography, business type or level of risk. Management evaluates the risk elements involved in loans relative to their collateral value and maintains the allowance for loan losses at a level which is adequate to absorb credit losses inherent in the loan portfolio. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgment about information available to them at the time of their examination.

The methodology used to calculate the allowance for loan losses and the provision for loan losses is a significant accounting principle, which is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions.

Goodwill

Goodwill is evaluated on an annual basis for impairments in value and adjusted accordingly. In June 2001, the Financial Accounting Standards Board, (“FASB”) issued SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Additionally, it further clarifies the criteria for the initial recognition and measurement of intangible assets separate from goodwill. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001 and prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets will be subject to at least an annual impairment review, and more frequently if certain impairment indicators are evident. SFAS No. 142 also requires that reporting units be identified for the purpose of assessing potential future impairments of goodwill.

Goodwill is included in other assets and totaled $360,000 at September 30, 2007 and December 31, 2006. The goodwill is no longer amortized, but instead is tested for impairment at least annually.

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Results of Operations

Net Interest Income

Total interest income increased by $737,000 or 10.12% during the nine month period ending September 30, 2007 as compared to the same period for 2006. For the same reporting periods, total interest expense increased $525,000 or 21.82%. These increases resulted in a total overall increase in net interest income of $212,000 or 4.35% for the nine month period ending September 30, 2007, when compared to the same period in 2006.

The net interest margin decreased from 4.73% at September 30, 2006, to 4.70% at September 30, 2007. Management’s continued focus on commercial and residential real estate lending as opposed to higher yielding consumer loans. Changes in market interest rates on deposits and borrowings were the main contributors to the overall decrease in net interest margin. The average yield on earning assets increased from 7.05% as of September 30, 2006 to 7.40% as of September 30, 2007.

The average interest rate being paid on time deposits increased from 3.93% as of September 30, 2006 to 4.56% as of September 30, 2007. The average interest rate being paid on borrowed funds decreased from 4.01% as of September 30, 2006 to 3.75% as of September 30, 2007. The changes in these average costs are primarily related to the recent market interest rate fluctuations, increased deposit volume during the reporting period, and the cost of borrowed funds.

Noninterest Income

During the nine month period ending September 30, 2007, non-interest income decreased by $27,000 or 2.82% when compared to the same period last year. The primary factor contributing to this decrease was gains on securities transactions of $206,000 compared to gains in the prior year of $305,000. Service charge income increased by $14,000, while other income increased by $58,000. The increase in service charge income is primarily the result of additional ATM fees being collected. The increase in other income is directly related to investment commission income generated by the Company’s subsidiary, Pioneer Financial Services, LLC.

Noninterest Expense

During the nine month period ending September 30, 2007, non-interest expense increased $145,000 or 3.84% in comparison to the same period for 2006. Salaries and benefits increased by $187,000 due to cost of living increases, promotional payroll adjustments, and the recent employment of personnel for the Company’s subsidiary, Pioneer Financial Services, LLC. Occupancy expenses increased $2,000 and equipment expense decreased by approximately $43,000.

Financial Condition

Securities

The Company’s securities portfolio is held to assist the Company in liquidity and asset liability management as well as capital appreciation. The securities portfolio consists of securities held to maturity and securities available for sale. Securities are classified as held to maturity when management has the intent and ability to hold the securities to maturity. These securities are carried at amortized cost. Securities available for sale include securities that may be sold in response to general market fluctuations, general liquidity needs and other similar factors. Securities available for sale are recorded at market value. Unrealized holding gains and losses of available for sale securities are excluded from earnings and reported (net of deferred income taxes) as a separate component of shareholders’ equity. At September 30, 2007, all of the Company’s securities were classified as available for sale.

As of September 30, 2007, the market value of securities available for sale was approximately $36,000 more than the amortized cost as shown in note 2 of the financial statements included in this report. Management has traditionally held debt securities until maturity and thus it does not expect market fluctuations in the value of these securities to have a material impact on earnings.

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Investments in securities, including those which were restricted, decreased by approximately $4.25 million during the nine month period ending September 30, 2007. This decrease is attributed to funding needs in support of the increased loan portfolio. The Company generally invests in securities with a relatively short-term maturity due to uncertainty in the direction of market interest rates. Of the investments in securities available for sale, 9.38% (based on market value) are invested in equities, some of which are dividend producing and subject to the corporate dividend exclusion for taxation purposes. The Company believes these investments offer adequate returns and/or have the potential for increases in value.

Loan Portfolio

The Company operates in a service area in the western portion of Virginia in the counties of Page, Greene, Rockingham, and the City of Harrisonburg, and has expanded its service area to include Albemarle County and the City of Charlottesville, Virginia. The Company does not make a significant number of loans to borrowers outside its primary service area. The Company is active in local residential construction mortgages and consumer lending. Commercial lending includes loans to small and medium sized businesses within its service area.

An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed regularly for adequacy. The risk associated with real estate and installment loans to individuals is based upon employment, the local and national economies, and consumer confidence. All of these affect the ability of borrowers to repay indebtedness. The risk associated with commercial lending is substantially based on the strength of the local and national economies in addition to the financial strength of the borrower.

While lending is geographically diversified within the service area, the Company does have loan concentrations in commercial real estate, residential real estate, and consumer auto loans. A significant percentage of real estate loans and installment loans are made to borrowers employed by businesses outside the service area.

During the nine month period ending September 30, 2007, net loans increased by approximately $7.2 million or 6.08%, as a result of management’s proactive efforts to add volume in the commercial real estate sector of the lending portfolio. The Company has taken measures to reduce the risk exposure related to consumer and automobile financing and continues to monitor its progress in this area. A schedule of loans by type is shown in note 3 of the consolidated financial statements included in this report.

The risk elements in lending activities include non-accrual loans, loans 90 days or more past due and restructured loans. Non-accrual loans are loans on which interest accruals have been suspended or discontinued permanently. Restructured loans are loans on which the original interest rate or repayment terms have changed due to financial hardship. Non-accrual loans and loans 90 days or more past due totaled $17,000 at September 30, 2007 compared to $67,000 at December 31, 2006. This represents a decrease of $50,000 and is mainly due to management’s continued proactive collection efforts. Management continually monitors non-accrual accounts and all non-performing assets in order to promptly identify any loss allocations that should be made. Although the potential exists for additional losses, management believes the Bank is generally well secured and continues to actively work with these customers to effect payment.

Impaired loans are those loans which have been identified by management as problem credits due to various circumstances concerning the borrower’s financial condition and frequent delinquency status. These loans may not be delinquent to the extent that would warrant a non-accrual classification, however, management has classified these accounts as impaired and is monitoring the circumstances and payment status closely. In most cases, a specific allocation to the Bank’s allowance for loan loss is made for an impaired loan. The total amount of impaired loans as of September 30, 2007 was $270,000 compared to $213,000 at December 31, 2006. Based on current collateral values, management has identified potential losses relating to impaired loans of approximately $68,000 as of September 30, 2007. Potential loss reserve allocations as of December 31, 2006 were $42,500. Specific valuation allowances have been made as a precautionary measure to cover these potential losses.

Problem loans (serious doubt loans) are loans whereby information known by management indicates that the borrower may not be able to comply with present payment terms. Management was not aware of any problem loans at September 30, 2007 that are not included in the past due, non-accrual loans, or impaired loans referred to above.

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Allowance for Loan Losses

Management’s analysis process for evaluating the adequacy of the allowance for loan loss is a continual process, which is monitored at least quarterly, or more frequently, as needed. The evaluation process consists of regular periodic reviews of the loans outstanding by loan type. Specific reviews and allocations are made for loans that have been identified as potential loss, in which the borrower’s financial condition has substantially weakened or habitual past due payment activity has occurred. Specific reviews and allocations are also made for various sectors of the loan portfolio that have been identified as higher risk categories. Historical loss ratios are applied to the remaining loan portfolio by loan type, based on the most recent loss trends. Management takes into consideration expected recoveries from prior charge offs as part of its allowance and funding calculation.

Management also evaluates the loan portfolio in light of national and local economic trends, changes in the nature and value of the portfolio and industry standards. Allocation factors relating to identified loan concentrations and loan growth trends are included in the calculation of the adequacy of the loan loss reserve. The periodic review of the allowance for loan loss and funding provision considers concentrations of loans in terms of geography, business type or level of risk. Management evaluates the risk elements involved in loans relative to collateral values and maintains the allowance for loan losses at a level which is adequate to absorb credit losses considered to be inherent in the loan portfolio. Management engages the services of an outside loan review firm periodically to evaluate the loan portfolio, provide an independent analysis of significant borrowers, and to assist in identifying potential problem credits. The independent loan review report is used by management as an additional tool for monitoring and minimizing risks that may be inherent in the loan portfolio. Management has also implemented an internal loan review process for the purpose of identifying and monitoring possible loan losses in the portfolio. Other factors considered in management’s evaluation process are changes in lending policies, procedures and underwriting criteria; changes in the nature and volume of the loan portfolio; the experience, ability, and depth of lending management or other lending personnel; the volume and severity of past dues, non-accruals, and classified loans; and other external or regulatory requirements. Regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgment about information available to them at the time of their examination.

The methodology used to calculate the allowance for loan losses and the provision for loan losses is a significant accounting principle which is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions.

The provision for loan losses and changes in the allowance for loan losses are shown in note 4 of the financial statements included in this report.

The allowance for loan loss balance of $1,532 million at September 30, 2007, increased by approximately $56,000 from its level at December 31, 2006. The increase in the allowance balance is primarily attributed to specific allocations related to impaired loans and growth in the consumer auto financing category. While the funding requirement for impaired loans and auto financing has increased, the majority of loan portfolio growth has been in commercial real estate accounts, which are considered to be a lower risk category. The Company’s past due trends have remained relatively stable and in a range consistent with the bank’s expectations during this period of loan growth. The lower risk growth funding factors related to commercial real estate loans have contributed to the slight decrease in the cumulative funding as a percentage of total loans. The cumulative balance in the allowance for loan loss account was equal to 1.20% and 1.23% of total loans at September 30, 2007 and December 31, 2006, respectively.

The allowance is deemed to be within an acceptable range based on management’s evaluation of the losses inherent in the loan portfolio at the end of this reporting period. The evaluation of the allowance for loan loss account for the period ending September 30, 2007 included specific allocations for certain borrowers, in which the payment performance and collateral value assessment indicates possible future losses. Management exercises the utmost caution and due diligence in allocating for possible loan losses, and follows a conservative methodology in order to protect its investors and to minimize the potential for large fluctuations in future provision expenses. Management’s practice of funding the allowance for loan loss account is to make necessary adjustments on a quarterly basis for the foreseeable period in an attempt to effectively match expenses to loan losses as they are occurring. Large fluctuations or variances outside of the acceptable range as calculated for the necessary allowance for loan loss reserves are recorded directly to income or expense in the reporting period.

Management’s evaluation of the allowance for loan losses for the periods ending September 30, 2007 and December 31, 2006 concluded that the reserved amount was adequate to cover potential estimated losses. The allowance for loan loss account is monitored closely by management on an on-going basis, and is periodically adjusted to ensure that an adequate level of loss coverage is maintained.

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Premises and Equipment

The Company continually monitors technological upgrades in the banking industry, and may, from time to time, in order to achieve higher levels of internal operational efficiency, purchase new or additional equipment relating to such technologies. The Company’s management sets specific budget allowances on an annual basis, which are deemed to be adequate to cover expenditures that may arise throughout the year relating to technological upgrades or enhancements. The Company also periodically evaluates opportunities for future branch locations and additional products in order to enhance customer service.

Deposits

The Company’s main source of funds is customer deposits received from individuals, governmental entities and businesses located within the Company’s service area. Deposit accounts include demand deposits, savings, money market and certificates of deposit. The Company’s total deposit portfolio has historically remained stable.

During the nine month period ending September 30, 2007, total deposits increased by $6.5 million or 5.24%. The increase in deposits was distributed among non-interest bearing demand accounts, savings accounts, and time deposits. The Company monitors its deposits carefully on an on-going basis in order to provide adequate funding for investments and loan growth opportunities.

Borrowings

The Bank has a line of credit with the Federal Home Loan Bank of Atlanta (“FHLB”) upon which credit advances can be made up to 40% of total assets, subject to certain eligibility requirements. As of September 30, 2007, total borrowings were $9.5 million compared to $10.7 million at December 31, 2006. This represents a decrease of $1.2 million or 11.21%. This decrease is attributed to regularly scheduled principal reductions that occurred during the reporting period. The Bank utilizes borrowings periodically as a source of funds for loan growth and other investment opportunities in order to maintain a profitable interest spread. Borrowings are generally matched with maturities of specific groups of loans, and are normally advanced in terms ranging from 1 – 5 years.

Capital

The Company maintains a strong capital base as support for possible future expansion, to promote public confidence, and to support operations and for continued growth at a manageable level. As of September 30, 2007, and December 31, 2006, the Company’s total capital-to-asset ratios were 10.11% and 10.04%, respectively. The Company’s capital ratios exceed regulatory minimums. Earnings have been sufficient to allow for dividends to be declared on a quarterly basis and management has no reason to believe this payment schedule will not continue.

Liquidity

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

Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, deposits obtained through the adjustment of interest rates, purchases of federal funds and borrowings. To further meet its liquidity needs, the Company also maintains lines of credit with the FHLB and certain correspondent banks.

There are no off-balance sheet items that should impair future liquidity. Liquidity as of September 30, 2007 remains adequate.

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Interest Rate Sensitivity

The Company has historically had a stable core deposit base and, therefore, does not have to rely on volatile funding sources. Because of the stable core deposit base, changes in interest rates should not have a significant effect on liquidity. The Company also uses loan repayments and maturing investments to meet its liquidity needs. The Bank’s membership in the Federal Home Loan Bank System provides additional liquidity. The matching of long-term receivables and liabilities helps the Company reduce its sensitivity to interest rate changes.

The Company reviews its interest rate gap periodically and makes adjustments as needed.

Table II contains an analysis, which shows the re-pricing opportunities of earning assets and interest bearing liabilities as of September 30, 2007.

The Company had a negative cumulative Gap Rate Sensitivity Ratio of 42.57% for the one year re-pricing period as of September 30, 2007, compared to a negative cumulative Gap Sensitivity of 39.46% at December 31, 2006. This negative gap position generally indicates that earnings would improve in a declining interest rate environment as liabilities re-price more quickly than assets. Conversely, earnings would probably decrease in periods during which interest rates are increasing. However, in actual practice, this may not be the case as deposits may not re-price concurrently with changes in rates within the general economy. Management constantly monitors the Company’s interest rate risk and has decided the current position is acceptable for a well-capitalized community bank operating in a rural environment.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements but may change current practice for some entities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The Company does not expect the implementation of SFAS 157 to have a material impact on its consolidated financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this Statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The fair value option established by this Statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument and is irrevocable. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is in the process of evaluating the impact SFAS 159 may have on its consolidated financial statements.

Effect of Proposed Accounting Standards

The Company does not believe that any newly issued but as yet unapplied accounting standards will have a material impact on the Company’s financial position or operations.

Securities and Exchange Commission Web Site

The Securities and Exchange Commission maintains a Web site ( http://www.sec.gov ) that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC, including Pioneer Bankshares, Inc.

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