UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

 

FORM 10-K

 

 

 

Commission File Number: 000-25081

 

 

Registrant’s telephone number, including area code:  (970) 476-2002

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Name of exchange on which registered: None

 

Securities registered pursuant to Section 12(g) of the Act: Common stock, $1.00 par value per share.

 

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   ý  No   o.

 

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

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the registrant’s most recently completed second fiscal quarter:  As of June 30, 2003, 5,489,139 shares of common stock, $1.00 par value, were issued and outstanding with an aggregate value of $41,475,493 held by non-affiliates (based on market value of $13.55 per share) (computed by reference to the price at which the common stock was sold.)

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: As of February 29, 2004, there were issued and outstanding 5,298,093 shares of common stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held May 17, 2004, are incorporated by reference into Part III.

 

 

VAIL BANKS, INC.

 

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2003

 

TABLE OF CONTENTS

 

PART I
	ITEM 1.  BUSINESS
	General
	History
	Community Banking Philosophy
	Growth Strategies
	Segment Information
	Products and Services
	Competition
	Administration of WestStar
	Technology
	Associates
	Risk Factors
	Supervision and Regulation
	Executive Officers of Vail Banks
	ITEM 2.  PROPERTIES..
	ITEM 3.  LEGAL PROCEEDINGS..
	ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
PART II
	ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
	Market Information
	Holders
	Dividends
	ITEM 6.  SELECTED FINANCIAL DATA.
	ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	Introduction
	Critical Accounting Policies and Estimates
	Certain Factors Affecting Forward-Looking Statements
	Results of Operations
	Financial Condition
	Related Party Transactions
	Liquidity and Interest Rate Sensitivity
	Capital Resources
	Recent Accounting Pronouncements
	ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	Quantitative Disclosures About Market Risk
	Qualitative Disclosures About Market Risk
	ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
	ITEM 9A.  CONTROLS AND PROCEDURES.
PART III
	ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
	ITEM 11.  EXECUTIVE COMPENSATION.
	ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
	ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
	ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES.
	ITEM 15.  EXHIBITS, LISTS AND REPORTS ON FORM 8-K.
	FINANCIAL STATEMENTS
	Independent Auditors’ Report
	Consolidated Balance Sheets
	Consolidated Statements of Income
	Consolidated Statements of Shareholders’ Equity and Comprehensive Income
	Consolidated Statements of Cash Flows
	Notes to Consolidated Financial Statements
SIGNATURES

 

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PART I

 

ITEM 1.  BUSINESS.

 

General

 

Vail Banks, Inc. (Vail Banks) is a bank holding company headquartered in Avon, Colorado with consolidated assets of $575.6 million at December 31, 2003. Vail Banks has three wholly-owned subsidiaries, WestStar Bank (WestStar), Vail Banks Statutory Trust I, and Vail Banks Statutory Trust II.  Additionally, WestStar and Vail Banks own a 54.04% interest in Avon 56 Limited, a real estate partnership, and WestStar owns a 100% interest in First Western Mortgage Services, Inc. (First Western), a retail mortgage lending company.  All entities are collectively referred to herein as the Company or Vail Banks.  The Company intends to merge First Western into WestStar by the end of the second quarter 2004.

 

WestStar is a Colorado state bank with 22 retail offices located primarily in the “Western Slope” and “Front Range” regions of Colorado.  It was formed in 1977 as a community bank to serve the local residents and businesses of Vail. In 1993, Vail Banks was formed as a bank holding company for WestStar. Vail Banks has maintained WestStar’s position as an institution offering a relatively broad range of convenient banking services delivered with personalized customer service.

 

The ‘‘Western Slope,’’ includes Summit County (which includes the Breckenridge, Keystone and Copper Mountain ski resorts), Grand County (which serves the Winter Park ski resort), Eagle County (which includes the Vail and Beaver Creek ski resorts), Delta County, Garfield County, Pitkin County (which serves the Aspen and Snowmass ski resorts), Mesa County, Montrose County, San Miguel County (which includes the town and ski resort of Telluride), and Routt County (which includes the town and ski resort of Steamboat Springs).  The “Front Range”, includes Denver and Estes Park. These areas of Colorado are home to a variety of commercial, recreational, entertainment, and cultural enterprises.

 

The Western Slope has experienced growth in past years, primarily as a result of an expanding market for first and second homes, and summer and winter tourism. As the year-round population of this region has grown, local businesses have prospered by servicing this growth. Consequently, a large concentration of Vail Banks’ business is in construction lending and providing banking services for small-to-medium size businesses in its markets. To meet the growing needs of its customers and to prepare for future growth, Vail Banks has developed a strong infrastructure by expanding its computer technology and centralizing certain administrative, processing, accounting and other operational functions.

 

Vail Banks’ growth has been designed to maintain customer loyalty through continuity of operations and associates. Historically, shareholders of entities merged into Vail Banks, who are typically members of the local community, have elected to hold ownership stakes in Vail Banks after the merger. The additions of Bank of Telluride (founded in 1969), Western Colorado Bank (founded in 1950), Glenwood Independent Bank (founded in 1955) and United Valley Bank (founded in 1908) expanded Vail Banks’ presence in Western Slope and Front Range markets, as these were well-established community banks that had significant local sponsorship. Several directors of the Company, as well as both its Chairman and President, have been associated with WestStar for more than ten years. Additionally, several WestStar directors who previously served as directors of acquired institutions had been associated with those banks for more than ten years.

 

History

 

In December 1993, Vail Banks commenced operations by acquiring 100% of the outstanding shares of WestStar, which opened in December 1977. Since that time, Vail Banks has grown through a combination of internal growth, de novo establishment of retail offices and external growth, including the acquisition of community banks.  In 1994, WestStar converted from a national bank charter to a state bank charter.  In 2003, the Company opened a new branch in the Tech Center area of Denver in order to expand its Denver and Front Range presence.

 

Community Banking Philosophy

 

WestStar provides a relatively broad range of banking products and services to consumers and businesses in all of its retail offices.  Retail offices are operated with the goal of offering individualized customer service and providing superior financial services. Many administrative operations, such as data processing, loan administration, account reconciliation and maintenance, accounting, compliance and broad policy decisions are centralized to ensure consistency, accuracy and efficiency

 

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and to allow our associates to concentrate on providing superior customer service.  The managers and associates of each retail office focus on day-to-day customer service, business development and selling.  Management of Vail Banks believes that this organizational structure allows retail offices to offer the individualized customer service of a community bank while maximizing the benefits of technological expertise, operating synergies and other administrative cost savings and efficiencies.

 

Management is committed to investing in its communities. Executive officers and regional presidents live in the communities served by their retail offices, and Vail Banks encourages board members and bank associates to be actively involved in civic and public service activities in their communities.

 

Growth Strategies

 

Vail Banks intends to enhance and solidify its position as a major provider of banking services for individuals and small-to-medium size businesses on the Western Slope and the Front Range. As a result of its significant investment in retail offices, technology and administration infrastructure, management believes that Vail Banks’ growth, both internally and by merger or acquisition, has been efficiently integrated.

 

Vail Banks believes that it will grow primarily through expansion of its existing market share and de novo establishment of retail offices.  From December 1995 to December 2003, Vail Banks completed eight mergers and acquisitions and opened eight de novo branches.

 

During the past two years, the Company did not experience the same rate of growth that it had in prior years.  Gross loans were $312.5 million at December 31, 2003 and $331.0 million at December 31, 2002, as compared to $391.7 million at December 31, 2001.  This decrease was primarily due to the softening of the economy, a conservative underwriting policy and an internal focus on resolving problem loans.  The Company believes these decreases were temporary and expects that loan volume will increase as the economy recovers.

 

Expansion of Existing Market Share.     Vail Banks intends to increase its overall market share in its markets by solidifying relationships with current customers and attracting new customers who desire a local banking relationship. Management believes that this can be accomplished by (1) evaluating the needs of its existing and potential customers to determine ways to enhance services and products, (2) increasing the focus on sales training and motivating its associates, (3) providing personalized customer service, and (4) further implementing technological advances to make banking more efficient and convenient.

 

De Novo Establishment of Retail Offices.     Vail Banks intends to continue to expand by opening new retail offices.  Management believes that initially establishing a small presence in growing communities positions Vail Banks to expand with the community, thereby fostering a local identity with existing businesses and consumers in these communities, as well as offering new customers an alternative to impersonal, institutional banks.  Additionally, management has committed to establishing additional banking locations to expand its presence in the Front Range market.  Such offices will be opened over a period of years as market opportunities and availability of banking talent dictate.

 

Mergers and Acquisitions.     Vail Banks’ merger and acquisition strategy will be a secondary approach for growth opportunities.  Previously, Vail Banks increased its market share in its existing markets and attractive new markets by merging with well-established community banks. In assessing future mergers, Vail Banks will focus primarily on credit quality, financial performance, market share, management, location, community demographics, strength of the local economy, potential merger synergies and the terms of the transaction. Management believes that merging with established banks and then methodically integrating their operations into Vail Banks allows Vail Banks to offer its relatively broad range of products and services while maintaining the merged bank’s reputation and community ties. Vail Banks’ strategy is to streamline operations judiciously to optimize the balance between cost savings and minimizing the interruption of community-based services of the acquired bank.

 

Segment Information

 

Segment information is presented in accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information.  This standard is based on a management approach that requires segmentation based on the Company’s internal organization and internal monitoring of operations.  During 2003 and 2002, the Company had two reportable segments, banking (WestStar) and mortgage origination (First Western).  During 2001,

 

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the Company had only one segment, banking, that met the quantitative threshold for disclosure.  The banking segment provides a full range of commercial and consumer banking products to customers including deposit products, commercial loans, real estate loans, consumer loans and other business services.  The banking segment’s principal source of income is the net spread between the interest earned on loans and investment securities and the interest cost associated with the deposits and borrowings used to finance such loans and investments.  The mortgage origination segment originates mortgage loans and sells them to investors in the secondary market.  Its principal source of income is the origination and processing fees.  These two segments are strategic business units that offer different products and services.  They are managed separately because each segment appeals to different markets and accordingly, requires different technology and marketing strategies.

 

Information about reportable segments and reconciliation of such information to the consolidated financial statements as of and for the years ended December 31, 2003, 2002 and 2001 is contained in “Notes to Consolidated Financial Statements—Note 23” contained in Item 15 of this Annual Report on Form 10-K.  The accounting policies of the segments are the same as those described in the summary of significant accounting policies contained in “Notes to Consolidated Financial Statements—Note 1” contained in Item 15 of this Annual Report on Form 10-K.  Management evaluates the performance of each segment based on profit or loss from operations.  Certain administrative costs, however, are borne by the banking segment and are not allocated to the mortgage origination segment.  Accordingly, the information presented is not necessarily indicative of the segments’ financial condition and results of operations had each been operating as independent entities.  The measurements used in reporting these segments are the same as those reviewed monthly by executive management.

 

Parent company financial information is deemed to represent an overhead function rather than an operating segment.  Also included in this category are expenses related to the guaranteed preferred beneficial interests in Vail Banks’ subordinated debentures (trust preferred securities).

 

The Company does not have a customer from whom it derives 10 percent or more of its revenues and operates in only one geographical area.

 

Products and Services

 

WestStar serves the banking needs of its business and consumer customers by providing a relatively broad range of commercial and consumer banking products and services in all of its communities. These products and services include short-term and medium-term loans, revolving credit facilities, accounts receivable financing, equipment financing, short-term commercial mortgage lending and mortgage broker services, installment loans, home improvement loans, short-term loans for the purchase or refinancing of principal residences or second homes, personal banking through internet and telephone access, safe deposit box services and various savings accounts, money market accounts, time certificates of deposit and checking accounts, automated teller machines, depository services, corporate cash management services and repurchase agreements.  First Western originates mortgage loans and sells them to investors in the secondary market.

 

Lending.     WestStar offers loans for business and consumer purposes and focuses its lending activities on individuals and small-to-medium size businesses.  Lending activities are funded primarily from core deposits gathered in the local communities. Loan products are concentrated in relatively short-term, variable rate loans, with 48% of the loans at December 31, 2003 having remaining terms of less than one year.  Collateral for loans is concentrated in real estate and operating business assets. First Western offers an array of residential mortgage products.  The lending activities of the Company are not seasonal in nature.

 

Deposits.     WestStar offers a relatively broad range of depository products including checking, savings and money market accounts, and certificates of deposit.  Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to statutory limits.  Within ranges set by policies determined by WestStar’s executive management, regional presidents have local authority to determine the type, mix and pricing of the depository products offered to best compete in a retail office’s particular marketplace.  Additionally, because many of WestStar’s markets are located in resort areas, deposits tend to trend upward during the ski season.  However, increases in deposits in non-resort markets have reduced the overall impact of such seasonality.

 

Other Services.     WestStar offers its customers the flexibility of monitoring their loan and deposit account activity and conducting some banking transactions, including the receipt of electronic statements, 24 hours a day from their homes or businesses via www.weststarbank.com on the internet. Additionally, telephone access allows customers to receive current

 

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account balances, deposit status, checks paid, withdrawals made, loan status, loan amounts due and other specifics relating to services provided by WestStar. As of February 29, 2004, WestStar had 19 automated teller machines, 14 that were located at WestStar’s retail offices and 5 that were located at other locations.

 

Competition

 

The banking business is highly competitive and the profitability of WestStar depends principally upon its ability to compete in its markets. WestStar competes with other banks, savings institutions, credit unions, finance companies, brokerage and investment banking firms, insurance companies, asset-based lenders and certain other nonfinancial institutions, including retail stores that offer credit programs and governmental organizations that offer financing programs. Many competitors of WestStar have much greater financial resources, greater name recognition and more offices than WestStar. Some of these entities and institutions are not subject to the same regulatory restrictions as WestStar. WestStar believes it has been able to compete effectively with its competitors by emphasizing customer service, technology and local decision-making, by establishing long-term customer relationships and building customer loyalty, and by providing products and services designed to address the specific needs of its customers.

 

The factors affecting competition include banking and financial services provided, customer service and responsiveness, customer convenience and office location. Vail Banks believes that WestStar will continue to compete successfully in its communities in which it operates and that its competitive strengths include its reputation for developing and retaining banking relationships, responsiveness to customer needs and individualized customer service, and skilled, resourceful associates. Vail Banks believes that large, institutional banks cannot or are unwilling to offer a high level of individualized customer service, and that WestStar’s customers and potential customers choose to bank with WestStar to take advantage of this attention while also receiving products and services at competitive prices. Vail Banks further believes that the community commitment and involvement of its associates and its commitment to providing quality financial services are factors that should allow it to continue to maintain and improve its competitive position.

 

First Western competes with both retail and internet mortgage brokers.  These competitors may have greater financial or other resources than First Western.  First Western has been able to compete effectively with its competitors due to its desirable array of mortgage products and its longevity in the mortgage origination business as well as the longevity of certain of its loan officers with First Western.

 

Vail Banks also faces competition in acquiring financial institutions. Colorado has experienced a significant consolidation of its banking industry, and many large holding companies with greater resources than Vail Banks (including several out-of-state holding companies) are pursuing acquisitions in Colorado. This competition affects the acquisition opportunities for Vail Banks and can affect the cost of such acquisitions.

 

Administration of WestStar

 

The retail offices operate through a customer driven organization. Regional presidents operate with significant customer service-oriented local autonomy, within policies established by WestStar’s executive management, to provide financial services, make lending decisions, sell products and present a favorable impression of WestStar to the community in order to attract new customers and retain existing ones.

 

Administrative services, oversight and support to the retail offices, including data processing, accounting services, investments, credit policy formulation, loan administration, a customer service center, internet banking support, other customer service assistance, and audit and compliance review are centralized at the Vail Banks’ administrative center in Gypsum.

 

Management believes that by standardizing products, services and systems, and providing appropriate centralized support, retail office associates can concentrate on customer service and community relations. Management also believes that continued centralization of services benefits the individual retail offices by lowering expenses of administration and data processing services, streamlining credit administration and supervision, and facilitating compliance with the requirements of complex banking regulations. Vail Banks believes that autonomy at the retail office level allows its banking subsidiary to better serve customers in their respective communities, and thus enhances business opportunities and operations.

 

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Technology

 

Vail Banks’ use of advanced technology enables it to offer customers fast, efficient services and connects all of WestStar’s associates with on-line access to information concerning all customer account data. Additionally, advanced hardware and software have been installed that allow images to be taken of all items (checks, deposit tickets and payments).  Once processed, the images are simultaneously associated with the appropriate customer’s account, where they are stored and retrieved to be printed with customer statements or delivered to the customer in the form of an electronic statement.  An imaging system also allows, via a data network, instant access at all retail offices to loan files, customer signature cards and other data that was previously available only at the administrative center or the originating retail office.  Vail Banks believes that its technology platform is among the most advanced for banks of its size in Colorado and provides it with the resources to continue to offer leading-edge services to customers.

 

Associates

 

As of February 29, 2004, the Company employed 242 persons, 231 on a full-time basis and 11 on a part-time basis. The Company is not a party to any collective bargaining agreement, and believes that its employee relations are good.

 

Risk Factors

 

Need for Additional Financing

 

Vail Banks’ success may depend on its ability to obtain additional debt or equity funding. Vail Banks cannot assure that it will be successful in consummating any future financing transactions.  Factors that could affect Vail Banks’ access to the capital markets, or the costs of such capital, include (1) changes in interest rates, (2) general economic conditions and the perception in the capital markets of Vail Banks’ business, (3) results of operations, (4) leverage, (5) financial condition and (6) business prospects. Each of these factors is to a large extent subject to economic, financial, competitive and other factors beyond Vail Banks’ control. Borrowing restrictions contained in certain regulations which apply to Vail Banks and WestStar may also have an effect on Vail Banks’ ability to obtain additional financing. Vail Banks’ future credit facilities may significantly restrict its ability to incur additional indebtedness. Vail Banks’ ability to repay any then outstanding indebtedness at maturity may depend on its ability to refinance such indebtedness. Its ability to refinance could be adversely affected if Vail Banks is not able to sell additional debt or equity securities on terms reasonably satisfactory to Vail Banks.

 

Local Economic Conditions

 

The success of Vail Banks depends to a significant extent upon general economic conditions in the communities it serves. Vail Banks primarily operates in the Western Slope region of Colorado. Some parts of the Western Slope are largely dependent on seasonal tourism that particularly affects small-to-medium size businesses. These businesses are a significant portion of Vail Banks’ customers. The seasonality of Vail Banks’ business in those areas results in fluctuations in deposit needs. Deposits tend to trend upward during the ski season.

 

In addition, a decline in the economy of the Western Slope region or the Front Range region, where the Company has operations, could have a material adverse effect on Vail Banks’ business. A decline could affect (1) the demand for new loans, (2) refinancing activity, (3) the ability of borrowers to repay outstanding loans, (4) the value of loan collateral and (5) loan volumes.  A decline could also adversely affect asset quality and net income. See ‘‘Business—General’’ in this Item 1.

 

Dependence Upon Key Personnel

 

The continued success of Vail Banks substantially depends on the efforts of the directors and executive officers of Vail Banks. Vail Banks particularly depends on E.B. Chester, Jr., Lisa M. Dillon and Gary S. Judd. The success of Vail Banks depends in large part on the retention of these and other key management personnel. It also depends on Vail Banks’ ability to hire and retain additional qualified associates in the future. Neither Mr. Chester, Ms. Dillon, nor Mr. Judd have entered into employment agreements with Vail Banks. Vail Banks does not maintain key-person life insurance coverage on any of them.

 

Certain Anti-Takeover Provisions

 

Vail Banks’ Articles of Incorporation and Bylaws contain certain provisions that may delay, discourage or prevent an attempted acquisition or change in control of Vail Banks. These provisions include (1) a Board of Directors classified into three

 

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classes of directors with the directors of each class having staggered, three-year terms and providing for the removal of directors only for cause, (2) noncumulative voting for directors, and (3) the ability of the Board of Directors of Vail Banks to issue shares of preferred stock of Vail Banks without shareholder approval. The preferred stock may be issued upon any terms that the Board of Directors may determine. The issuance of preferred stock may provide desirable flexibility in connection with possible mergers, acquisitions and financings and may be used for other corporate purposes.  However, the issuance of preferred stock may make it more difficult for a third party to acquire, or could discourage a third party from acquiring, a controlling interest in Vail Banks.

 

Government Regulation

 

The banking industry is regulated by federal and state regulatory authorities. Regulations substantially affect the business and financial results of all financial institutions and holding companies, including WestStar and Vail Banks. The Board of Governors of the Federal Reserve System (the Federal Reserve) supervises and regularly examines Vail Banks and WestStar.  Additionally, the Colorado Division of Banking (CDB) supervises and regularly examines WestStar.  Federal and state banking law regulates and limits Vail Banks’ credit extensions, securities purchases, dividend payments, acquisitions, branching and many other aspects of the banking business. Banking laws are designed primarily to protect depositors and customers, not investors. These laws include, among other things, (1) minimum capital requirements, (2) limitations on products and services offered, (3) geographical limits, (4) consumer credit regulations, (5) community investment requirements and (6) restrictions on transactions with affiliated parties.

 

Financial institution regulation has been the subject of significant legislation in recent years. This regulation may be the subject of further significant legislation in the future. Vail Banks has no control over changes in regulation.  Vail Banks cannot predict the impact of changes in such regulations on Vail Banks’ business and profitability. Changes in regulation could adversely affect Vail Banks’ financial condition and results of operations. See ‘‘Supervision and Regulation’’ in this Item 1.

 

Competition

 

The banking business is highly competitive. The profitability of WestStar depends principally upon its ability to compete in its market areas. WestStar competes with other banks, savings institutions, credit unions, finance companies, brokerage and investment banking firms, insurance companies, asset-based lenders and certain other nonfinancial institutions, including retail stores which offer credit programs and governmental organizations that offer financing programs.  Many competitors have greater financial and other resources than WestStar. WestStar has been able to compete effectively with other financial institutions by (1) emphasizing customer service, technology and local office decision-making, (2) establishing long-term customer relationships and building customer loyalty, and (3) providing products and services designed to address the specific needs of its customers. WestStar may not be able to continue to compete effectively in the future. In addition, First Western competes with both retail and internet mortgage brokers.  These competitors may have greater financial or other resources than First Western.  See ‘‘Business—Competition’’ in this Item 1.

 

Control by Management

 

As of February 29, 2004, the directors and executive officers of Vail Banks beneficially own approximately 49% of the outstanding common stock, 23% of which is beneficially owned by E.B. Chester, Jr., Chairman of Vail Banks. Accordingly, these persons will have substantial influence over the business, policies and affairs of Vail Banks, including the ability to potentially control the election of directors and other matters requiring shareholder approval by simple majority vote.

 

Interest Rate Risk

 

Vail Banks’ earnings depend to a great extent on its net interest income. Net interest income is the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings. The net interest margin is highly sensitive to many factors that are beyond Vail Banks’ control. These factors include general economic conditions and the policies of various governmental and regulatory authorities. Changes in the discount rate or targeted federal funds rate by the Federal Reserve usually lead to general changes in interest rates. These interest rate shifts affect Vail Banks’ interest income, interest expense and investment portfolio. Also, governmental policies, such as the creation of a tax deduction for individual retirement accounts, can increase savings and affect the cost of funds. From time to time, the interest rate structures of earning assets and liabilities may not be balanced, and a rapid increase or decrease in interest rates could have an adverse effect on the net interest margin and results of operations of Vail Banks. Vail Banks cannot predict the nature, timing and effect of any future changes in federal monetary and fiscal policies.

 

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Supervision and Regulation

 

The following discussion of statutes and regulations affecting bank holding companies and banks is a summary thereof and is qualified in its entirety by reference to such statutes and regulations.  This explanation does not purport to describe state, federal or Nasdaq National Market supervision and regulation of general business corporations or Nasdaq listed companies.

 

General.  Vail Banks is a registered bank holding company subject to regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the Act).  Vail Banks is required to file financial information with the Federal Reserve periodically and is subject to periodic examination by the Federal Reserve.

 

The Act requires every bank holding company to obtain the Federal Reserve’s prior approval before (1) it may acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank that it does not already control; (2) it or any of its non-bank subsidiaries may acquire all or substantially all of the assets of a bank; and (3) it may merge or consolidate with any other bank holding company.  In addition, a bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of the voting shares of any company engaged in non-banking activities.  This prohibition does not apply to activities listed in the Act or found by the Federal Reserve, by order or regulation, to be closely related to banking or managing or controlling banks as to be a proper incident thereto.  Some of the activities that the Federal Reserve has determined by regulation or order to be closely related to banking include:

 

•                                          making or servicing loans and certain types of leases;

•                                          performing certain data processing services;

•                                          acting as fiduciary or investment or financial advisor;

•                                          providing brokerage services;

•                                          underwriting bank eligible securities;

•                                          underwriting debt and equity securities on a limited basis through separately capitalized subsidiaries; and

•                                          making investments in corporations or projects designed primarily to promote community welfare.

 

Although the activities of bank holding companies have traditionally been limited to the business of banking and activities closely related or incidental to banking, the Gramm-Leach-Bliley Act relaxed the previous limitations, permitting bank holding companies to engage in a broader range of financial activities.  Specifically, bank holding companies may now elect to become financial holding companies which may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature.  Among the activities that are deemed “financial in nature” are:

 

•                                          lending, exchanging, transferring, investing for others or safeguarding money or securities;

•                                          insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker with respect thereto;

•              providing financial, investment, or economic advisory services, including advising an investment company;

•              issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly; and

•              underwriting, dealing in or making a market in securities.

 

A bank holding company may become a financial holding company under this statute only if each of its subsidiary banks is well capitalized, is well managed and has at least a satisfactory rating under the Community Reinvestment Act.  A bank holding company that falls out of compliance with such requirements may be required to cease engaging in certain activities.  Any bank holding company that does not elect to become a financial holding company remains subject to the current restrictions of the Bank Holding Company Act.

 

Under the Gramm-Leach-Bliley Act, the Federal Reserve Board serves as the primary “umbrella” regulator of financial holding companies with supervisory authority over each parent company and limited authority over its subsidiaries.  The primary regulator of each subsidiary of a financial holding company will depend on the type of activity conducted by the subsidiary.  For example, broker-dealer subsidiaries will be regulated largely by securities regulators and insurance subsidiaries will be regulated largely by insurance authorities.

 

Vail Banks cannot predict the full impact of this legislation and has no immediate plans to become a financial holding company.

 

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On October 26, 2001, the United States Congress adopted the USA Patriot Act of 2001 (Patriot Act) to combat terrorism.  Under the Patriot Act, FDIC insured banks and commercial banks are required to increase their due diligence efforts for correspondent accounts and private banking customers.  The Patriot Act requires WestStar to engage in additional record keeping and reporting, to obtain identification of account owners or customers of foreign bank account holders, and to restrict or prohibit certain correspondent accounts.

 

Vail Banks must also register with the CDB and file periodic information with the CDB.  As part of such registration, the CDB requires information with respect to, among other matters, the financial condition, operations, management and intercompany relationships of Vail Banks and its subsidiary.  The CDB may also require such other information as is necessary to ascertain whether the provisions of Colorado law and the regulations and orders issued thereunder by the CDB have been complied with, and the CDB may examine Vail Banks and its subsidiary.

 

Vail Banks is an “affiliate” of its banking subsidiary under the Federal Reserve Act, which imposes certain restrictions on (1) loans by WestStar to Vail Banks, (2) investments in the stock or securities of Vail Banks by its banking subsidiary, (3) its banking subsidiary’s taking the stock or securities of an “affiliate” as collateral for loans by it to a borrower and (4) the purchase of assets from Vail Banks by its banking subsidiary.  Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

 

WestStar is a member of the Federal Reserve System and is subject to the supervision of and is regularly examined by the Federal Reserve.  Furthermore, WestStar, as a state banking association organized under Colorado law, is subject to the supervision of, and is regularly examined by, the CDB.  Both the Federal Reserve and the CDB must grant prior approval of any merger, consolidation or other corporate reorganization involving WestStar. A bank can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of a commonly controlled institution.

 

Payment of Dividends. Vail Banks is a legal entity separate and distinct from WestStar.  Most of the revenues of Vail Banks result from dividends paid to it by WestStar.  There are statutory and regulatory requirements applicable to the payment of dividends by WestStar, as well as by Vail Banks to its shareholders.

 

Under the regulations of the CDB and the Federal Reserve, approval of the regulators will be required if the total of all dividends declared by WestStar in any calendar year exceed the total of its net profits of that year combined with its retained net profits of the preceding two years, less any required transfers to a fund for the retirement of any preferred stock.

 

The payment of dividends by Vail Banks and WestStar may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines.  In addition, if, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending upon the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. Capital adequacy considerations could further limit the availability of dividends.  Due to the high volume of dividends relative to earnings paid in earlier years, beginning in 2004, any dividend payments from WestStar to Vail Banks will require prior regulatory approval.  Management believes that approval will be granted as long as WestStar maintains its well-capitalized regulatory status.

 

Monetary Policy.  The results of operations of WestStar are affected by credit policies of monetary authorities, particularly the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of Vail Banks’ banking subsidiary.

 

Capital Adequacy.  The Federal Reserve and the FDIC have implemented substantially identical risk-based rules for assessing bank and bank holding company capital adequacy. These regulations establish minimum capital standards in relation to assets and off-balance sheet exposures as adjusted for credit risk. Banks and bank holding companies are required to have (1) a minimum level of total capital (as defined) to risk-weighted assets of 8%; (2) a minimum Tier 1 capital (as defined below) to risk-weighted assets of 4%; and (3) a minimum shareholders’ equity to risk-weighted assets of 4%. In addition, the Federal Reserve and the FDIC have established a minimum 4% leverage ratio (Tier 1 capital to average assets) for all but the most highly rated banks and bank holding companies. ‘‘Tier 1 capital’’ generally consists of common equity not including unrecognized gains and losses on securities, minority interests in equity accounts of consolidated subsidiaries and certain

 

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perpetual preferred stock, less certain intangibles. The Federal Reserve and the FDIC use the leverage ratio in tandem with the risk-based ratio to assess the capital adequacy of banks and bank holding companies. The FDIC’s and the Federal Reserve’s capital adequacy standards also provide for the consideration of interest rate risk in the overall determination of a bank’s capital ratio, requiring banks with greater interest rate risk to maintain greater capital for the risk.

 

In addition, the FDIC regulations and Federal Reserve ‘‘prompt corrective action’’ provisions, designed to efficiently resolve failing financial institutions, set forth five regulatory zones in which all banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s capital leverage ratio reaches 2%. Better-capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser capital ratios.

 

The FDIC and the Federal Reserve regulations implementing “prompt corrective action” place financial institutions in the following five categories based on capitalization ratios (1) a ‘‘well capitalized’’ institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a leverage ratio of at least 5%; (2) an ‘‘adequately capitalized’’ institution has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a leverage ratio of at least 4%; (3) an ‘‘undercapitalized’’ institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a ‘‘significantly undercapitalized’’ institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based capital ratio of under 3% or a leverage ratio of under 3%; and (5) a ‘‘critically undercapitalized’’ institution has a leverage ratio of 2% or less.  Institutions in any of the three undercapitalized categories are prohibited from declaring dividends or making capital distributions without regulatory approval.  The Federal Reserve regulations also establish procedures for ‘‘downgrading’’ an institution to a lower capital category based on supervisory factors other than capital.

 

Under the Federal Reserve’s regulations, both Vail Banks and WestStar met all capital adequacy requirements to which they were subject at December 31, 2003. Vail Banks had Tier 1 and total risk-based capital ratios of 11.50% and 13.72%, respectively, and a leverage ratio of 7.45%.  WestStar was deemed to be “well capitalized” with Tier 1 and total risk-based capital ratios of 10.90% and 11.88%, respectively, and a leverage ratio of 7.04%.  For further information, see “Notes to Consolidated Financial Statements—Note 18” contained in Item 15 of this Annual Report on Form 10-K.

 

Executive Officers of Vail Banks

 

Certain information regarding the executive officers of the Company is set forth in the following table and paragraphs.

 

Name		Age		Position
E.B. Chester, Jr.		61		Chairman of the Board
Lisa M. Dillon		50		Vice Chairman of the Board
Gary S. Judd		63		President and Chief Executive Officer
Peter G. Williston		47		Senior Executive Vice President, Chief Financial Officer and Corporate Secretary
Dan E. Godec		48		President of WestStar Bank

 

Mr. Chester, who formed Vail Banks through a series of acquisitions, has served as Chairman of the Board of Directors of Vail Banks since 1993 and the Chairman of the Board of Directors of WestStar since 1989.  Currently, Mr. Chester also serves as Chairman of the Board of Directors of Camp International, Ltd., a supplier of database services to the commercial aviation industry, and as Manager of King Creek Ranch LLC, a ranching business.

 

Ms. Dillon has served as Vice Chairman of Vail Banks since July 2000.  Ms. Dillon, who started her career with WestStar in 1979, served as President of Vail Banks from 1993 until January 2004, President of WestStar from 1989 to 1999 and as a director of WestStar since 1989.

 

Mr. Judd became a director of Vail Banks in May 2003.  He was elected as President and Chief Executive Officer of Vail Banks in January 2004, and previously served as a Division President and President, Regional Operations, of WestStar since May 2003.  Mr. Judd co-founded Vectra Bank in Colorado in 1989 and served as its President until January 2000.  From

 

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2000 to 2002, Mr. Judd was President and Chief Executive Officer of Metyor, Inc.  Mr. Judd also spent 16 years with Citibank, N.A. in management positions in the United States and overseas.

 

Mr. Williston has served as the Senior Executive Vice President and Chief Financial Officer of Vail Banks since June  2000.  Prior to joining Vail Banks, Mr. Williston was employed by Union Planters Bank in Memphis, Tennessee where he served as Senior Vice President and Regional Manager.  Mr. Williston initially joined Union Planters Bank in 1983 and during his tenure there he also served as Senior Vice President and Controller, Vice President and Audit Department Manager, and Secretary to the Board of Directors. Mr. Williston is a certified public accountant.

 

Mr. Godec became a Director of Vail Banks in July 2000.  Mr. Godec has served as the President and a director of WestStar since 1999 and as Chief Executive Officer of WestStar since 2000.  Prior to becoming President of WestStar, Mr. Godec served as Senior Executive Vice President of WestStar from January to April 1999 and served as the Senior Vice President of WestStar from January 1996 to January 1999.

 

ITEM 2.  PROPERTIES.

 

As of March 5, 2004, Vail Banks had 22 operating branch offices and an administrative center.  Of these 23 properties, ten were leased and 13 were owned.  Vail Banks also leased three properties previously occupied by WestStar branches for which WestStar was still obligated.  Leases on these three closed branches expire between 2005 and 2006.  Plans are currently underway to either terminate these leases or find tenants to sublease the properties.  Vail Banks is currently in the construction phase for a new facility in Glenwood Springs to replace an existing branch office and in the design phase for a new retail office in Fruita. Vail Banks has also undertaken significant remodels of its retail offices in Avon and Norwood.  All properties are located in Colorado and range in size from 450 square feet to 34,000 square feet.  None of the properties owned by Vail Banks are encumbered.  The aggregate annual lease payments for properties in 2003 were $1.3 million. Leases for the facilities expire at various periods through 2011 with options to renew through 2028.  Vail Banks considers its properties adequate for its current needs.

 

On March 5, 2004, the Company sold its bank building in Vail, Colorado and is leasing back a portion of the space.  The lease, which is being accounted for as an operating lease, has a term of five years with three five-year renewal options and will require future minimum lease payments aggregating approximately $881,000.  The proceeds of the sale included a mortgage note receivable of $7.9 million due in 2024, with an interest rate of 5.13%.

 

ITEM 3.  LEGAL PROCEEDINGS.

 

Vail Banks and its banking subsidiary periodically are parties to or otherwise involved in legal proceedings arising in the normal course of business, such as claims to enforce liens, claims involving the making and servicing of real property loans and other issues incident to their business. Management does not believe that there is any pending or threatened proceeding against Vail Banks or its banking subsidiary which, if determined adversely, would have a material effect on the business, results of operations, or financial position of Vail Banks or its banking subsidiary.

 

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

 

No matters were submitted to security holders during the fourth quarter of fiscal year 2003.

 

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PART II

 

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

 

Market Information

 

Vail Banks’ common stock began trading on The NASDAQ Stock Market under the symbol “VAIL” on December 10, 1998.  Prior to that time, there was no formal trading market for the common stock.  The following table sets forth, for the periods indicated, the high and low bid prices of the common stock on The NASDAQ Stock Market.

 

		Year Ended December 31, 2003						Year Ended December 31, 2002
		High			Low			High			Low
First Quarter		$	12.40		$	11.32		$	12.45		$	10.77
Second Quarter		13.60			11.90			14.74			11.50
Third Quarter		14.84			13.51			13.99			11.44
Fourth Quarter		14.92			11.63			12.16			10.52

 

Holders

 

As of February 13, 2004, there were 90 holders of record of the common stock.  Investors who beneficially own common stock that is held in street name by brokerage firms or similar holders are not included in this number.  Vail Banks believes there are approximately 2,000 beneficial holders of its common stock.

 

Dividends

 

Cash dividends paid per share were as follows:

 

		2003			2002
First Quarter		$	0.06		$	0.05
Second Quarter		0.06			0.05
Third Quarter		0.07			0.06
Fourth Quarter		0.07			0.06

 

Additionally, a cash dividend of $0.07 per share was declared on January 19, 2004 and paid on February 13, 2004 to shareholders of record on January 30, 2004.

 

Holders of common stock are entitled to receive dividends when, as and if declared by Vail Banks’ Board of Directors out of funds legally available therefore. The final determination of the timing, amount and payment of dividends on the common stock is at the discretion of the Board of Directors. The declaration of dividends will depend on conditions then existing, including Vail Banks’ profitability, financial condition, capital requirements, future growth plans and other relevant factors. The principal source of Vail Banks’ income is dividends received from WestStar. The payment of these dividends by WestStar is subject to certain restrictions imposed by the federal and state banking laws and regulations.

 

Vail Banks’ ability to pay cash dividends on the common stock is also subject to statutory restrictions, including banking regulations, and restrictions arising under the terms of securities or indebtedness which may be issued or incurred in the future. The terms of such securities or indebtedness may restrict payment of dividends on common stock until required payments and distributions are made on such securities or indebtedness. Under regulations of the CDB and the Federal Reserve, approval of the regulators will be required if the total of all dividends declared by any banking subsidiary in any year exceeds the total of its net profits of that year combined with its retained net profits of the preceding two years.  Beginning in 2004, any dividend payments from WestStar to Vail Banks will require prior regulatory approval due to the high volume of dividends relative to earnings paid in earlier years.  Management believes that approval will be granted as long as WestStar maintains its well-capitalized regulatory status.  See ‘‘Supervision and Regulation’’ in Item 1.

 

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ITEM 6.  SELECTED FINANCIAL DATA.

 

The selected historical financial data set forth below should be read in conjunction with the “General,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Financial Statements and Notes to Consolidated Financial Statements” sections, as well other financial data contained elsewhere in this Annual Report on Form 10-K.

 

(dollars in thousands, except for share data)		2003			2002			2001			2000			1999
EARNINGS (1)
Net interest income		$	21,498		$	25,408		$	28,835		$	27,553		$	24,214
Provision for loan losses		578			382			800			1,047			455
Non-interest income		11,142			12,024			11,397			8,095			3,970
Non-interest expense		31,038			28,440			29,006			26,225			20,512
Net income		714			5,613			6,103			4,956			4,424
PER SHARE DATA (1)
Basic earnings		$	0.14		$	0.99		$	1.02		$	0.80		$	0.73
Diluted earnings		0.13			0.95			1.00			0.79			0.73
Book value per common share at year end		10.95			11.64			11.03			10.29			9.60
Tangible book value per common share at year end		3.96			5.23			4.62			4.32			5.62
Closing market price		11.94			12.00			10.90			10.38			9.88
AT YEAR END
Total assets		$	575,610		$	554,263		$	555,331		$	563,271		$	464,282
Earning assets		476,864			452,943			454,076			457,970			373,526
Loans		311,774			331,003			391,725			427,136			336,735
Allowance for loan losses		3,503			3,747			4,375			4,440			2,739
Non-interest bearing deposits		101,305			97,383			103,730			99,609			86,991
Total deposits		448,515			428,698			442,350			482,002			372,742
Shareholders’ equity		57,859			66,772			63,456			66,430			58,295
Shares outstanding		5,283,264			5,734,303			5,754,152			6,456,400			6,069,370
AVERAGE BALANCES
Total assets		$	589,664		$	561,496		$	559,570		$	517,250		$	442,755
Earning assets		494,134			465,750			460,807			420,421			359,552
Loans		324,086			356,703			410,613			385,672			301,052
Non-interest bearing deposits		94,512			98,122			98,439			89,458			86,377
Total deposits		456,810			439,884			465,194			419,955			374,825
Shareholders’ equity		62,457			65,150			63,865			62,268			56,154
Weighted average common shares outstanding-Basic		5,220,221			5,651,737			5,965,374			6,205,669			6,040,618
Weighted average common shares outstanding-Diluted		5,617,720			5,914,891			6,111,103			6,290,461			6,091,635
PERFORMANCE (1)
Return on assets		0.12		%	1.00		%	1.09		%	0.96		%	1.00		%
Return on equity		1.14			8.62			9.56			7.96			7.88
Dividend payout ratio		200			23			18			15			0
Cash dividends paid per share		$	0.26		$	0.22		$	0.18		$	0.12		$	0.00
Net interest margin (2)		4.46		%	5.49		%	6.30		%	6.59		%	6.78		%
Efficiency ratio		95			76			72			74			73
Loan to deposit ratio (at year end)		70			77			89			89			90
ASSET QUALITY (at year end)
Net charge-offs to average loans		0.25		%	0.28		%	0.21		%	0.10		%	0.10		%
Allowance for loan losses to loans		1.12			1.13			1.12			1.04			0.81
Allowance for loan losses to non-performing loans (3)		200.52			100.35			214.25			263.50			148.62
Non-performing assets to loan-related assets (4) (5)		0.68			1.20			0.58			0.42			0.63
Risk assets to loan-related assets (5) (6)		0.73			1.20			0.73			0.42			0.64
CAPITAL (at year end)
Equity to assets		10.05		%	12.05		%	11.43		%	11.79		%	12.56		%
Tangible equity to assets		3.63			5.41			4.79			4.96			7.35
Leverage ratio (7)		7.45			10.27			9.43			5.45			8.05
Tier 1 risk based capital (7)		11.50			14.15			11.73			7.14			10.71
Total risk based capital (7)		13.72			15.61			13.41			8.25			11.54

 

(1)      During 2002, the Company implemented Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, which eliminated goodwill amortization expense beginning January 1, 2002.  The Company continued to amortize other intangible assets.  For further information, see “Notes to Consolidated Financial Statements—Note 5” contained in Item 15 of this Annual Report on Form 10-K.

(2)  Net interest margin is reported on a fully taxable equivalent basis.

(3)  Non-performing loans consist of non-accrual and restructured loans.

(4)  Non-performing assets consist of non-performing loans and foreclosed properties.

(5)  Loan related assets consist of total loans and foreclosed properties.

(6)  Risk assets consist of non-performing assets and loans 90 days or more past due but continuing to accrue interest.

(7)  For further information, see “Notes to Consolidated Financial Statements—Note 18” contained in Item 15 of this Annual Report on Form 10-K.

 

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

 

Introduction

 

The following section presents management’s review of the financial condition and operating results of Vail Banks, Inc. and its subsidiaries (collectively Vail Banks or the Company).  It is intended to assist readers in evaluating Vail Banks’ performance.  Certain reclassifications have been made to previous periods’ information to conform to the 2003 presentation. The following analysis should be read in conjunction with the Consolidated Financial Statements and accompanying notes as well as the selected financial information included elsewhere in this Annual Report on Form 10-K.

 

Critical Accounting Policies and Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated balance sheet and the reported amounts of revenues and expenses during the reporting period.  The Securities and Exchange Commission has defined a company’s most critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.  Based on this decision, management has identified the following critical accounting policies and judgments.  Although management believes its estimates and assumptions are reasonable, they are based upon information available when they are made.  Actual results may differ significantly from these estimates under different assumptions or conditions.

 

Allowance for Loan Losses

 

The allowance for loan losses calculation process has two components.  The first component represents the allowance for impaired loans computed in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114 Component).  To determine the SFAS 114 Component, collateral dependent impaired loans are evaluated using internal analyses as well as third-party information, such as appraisals.  If an impaired loan is unsecured, it is evaluated using a discounted cash flow of the payments expected over the life of the loan giving consideration to currently existing factors that would impact the amount or timing of the cash flows.  The second component is the allowance calculated under SFAS No. 5, Accounting for Contingencies (SFAS 5 Component), and represents the estimated probable but undetected losses inherent within the portfolio due to uncertainties in economic conditions, delays in obtaining information about a borrower’s financial condition, delinquent loans that have not been determined to be impaired, trends in speculative construction real estate lending, results of internal and external loan reviews, and other factors.  This component of the allowance is calculated by assigning a certain risk weighting, within a predetermined range, to each identified risk factor.

 

At December 31, 2003, an allowance for loan losses of $3.5 million has been provided.  Management believes that this allowance is adequate to cover probable losses based on all currently available evidence. Future additions to the allowance may be required based on management’s continuing evaluation of the inherent risks in the portfolio.  Additional provisions for loan losses may need to be recorded if the economy resumes a decline, asset quality deteriorates, or historical loss experience changes.  Also, state or federal regulators, when reviewing Vail Banks’ loan portfolio in the future, may require Vail Banks to increase the allowance, which could adversely affect Vail Banks’ earnings.  An analysis of the allowance for loan losses as well as its allocation among certain categories of the loan portfolio can be found in the “Financial Condition” section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

 

Accounting for Goodwill and Other Intangible Assets

 

In assessing the recoverability of goodwill and other intangible assets, Management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets.  If these estimates and related assumptions change in the future, Management may be required to record impairment charges not previously recorded.  On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets.  This statement requires the Company to assess goodwill and intangible assets for impairment at a minimum annually, using a two-step process that begins with an estimation of the fair value of the reporting unit.  The first step is a screen for impairment, and the second step measures the amount of any impairment.

 

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The Company performed its annual goodwill impairment test during the fourth quarter of 2003 and determined that the goodwill was not impaired as of that date.  The Company also performed an annual impairment test of other intangible assets, comprised of core deposit premium, during the fourth quarter of 2003.  Due to the attrition of acquired deposit accounts, the Company determined that $543,000 of the remaining net book value was impaired and recorded this amount as additional amortization expense during 2003.  The Company also reassessed the remaining useful life of the core deposit intangible asset at December 31, 2003 and determined that it had a remaining useful life of five years.

 

Deferred Income Taxes

 

SFAS No. 109, Accounting for Income Taxes requires Management to exercise judgment about its future results in assessing the realizability of its deferred tax assets.  At December 31, 2003, the Company had gross deferred tax assets of $2.9 million.  Management has determined that the likelihood of realization of these deferred tax assets is greater than 50%, and accordingly no valuation allowance has been recorded.  If future taxable income differs from Management’s estimate, a valuation allowance may be required and will impact future net income.

 

Disclosures of Fair Value of Financial Instruments

 

SFAS No. 107, Disclosure about Fair Value of Financial Instruments requires the Company to disclose estimated fair values of its financial instruments.  Fair value estimates are made at a specific point in time, based on relevant market information.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.

 

Fair value estimates are based on financial instruments owned at December 31, 2003 and 2002 without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments, including deferred tax assets and premises and equipment.  In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in these estimates.

 

Certain Factors Affecting Forward-Looking Statements

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts.  When used in this report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward-looking statements.  These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control.  In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.  Actual results may differ materially from the results discussed in these forward-looking statements as a result of the factors set forth below.  Vail Banks does not intend to update any forward-looking statements whether written or oral, relating to matters discussed in this Annual Report on Form 10-K.

 

Financial Overview

 

Net income for 2003 decreased $4.9 million, or 87%, to $714,000 from $5.6 million in 2002.  This decrease was primarily due to a decrease in the net interest margin from 5.49% for 2002 to 4.46% for 2003 primarily because of reduced loan volumes and an increase in non-interest expense of $2.6 million, or 9%, to $31.0 million from $28.4 million in 2002.  Net income for 2002 decreased $490,000, or 8%, to $5.6 million from $6.1 million in 2001.  This decrease was primarily due to a decrease in the net interest margin from 6.30% for 2001 to 5.49% for 2002, which was partially offset by the cessation of goodwill amortization expense with the implementation of SFAS No. 142.

 

The return on average assets was 0.12% for the year ended December 31, 2003 compared to 1.00% for the year ended December 31, 2002 and 1.09% for the year ended December 31, 2001.

 

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The return on average equity was 1.14% for the year ended December 31, 2003 compared to 8.62% for the year ended December 31, 2002 and 9.56% for the year ended December 31, 2001.

 

Assets increased by $21.3 million, or 4%, to $575.6 million during 2003.  This increase was primarily due to an increase in cash, cash equivalents and investment securities of $47.2 million, offset by a decrease in loans held for sale generated by First Western of $7.4 million and a decrease in gross loans of $19.2 million.  Assets decreased by $1.1 million, or less than 1%, to $554.3 million during 2002.  This decrease was primarily due to a decrease in net loans of $60.1 million offset by an increase in cash, cash equivalents and investment securities of $59.9 million and an increase in loans held for sale generated by First Western of $2.9 million.

 

Pro Forma Operating Results

 

During June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 142, Goodwill and Other Intangible Assets, which provides guidance on accounting for goodwill and intangible assets after an acquisition has been completed.  Specifically, all new and pre-existing goodwill will no longer be amortized, but instead will be tested for impairment on an annual basis.  Amortization of other intangible assets will continue.  The Company adopted the provisions of SFAS 142 on January 1, 2002 and determined that the net unamortized goodwill of $36.0 million was not impaired as of that date.  Additionally, the Company reassessed the useful life of the core deposit intangible asset related to a previously acquired branch.  The Company determined that as of January 1, 2002, the core deposit intangible asset had a remaining useful life of twelve years.  Accordingly, the $890,000 unamortized balance as of January 1, 2002 was to be amortized to expense on a straight-line basis over twelve years.  This reduction in remaining life resulted in additional core deposit intangible amortization expense of $34,000 ($22,000 after tax) for the year ended December 31, 2002 over the comparable period during 2001.

 

In addition to the transitional impairment test required as of January 1, 2002, SFAS 142 requires that an annual impairment test be performed.  The Company performed this annual goodwill impairment test during the fourth quarter of 2003 and determined that the goodwill was not impaired as of that date.  The Company also reviews its intangible assets (other than goodwill) for other-than-temporary impairment on an annual basis.  If circumstances indicate that impairment may exist, recoverability of the asset is assessed based on expected undiscounted net cash flows.  In addition to the impairment test performed on January 1, 2002 upon adoption of SFAS 142, the Company performed its annual impairment test of other intangible assets during the fourth quarter of 2003.  Due to the attrition of acquired deposit accounts, the Company determined that $543,000 of the remaining net book value was impaired and recorded this amount as additional amortization expense during 2003.  The Company also determined that as of December 31, 2003, the core deposit intangible asset had a remaining useful life of five years.

 

17

 

The following table presents comparative net income and earnings per share information as if goodwill amortization expense had not been recorded for 2001:

 

(in thousands, except share data)		2003			2002			2001
NET INCOME
Reported net income		$	714		$	5,613		$	6,103
Add back:  Goodwill amortization		—			—			1,621
Adjusted net income		$	714		$	5,613		$	7,724
BASIC EARNINGS PER SHARE
Reported basic earnings per share		$	0.14		$	0.99		$	1.02
Add back: Effect of goodwill amortization		—			—			0.27
Adjusted basic earnings per share		$	0.14		$	0.99		$		1.29
DILUTED EARNINGS PER SHARE
Reported diluted earnings per share		$	0.13		$	0.95		$	1.00
Add back: Effect of goodwill amortization		—			—			0.26
Adjusted diluted earnings per share		$	0.13		$	0.95		$	1.26

 

Results of Operations

 

Net Interest Income

 

Net interest income continues to be Vail Banks’ principal source of income, representing the difference between interest and fees earned on loans and investments and interest paid on deposits and borrowings.  In this discussion, Net Interest Income on a fully tax-equivalent basis (FTE) includes tax-exempt income, such as interest on securities of states and municipalities, increased to an amount that would have been earned had such income been taxable.  This adjustment places taxable and nontaxable income on a common basis and permits comparisons of rates and yields.

 

18

 

The following table sets forth the average balances, interest income and expense, and average yields and rates for Vail Banks’ earning assets and interest bearing liabilities for the periods indicated on a fully tax-equivalent basis.

 

Average Balance Sheet and Net Interest Income Analysis

 

		2003								2002								2001
(in thousands on a fully taxable equivalent (FTE) basis)		Average Balance			Interest			Average Yield/Rate		Average Balance			Interest			Average Yield/Rate		Average Balance			Interest			Average Yield/Rate
ASSETS
Federal funds sold and other short-term investments		$	68,244		$	690		1.01	%	$	36,430		$	578		1.59	%	$	15,352		$	622		4.05	%
Investment securities
Taxable		71,987			2,222			3.09		57,104			2,882			5.05		23,112			1,405			6.08
Tax-exempt (1)		22,485			1,717			7.64		8,453			497			5.88		6,518			501			7.69
Loans (2) (3)		331,418			26,098			7.87		363,763			30,153			8.29		415,825			39,620			9.53
TOTAL EARNING ASSETS		494,134			30,727			6.22		465,750			34,110			7.32		460,807			42,148			9.15
Non-earning assets		95,530								95,746								98,763
TOTAL ASSETS		$	589,664							$	561,496							$	559,570
LIABILITIES
Interest bearing deposits
Interest bearing transaction accounts		$	225,623		$	1,390		0.62	%	$	231,690		$	1,620		0.70	%	$	271,580		$	5,996		2.21	%
Certificates of deposit		136,675			3,254			2.38		110,072			3,450			3.13		95,175			4,902			5.15
TOTAL INTEREST BEARING DEPOSITS		362,298			4,644			1.28		341,762			5,070			1.48		366,755			10,898			2.97
Securities sold under agreements to repurchase		167			1			0.42		—			—			—		—			—			—
Short-term borrowings