##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
  FORM 10-Q (Mark One) þ
    
    Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Quarter ended September 30, 2004
 o
    
    Transition report pursuant to Section 13 or 15(d)) of
the Securities Exchange Act of 1934
For Transition Period from ________________ to _______________
 Commission File Number 000-30447   VALLEY COMMUNITY BANCSHARES, INC.  Washington
(State or other jurisdiction
of incorporation or organization)
    
    91-1913479
(I.R.S. Employer Identification No.)1307 East Main, Puyallup, Washington
(Address of principal executive offices)
    
    98372
(Zip Code)
 (253) 848-2316
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes o No þ The number of shares of the issuers Common Stock, $1.00 par value,
outstanding at November 2, 2004 was 1,238,083.




---



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
INDEX TO QUARTERLY REPORT ON FORM 10-Q PagePART I FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsCondensed Consolidated Balance Sheet September 30, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statement of Income -- Three Months and Nine Months Ended September 30, 2004 and 2003
    
    
    2Condensed Consolidated Statement of Cash Flows -- Three Months and Nine Months Ended September 30, 2004 and 2003
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Management's Discussion and Analysis of Financial Condition And Results of Operation
    
    
    8Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    19Item 4.
    
    Controls and Procedures
    
    
    19FORWARD-LOOKING STATEMENTS
    
    
    20PART II OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    20Item 2.
    
    Changes in Securities and Use of Proceeds
    
    
    20Item 3.
    
    Defaults upon Senior Securities
    
    
    20Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    20Item 5.
    
    Other Information
    
    
    20Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    21Signatures
    
    
    22Certifications
    
    
    23EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32
  i




---



##### Table of Contents



Item 1. FINANCIAL STATEMENTS 
 VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
(dollars in thousands) September 30,
    
    December 31,2004
    
    2003ASSETSCash and due from banks
    
    $
    6,109
    
    
    $
    5,199Interest-bearing deposits with banks
    
    
    13,257
    
    
    
    8,503Federal funds sold
    
    
    9,273
    
    
    
    9,765Securities available-for-sale
    
    
    41,676
    
    
    
    38,560Federal Home Loan Bank stock
    
    
    378
    
    
    
    37270,693
    
    
    
    62,399Loans
    
    
    116,586
    
    
    
    114,261Less allowance for loan losses
    
    
    1,388
    
    
    
    1,388Loans, net
    
    
    115,198
    
    
    
    112,873Accrued interest receivable
    
    
    722
    
    
    
    681Premises and equipment, net
    
    
    5,744
    
    
    
    5,850Other assets
    
    
    296
    
    
    
    417Total assets
    
    $
    192,653
    
    
    $
    182,220LIABILITIESDepositsNoninterest-bearing
    
    $
    38,210
    
    
    $
    34,675Interest-bearing
    
    
    128,798
    
    
    
    122,556Total deposits
    
    
    167,008
    
    
    
    157,231Other borrowed funds
    
    
    544
    
    
    
    580Accrued interest payable
    
    
    158
    
    
    
    145Other liabilities
    
    
    644
    
    
    
    611Total liabilities
    
    
    168,354
    
    
    
    158,567STOCKHOLDERS EQUITYCommon stock, par value $1 per share; 5,000,000 shares authorized; 1,238,083 and 1,175,267
shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively.
    
    
    1,238
    
    
    
    1,175Additional paid-in capital
    
    
    18,760
    
    
    
    16,903Retained earnings
    
    
    4,037
    
    
    
    5,204Accumulated other comprehensive income (loss), net of tax
    
    
    264
    
    
    
    371Total stockholders equity
    
    
    24,299
    
    
    
    23,653Total liabilities and stockholders equity
    
    $
    192,653
    
    
    $
    182,220
 The accompanying notes are an integral part of these financial statements -1-




---



##### Table of Contents








VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(unaudited)
(dollars in thousands, except for per share amounts)

Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003INTEREST INCOMEInterest and fees on loans
    
    $
    1,889
    
    
    $
    1,897
    
    
    $
    5,605
    
    
    $
    5,743Interest on federal funds sold and deposits in banks
    
    
    102
    
    
    
    83
    
    
    
    231
    
    
    
    269Interest on securities
    
    
    267
    
    
    
    266
    
    
    
    809
    
    
    
    821Total interest income
    
    
    2,258
    
    
    
    2,246
    
    
    
    6,645
    
    
    
    6,833INTEREST EXPENSEInterest on deposits
    
    
    269
    
    
    
    296
    
    
    
    720
    
    
    
    1,003Interest on federal funds and other short-term borrowings
    
    
    1
    
    
    
    1
    
    
    
    4
    
    
    
    4Total interest expense
    
    
    270
    
    
    
    297
    
    
    
    724
    
    
    
    1,007Net interest income
    
    
    1,988
    
    
    
    1,949
    
    
    
    5,921
    
    
    
    5,826PROVISION FOR LOAN LOSSESNet interest income after provision
for loan losses
    
    
    1,988
    
    
    
    1,949
    
    
    
    5,921
    
    
    
    5,826NONINTEREST INCOMEService charges
    
    
    103
    
    
    
    114
    
    
    
    310
    
    
    
    351Gain on sale of investment securities, net
    
    
    
    
    
    
    
    
    
    
    49
    
    
    
    15Gain on sale of real estate held for sale
    
    
    
    
    
    
    173
    
    
    
    
    
    
    
    211Origination fees on mortgage loans brokered
    
    
    43
    
    
    
    119
    
    
    
    121
    
    
    
    320Other operating income
    
    
    106
    
    
    
    54
    
    
    
    303
    
    
    
    272Total noninterest income
    
    
    252
    
    
    
    460
    
    
    
    783
    
    
    
    1,169NONINTEREST EXPENSESalaries
    
    
    656
    
    
    
    644
    
    
    
    1,953
    
    
    
    1,955Employee benefits
    
    
    156
    
    
    
    165
    
    
    
    492
    
    
    
    504Occupancy
    
    
    129
    
    
    
    143
    
    
    
    414
    
    
    
    415Equipment
    
    
    116
    
    
    
    115
    
    
    
    352
    
    
    
    330Other operating expenses
    
    
    467
    
    
    
    464
    
    
    
    1,441
    
    
    
    1,461Total noninterest expense
    
    
    1,524
    
    
    
    1,531
    
    
    
    4,652
    
    
    
    4,665INCOME BEFORE INCOME TAX
    
    
    716
    
    
    
    878
    
    
    
    2,052
    
    
    
    2,330PROVISION FOR INCOME TAX
    
    
    219
    
    
    
    288
    
    
    
    633
    
    
    
    730NET INCOME
    
    $
    497
    
    
    $
    590
    
    
    $
    1,419
    
    
    $
    1,600EARNINGS PER SHAREBasic
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.15
    
    
    $
    1.30Diluted
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.14
    
    
    $
    1.29Weighted average shares outstanding
    
    
    1,238,089
    
    
    
    1,231,860
    
    
    
    1,237,483
    
    
    
    1,230,850Weighted average diluted shares outstanding
    
    
    1,246,385
    
    
    
    1,236,892
    
    
    
    1,246,169
    
    
    
    1,235,821


The accompanying notes are an integral part of these financial statements

-2-



---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
(dollars in thousands, except for per share amounts) Nine Months EndedSeptember 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    1,419
    
    
    $
    1,600Adjustments to reconcile net income to net cash from operating activities:Depreciation
    
    
    350
    
    
    
    356Deferred income tax
    
    
    44
    
    
    
    20Net amortization on securities
    
    
    214
    
    
    
    257FHLB stock dividends
    
    
    (10
    )
    
    
    (16
    )Gain on sale of securities available-for-sale
    
    
    (49
    )
    
    
    (15
    )Amortization of intangible assets
    
    
    73
    
    
    
    32Deferred gain on the sale of real estate
    
    
    
    
    
    
    (211
    )Amortization of deferred gain on sale of real estate
    
    
    
    
    
    
    211Changes in operating assets and liabilities:Decrease (increase) in accrued interest receivable
    
    
    (41
    )
    
    
    7Increase in accrued interest payable
    
    
    13
    
    
    
    (106
    )Decrease in other assets
    
    
    24
    
    
    
    43Decrease in other liabilities
    
    
    43
    
    
    
    929Net cash from operating activities
    
    
    2,080
    
    
    
    3,107Net decrease (increase) in federal funds sold
    
    
    492
    
    
    
    (3,993
    )Net decrease (increase) in interest-bearing deposits with banks
    
    
    (4,754
    )
    
    
    7,064Purchase of securities available-for-sale
    
    
    (14,471
    )
    
    
    (28,626
    )Proceeds from sales of securities available-for-sale
    
    
    2,630
    
    
    
    2,672Proceeds from maturities of securities available-for-sale
    
    
    8,399
    
    
    
    16,074Federal Home Loan Bank stock redeemed
    
    
    4
    
    
    
    42Net increase in loans
    
    
    (2,325
    )
    
    
    (6,881
    )Additions to premises and equipment
    
    
    (220
    )
    
    
    (210
    )Sale of real estate held for investment
    
    
    
    
    
    
    224Net cash from investing activities
    
    
    (10,245
    )
    
    
    (13,634
    )CASH FLOWS FROM FINANCING ACTIVITIESNet increase in deposits
    
    
    9,777
    
    
    
    13,136Net increase (decrease) in other borrowed funds
    
    
    12
    
    
    
    (84
    )Payment on other borrowed money
    
    
    (48
    )
    
    
    (48
    )Cash dividends paid
    
    
    (715
    )
    
    
    (675
    )Stock options exercised
    
    
    49
    
    
    
    24Net cash from financing activities
    
    
    9,075
    
    
    
    12,353NET INCREASE IN CASH AND DUE FROM BANKS
    
    
    910
    
    
    
    1,826CASH AND DUE FROM BANKS, beginning of year
    
    
    5,199
    
    
    
    4,847CASH AND DUE FROM BANKS, at end of period
    
    $
    6,109
    
    
    $
    6,673SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONCash payments forInterest
    
    $
    711
    
    
    $
    1,113Income taxes
    
    
    634
    
    
    
    691SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIESUnrealized losses on securities available-for-sale
    
    $
    (162
    )
    
    $
    (232
    )Deferred tax on unrealized losses on securities available-for-sale
    
    
    55
    
    
    
    79Distribution of five percent stock dividend
    
    
    1,871
    
    
    
    1,389
 The accompanying notes are an integral part of these financial statements -3-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1  Description of Business and Basis of Presentation Description of Business Valley Community Bancshares, Inc. (the Company) is a Washington State bank
holding company headquartered in Puyallup, Washington. The Company conducts its
business primarily through its wholly owned bank subsidiary, Valley Bank.
Valley Bank is referred to as the Bank in this Form 10-Q. The Companys main office is located in Puyallup, Washington, which also serves
as the main office of the Bank. The Bank provides a full range of commercial
banking services to small and medium-sized businesses, professionals and other
individuals through eight banking offices located in Puyallup, Auburn, and
Kent, Washington, and their environs. The Bank also provides mortgage banking services to its customers through Puget
Sound Mortgage Brokers, a division of the Bank. The principal sources of the Companys revenue are (i) interest and fees on
loans; (ii) deposit service charges; (iii) merchant credit card processing
fees; (iv) interest bearing deposits with Bank; (v) interest on investments
(principally government securities) and (vi) origination fees on mortgage loans
brokered. The Banks lending activity consists of short-to-medium-term
commercial and consumer loans, including operating loans and lines of credit,
equipment loans, automobile loans, recreational vehicle and truck loans,
personal loans or lines of credit, home improvement loans and rehabilitation
loans. The Bank also offers cash management services, merchant credit card
processing, safe deposit boxes, wire transfers, direct deposit of payroll and
social security checks, automated teller machine access, and automatic drafts
for various accounts. Basis of Presentation The condensed consolidated financial statements have been prepared by the
Company, for the three months and nine months ended September 30, 2004 and
September 30, 2003, without audit by the Companys independent auditors.
However, the financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America for
interim financial information and with instructions to Form 10-Q and Article 10
of Regulation S-X. In the opinion of the Companys management, all adjustments
consisting of normal recurring accruals necessary for a fair presentation of
the financial condition and results of operations for the interim periods
included herein have been made. The consolidated balance sheet of the Company
as of December 31, 2003 has been derived from the audited consolidated balance
sheet of the Company as of that date. The results of operations for the three
months and nine months ended September 30, 2004, are not necessarily indicative
of the results to be anticipated for the year ending December 31, 2004. Certain information and note disclosures normally included in the Companys
annual financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been condensed or
omitted. Therefore, these consolidated financial statements and notes thereto
should be read in conjunction with a reading of the financial statements for
the year ended December 31, 2003 and notes thereto included in the Companys
Form 10-K filed with the Securities and Exchange Commission. Certain amounts in
the 2003 financial statements have been reclassified to conform to the 2004
presentation. Note 2   Stock Option Plan The Company accounts for the stock option plan under recognition and
measurement principles of APB Opinion No. 25, Accounting for Stock Issued to
Employees,and related Interpretations using the intrinsic value method. No
stock-based employee compensation cost is reflected in net income, as all
options granted under the plan had an exercise price equal to the market value
of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition method as provided under FASB Statement No.
123, Accounting for Stock-Based Compensation,to stock-based employee
compensation. -4-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
Stock Option PlanIn thousands, except for per-share amounts Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Pro forma disclosures:Net income as reported
    
    $
    497
    
    
    $
    590
    
    
    $
    1,419
    
    
    $
    1,600Additional compensation for fairvalue of stock options
    
    
    7
    
    
    
    3
    
    
    
    12
    
    
    
    7Pro forma net income
    
    $
    490
    
    
    $
    587
    
    
    $
    1,407
    
    
    $
    1,593Earnings per share:BasicAs reported
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.15
    
    
    $
    1.30Pro forma
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.14
    
    
    $
    1.29DilutedAs reported
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.14
    
    
    $
    1.29Pro forma
    
    $
    0.39
    
    
    $
    0.48
    
    
    $
    1.13
    
    
    $
    1.29
 Note 3  Earnings per share Basic earnings per share amounts are computed based on the weighted average
number of shares outstanding during the period after giving retroactive effect
to stock dividends and stock splits. Diluted earnings per share amounts are
computed by determining the number of additional shares that are deemed
outstanding due to stock options under the treasury stock method. The following table sets forth the computation of basic and diluted earnings
per share for the three months and nine months ended September 30, 2004 and
2003 (dollars in thousands, except per share amounts): VALLEY COMMUNITY BANCSHARES, INC.
Earnings Per Share Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003NUMERATOR:Net income
    
    $
    497
    
    
    $
    590
    
    
    $
    1,419
    
    
    $
    1,600DENOMINATOR:Denominator for basic earnings per share:Weighted average shares
    
    
    1,238,089
    
    
    
    1,231,860
    
    
    
    1,237,483
    
    
    
    1,230,850Effect of diluted securities  stock options
    
    
    8,296
    
    
    
    5,032
    
    
    
    8,686
    
    
    
    4,971Denominator for diluted earnings per share:Weighted average shares and assumed
conversion of diluted stock options
    
    
    1,246,385
    
    
    
    1,236,892
    
    
    
    1,246,169
    
    
    
    1,235,821Basic earnings per share
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.15
    
    
    $
    1.30Diluted earnings per share
    
    $
    0.40
    
    
    $
    0.48
    
    
    $
    1.14
    
    
    $
    1.29
 Note 4 Comprehensive Income Total comprehensive income, which includes net income and unrealized gains and
losses on the Companys available-for-sale securities, amounted to $809,000 and
$479,000, for the three months ended September 30, 2004 and 2003, respectively.
Total comprehensive income, amounted to $1,312,000 and $1,447,000, for the nine
months ended September 30, 2004 and 2003, respectively. -5-




---



##### Table of Contents



Note 5  Investment Securities Investment securities have been classified as available-for-sale in according
with managements intent. The carrying amount of securities and their estimated
fair values are as follows (in thousands): September 30, 2004 Securities Available-For-Sale
    
    
    
    
    
    Gross
    
    Gross Unrealized LossesAmortized
    
    Unrealized
    
    Less than
    
    12 Months
    
    FairCost
    
    Gains
    
    12 Months
    
    or More
    
    ValueU.S. Treasury and U.S. Government
corporations and agencies
    
    $
    16,777
    
    
    $
    16
    
    
    $
    55
    
    
    $
    
    
    
    $
    16,738State and political subdivisions
    
    
    8,428
    
    
    
    352
    
    
    
    3
    
    
    
    
    
    
    
    8,777Mortgage-backed securities
    
    
    16,070
    
    
    
    136
    
    
    
    18
    
    
    
    27
    
    
    
    16,161$
    41,275
    
    
    $
    504
    
    
    $
    76
    
    
    $
    27
    
    
    $
    41,676
 December 31, 2003 Securities Available-For-Sale
    
    
    
    
    
    Gross
    
    Gross Unrealized LossesAmortized
    
    Unrealized
    
    Less than
    
    12 Months
    
    FairCost
    
    Gains
    
    12 Months
    
    or More
    
    ValueU.S. Treasury and U.S. Government
corporations and agencies
    
    $
    13,614
    
    
    $
    109
    
    
    $
    2
    
    
    $
    
    
    
    $
    13,721State and political subdivisions
    
    
    7,421
    
    
    
    361
    
    
    
    4
    
    
    
    
    
    
    
    7,778Mortgage-backed securities
    
    
    16,964
    
    
    
    151
    
    
    
    54
    
    
    
    
    
    
    
    17,061$
    37,999
    
    
    $
    621
    
    
    $
    60
    
    
    $
    
    
    
    $
    38,560
 At September 30, 2004 and December 31, 2003, there were approximately 35 and 20
investment securities, respectively, that had fair values less than amortized
cost and therefore contains unrealized losses. The Company has evaluated these
securities and has determined that the decline in value is temporary and is
related to the change in market interest rates since purchase. The decline in
value is not related to any company or industry specific event. The Company
anticipates full recovery of amortized cost with respect to these securities at
maturity or sooner in the event of a more favorable market interest rate
environment. Note 6  Loans The major classifications of loans at September 30, 2004 and December 31, 2003
are summarized as follows (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Loan Portfolio
(dollars in thousands) September 30,
    
    December 31,2004
    
    2003Amount
    
    Percent
    
    Amount
    
    PercentReal
EstateConstruction
    
    $
    13,288
    
    
    
    11.4
    %
    
    $
    9,913
    
    
    
    8.7
    %Residential
    
    
    10,494
    
    
    
    9.0
    %
    
    
    12,095
    
    
    
    10.6
    %Commercial
    
    
    61,836
    
    
    
    52.9
    %
    
    
    65,114
    
    
    
    56.9
    %Commercial
    
    
    28,939
    
    
    
    24.8
    %
    
    
    24,872
    
    
    
    21.7
    %Consumer and other
    
    
    2,216
    
    
    
    1.9
    %
    
    
    2,409
    
    
    
    2.1
    %Lease financing
    
    
    46
    
    
    
    0.0
    %
    
    
    63
    
    
    
    0.0
    %Total loans
    
    
    116,819
    
    
    
    100.0
    %
    
    
    114,466
    
    
    
    100.0
    %Deferred loan fees
    
    
    (233
    )
    
    
    
    
    
    
    (205
    )Net loans
    
    $
    116,586
    
    
    
    
    
    
    $
    114,261
 -6-




---



##### Table of Contents



Note 7  Allowance for Loan Losses Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the
appropriate provision required to maintain an
adequate allowance. In assessing the adequacy of the allowance, management
reviews the size, quality and risks of loans in the portfolio and considers
factors such as specific known risks, past experience, the status and amount of
nonperforming assets and economic conditions. A specific percentage is
allocated to each major classification and not specifically reserved while
additional amounts are added for individual loans considered to have specific
loss potential. Loans identified as losses are charged-off. Based on total
allocations, the provision is recorded to maintain the allowance at a level
deemed appropriate by management. While management uses available information
to recognize losses on loans, there can be no assurance that future additions
to the allowance will not be necessary. The allowance for loan losses at September 30, 2004 and December 31, 2003,
totaled $1,388,000. Management believes that the allowance for loan losses at
September 30, 2004 adequately reflects the risks in the loan portfolio.
Various regulatory agencies, as an integral part of their examination process,
periodically review the Banks allowance for loan losses. Such agencies may
require the Bank to recognize changes to the allowance based on their judgments
of information available to them at the time of their examination. The following table summarizes the activity in the allowance for loan losses
(dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. Loan Loss Experience Three and Nine MonthsSeptember 30,2004
    
    2003Balance at beginning of period
    
    $
    1,388
    
    
    $
    1,388Charge-offsRecoveries:Net recoveries
    
    
    -0-
    
    
    
    -0-Additions charged to operationsBalance at end of period
    
    $
    1,388
    
    
    $
    1,388
 Note 8  Business Segment Information Beginning January 1999 and through December 2002, the Company owned two
community-banking institutions, Puyallup Valley Bank and Valley Bank. These
banks were managed at the subsidiary bank level. Each subsidiary bank had a
board of directors and an executive management team responsible for the
operation and performance of the respective subsidiary bank. On January 17, 2003, the Company merged the subsidiary banks into one community
bank named Valley Bank. In addition, the Company consolidated its board of
directors and executive management team into a new organizational structure,
while converting separated banking systems into a single operation. As a result
of these system and organizational changes, the financial information that is
used by the chief operating decision maker in allocating resources and
assessing performance is only provided for one reportable segment for the three
months and nine months ended September 30, 2004 and 2003. Note 9  Recent Accounting Pronouncements During the third quarter ended September 30, 2004 the Financial Accounting
Standard Board (FASB) did not issue any new accounting pronouncements. -7-




---



##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS Critical Accounting Policies The preparation of the Companys consolidated financial statements requires
management to make estimates and assumptions that affect amounts reported in
the consolidated financial statements. Changes in these estimates and
assumptions are considered reasonably possible and may have a material impact
on the consolidated financial statements and thus actual results could differ
from the amounts reported and disclosed herein. The Company considers the
allowance for loan loss a critical accounting policy subject to estimate. For a
full discussion of the Companys methodology of assessing the adequacy of the
allowance for loan losses, see Managements Discussion and Analysis of
Financial Condition and Results of Operation in the Companys 2003 Annual
Report on Form 10-K. Results of Operations The following table shows the various performance ratios for the Company for
the three months and nine months ended September 30, 2004 and 2003,
respectively: VALLEY COMMUNITY BANCSHARES, INC.
Selected Financial Data 1
(dollars in thousands, except per share amounts) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Financial PerformanceNet Income
    
    $
    497
    
    
    $
    590
    
    
    $
    1,419
    
    
    $
    1,600Average Assets
    
    
    186,818
    
    
    
    182,057
    
    
    
    181,391
    
    
    
    176,651Average Stockholders Equity
    
    
    24,037
    
    
    
    22,781
    
    
    
    23,723
    
    
    
    22,494Return on Assets (net income divided by average assets)
    
    
    1.06
    %
    
    
    1.29
    %
    
    
    1.04
    %
    
    
    1.21
    %Return on Equity (net income divided by average equity)
    
    
    8.23
    %
    
    
    10.27
    %
    
    
    7.99
    %
    
    
    9.51
    %Net Interest
Margin (net interest income (tax adjusted) 1
Divided by earning assets)
    
    
    4.61
    %
    
    
    4.64
    %
    
    
    4.76
    %
    
    
    4.83
    %Efficiency Ratio (noninterest expense divided by
noninterest income plus net interest income)
    
    
    68.04
    %
    
    
    63.55
    %
    
    
    69.39
    %
    
    
    66.69
    %Ratio of noninterest income to average assets
    
    
    3.25
    %
    
    
    3.34
    %
    
    
    3.43
    %
    
    
    3.53
    %
 The Company earned net income of $497,000 or $0.40 per diluted share for the
three months ended September 30, 2004, compared to net income of $590,000 or
$0.48 per diluted share, for the three-months ended September 30, 2003, a
decrease of 15.8 percent. The Companys return on average assets was 1.06
percent for the three months ended September 30, 2004, compared to 1.29 percent
for the three months ended September 30, 2003. The Company earned net income of $1,419,000 or $1.14 per diluted share for the
nine months ended September 30, 2004, compared to net income of $1,600,000 or
$1.29 per diluted share, for the nine months ended September 30, 2003, a
decrease of 11.3 percent. The Companys return on average assets was 1.04
percent for the nine months ended September 30, 2004, compared to 1.21 percent
for the nine months ended September 30, 2003. The decrease in net income for the three months and nine months ended
September 30, 2004 was the result of a decrease in noninterest income partially
offset by an increase in net interest income and a decrease in noninterest
expense. The major factors impacting net income for the three months ended September 30,
2004 are as follows:  
    
    Origination fees on mortgage loans brokered declined as residential loan customers slowed their mortgage refinancing
activity.
    
    Included in 2003 was the amortization of a deferred gain on the sale of real estate held for investment.   1The computation of the ratios is based on the recorded assets and liabilities
after the effect of changes in market values of securities available for sale. 1See the following page for a reconciliation of tax adjusted net interest
income. -8-




---



##### Table of Contents



The Company completed the implementation of the Banks internet banking
product in September 2004. As a result the Company will begin incurring higher
non-interest expenses during the fourth quarter of 2004. The Company does not
anticipate sufficient revenues to offset the added costs of this product, as
result profitability is anticipated to be negatively impacted on a go forward
basis. The Company will begin the implementation of Section 404 of the Sarbanes Oxley
Act of 2002 beginning the fourth quarter of 2004. The Company anticipates
initial compliance costs of approximately $125,000 and annual compliance costs
of approximately $50,000. Net Interest Income Net interest income is the most significant component contributing to net
income. It is the difference between interest earned on earning assets
(primarily loans and investments) and interest paid on interest bearing
liabilities (deposits and borrowings). The volume of and yields earned on
earning assets and the volume of and the rates paid on interest bearing
liabilities determine net interest income. Interest earned and interest paid is
also affected by general economic conditions, particularly changes in market
interest rates, and by government policies and the action of regulatory
authorities. The earnings on certain assets are exempt from federal income tax. It is
customary in the financial services industry to analyze changes in net interest
income on a tax equivalent (TE) basis. TE is a non-GAAP performance measure
used by management in operating the business, which management believes
provides investors with a more accurate picture of the interest margin for
comparative purposes. Under this method, nontaxable income from loans and
investments is adjusted to an amount, which would have been earned if such
income were subject to federal income tax. The discussion below presents an analysis based on tax equivalent amounts at a
34% tax rate. VALLEY COMMUNITY BANCSHARES, INC.
Net Interest Income, adjusted to a Tax Equivalent Basis
(dollars in thousands), Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Interest income, as reported
    
    $
    2,258
    
    
    $
    2,246
    
    
    $
    6,645
    
    
    $
    6,833Effect of tax exempt income
    
    
    41
    
    
    
    36
    
    
    
    120
    
    
    
    102TE interest income
    
    
    2,299
    
    
    
    2,282
    
    
    
    6,765
    
    
    
    6,935Interest expense
    
    
    270
    
    
    
    297
    
    
    
    724
    
    
    
    1,007TE net interest income
    
    $
    2,029
    
    
    $
    1,985
    
    
    $
    6,041
    
    
    $
    5,928
 TE net interest income, divided by average earning assets is referred to as net
interest margin. For the three months ended September 30, 2004 the Companys
net interest margin was 4.61 percent compared to 4.64 percent for the three
months ended September 30, 2003. For the nine months ended September 30, 2004
the Companys net interest margin was 4.76 percent compared to 4.83 percent for
the nine months ended September 30, 2003. TE interest income was $2,299,000 and $6,765,000 for the three months and nine
months ended September 30, 2004, respectively compared to $2,282,000 and
$6,935,000 for the three months and nine months ended September 30, 2003,
respectively. The three month increase was the result of additional earnings
received on the increased volume of earning assets partially offset by a
decrease in the yield earned on earning assets. The nine month decrease was the
result of a decrease in the yield earned on earning assets partially offset by
the additional earnings received on the increased volume of earning assets. The
yield on interest-earning assets decreased to 5.23 percent for the three months
ended September 30, 2004 compared to 5.34 percent during the same period a year
ago and decreased to 5.31 percent for the nine months ended September 30, 2004
compared to 5.65 percent during the same period a year ago. Interest expense was $270,000 and $724,000 for the three months and nine months
ended September 30, 2004, respectively compared to $297,000 and $1,007,000 for
the three months and nine months ended September 30, 2003, respectively. The
three month and nine month decrease was due to a decrease in the Companys cost
of funds resulting from low market interest rates. The cost of funds decreased
to 0.86 percent for the three months ended September 30, 2004 compared to 0.94
percent during the same period a year ago and decreased to 0.80 percent for the
nine months ended September 30, 2004 compared to 1.11 percent during the same
period a year ago. -9-




---



##### Table of Contents



Market interest rates continue to be at historical lows as a result of a
slow national and regional economy and because of an aggressively accommodating
Federal Reserve monetary policy beginning in 2001. The significant decrease in
market interest rates initially had a positive impact on the Companys net
interest margin as the Company experienced a greater reduction in deposit costs
in comparison to the reduction in the earnings on loans and investments.
However, during 2003 and 2004 market interest remained relatively low which
resulted in a greater reduction in the earnings on loans and investments as
compared to the reduction in deposit costs. The Companys current interest rate risk position suggests that in the event of
an increase in market interest rates, the Companys TE net interest income and
margin may decrease. The decrease results because the Company has a greater
amount of interest bearing liabilities subject to repricing when compared to
the repricing of interest earning assets. Any TE net interest income and margin
decrease is dependent on the timing and magnitude of any interest rate
increase. Therefore, the decrease may be somewhat offset because the rate paid
on deposits, with administered interest rates, generally do not increase as
rapidly as an account whose rates change with market interest rates. In the
event of continued low market interest rates, the Company anticipates a further
decrease in net interest margin as interest-earning assets reprice to the lower
interest rate levels while the ability to lower deposit rates is somewhat
limited. The following table sets forth information concerning the Companys average
balance and average interest rates earned or paid, interest rate spread and net
interest margin for the three months ended September 30, 2004 and 2003: VALLEY COMMUNITY BANCSHARES, INC.
AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands) For the Three Months Ended September 30,2004
    
    2003Average
    
    Revenue/
    
    Yield/
    
    Average
    
    Revenue/
    
    Yield/ASSETS
    
    Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateInterest-earning assetsLoans (including fees) 1
    
    $
    116,186
    
    
    $
    1,889
    
    
    
    6.47
    %
    
    $
    112,349
    
    
    $
    1,897
    
    
    
    6.70
    %Investment securities 2 3
    
    
    36,224
    
    
    
    308
    
    
    
    3.38
    %
    
    
    36,473
    
    
    
    302
    
    
    
    3.28
    %Other earning assets
    
    
    22,558
    
    
    
    102
    
    
    
    1.80
    %
    
    
    20,819
    
    
    
    83
    
    
    
    1.58
    %Total Interest-earning assets
    
    
    174,968
    
    
    
    2,299
    
    
    
    5.23
    %
    
    
    169,641
    
    
    
    2,282
    
    
    
    5.34
    %Total noninterest-earning assets
    
    
    11,850
    
    
    
    
    
    
    
    
    
    
    
    12,416TOTAL ASSETS
    
    $
    186,818
    
    
    
    
    
    
    
    
    
    
    $
    182,057Interest-bearing liabilitiesDeposits
    
    $
    124,359
    
    
    $
    269
    
    
    
    0.86
    %
    
    $
    124,798
    
    
    $
    296
    
    
    
    0.94
    %Other borrowed funds
    
    
    375
    
    
    
    1
    
    
    
    1.06
    %
    
    
    483
    
    
    
    1
    
    
    
    0.82
    %Total Interest-bearing liabilities
    
    
    124,734
    
    
    
    270
    
    
    
    0.86
    %
    
    
    125,281
    
    
    
    297
    
    
    
    0.94
    %Noninterest-bearing liabilities
    
    
    38,047
    
    
    
    
    
    
    
    
    
    
    
    33,995Stockholders equity
    
    
    24,037
    
    
    
    
    
    
    
    
    
    
    
    22,781TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    186,818
    
    
    
    
    
    
    
    
    
    
    $
    182,057Net interest spread
    
    
    
    
    
    $
    2,029
    
    
    
    4.37
    %
    
    
    
    
    
    $
    1,985
    
    
    
    4.40
    %Margin AnalysisTE interest income/earning assets
    
    
    
    
    
    $
    2,299
    
    
    
    5.23
    %
    
    
    
    
    
    $
    2,282
    
    
    
    5.34
    %Interest expense/earning assets
    
    
    
    
    
    
    270
    
    
    
    0.61
    %
    
    
    
    
    
    
    297
    
    
    
    0.69
    %Net interest margin
    
    
    
    
    
    $
    2,029
    
    
    
    4.61
    %
    
    
    
    
    
    $
    1,985
    
    
    
    4.64
    %
   1 Average loan balance includes nonaccrual loans, if any. Interest income on
nonaccrual loans has been included. 2 Tax-exempt income has been adjusted to a tax-equivalent basis using an
incremental rate of 34%. 3 The yield on investment securities is calculated using historical cost basis. -10-




---



##### Table of Contents



The following table sets forth information concerning the Companys average
balance and average interest rates earned or paid, interest rate spread and net
interest margin for the nine months ended September 30, 2004 and 2003: VALLEY COMMUNITY BANCSHARES, INC.



AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands) For the Nine Months Ended September 30,2004
    
    2003Average
    
    Revenue/
    
    Yield/
    
    Average
    
    Revenue/
    
    Yield/ASSETS
    
    Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateInterest-earning assetsLoans (including fees) 1
    
    $
    116,422
    
    
    $
    5,605
    
    
    
    6.43
    %
    
    $
    109,874
    
    
    $
    5,743
    
    
    
    6.99
    %Investment securities 2 3
    
    
    36,087
    
    
    
    929
    
    
    
    3.44
    %
    
    
    33,850
    
    
    
    923
    
    
    
    3.65
    %Other earning assets
    
    
    17,067
    
    
    
    231
    
    
    
    1.81
    %
    
    
    20,381
    
    
    
    269
    
    
    
    1.76
    %Total Interest-earning assets
    
    
    169,576
    
    
    
    6,765
    
    
    
    5.31
    %
    
    
    164,105
    
    
    
    6,935
    
    
    
    5.65
    %Total noninterest-earning assets
    
    
    11,815
    
    
    
    
    
    
    
    
    
    
    
    12,546TOTAL ASSETS
    
    $
    181,391
    
    
    
    
    
    
    
    
    
    
    $
    176,651Interest-bearing liabilitiesDeposits
    
    $
    121,078
    
    
    $
    720
    
    
    
    0.79
    %
    
    $
    121,331
    
    
    $
    1,003
    
    
    
    1.11
    %Other borrowed funds
    
    
    532
    
    
    
    4
    
    
    
    1.00
    %
    
    
    476
    
    
    
    4
    
    
    
    1.12
    %Total Interest-bearing liabilities
    
    
    121,610
    
    
    
    724
    
    
    
    0.80
    %
    
    
    121,807
    
    
    
    1,007
    
    
    
    1.11
    %Noninterest-bearing liabilities
    
    
    36,058
    
    
    
    
    
    
    
    
    
    
    
    32,350Stockholders equity
    
    
    23,723
    
    
    
    
    
    
    
    
    
    
    
    22,494TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    181,391
    
    
    
    
    
    
    
    
    
    
    $
    176,651Net interest spread
    
    
    
    
    
    $
    6,041
    
    
    
    4.52
    %
    
    
    
    
    
    $
    5,928
    
    
    
    4.54
    %Margin AnalysisTE interest income/earning assets
    
    
    
    
    
    $
    6,765
    
    
    
    5.31
    %
    
    
    
    
    
    $
    6,935
    
    
    
    5.65
    %Interest expense/earning assets
    
    
    
    
    
    
    724
    
    
    
    0.57
    %
    
    
    
    
    
    
    1,007
    
    
    
    0.82
    %Net interest margin
    
    
    
    
    
    $
    6,041
    
    
    
    4.76
    %
    
    
    
    
    
    $
    5,928
    
    
    
    4.83
    %
   1 Average loan balance includes nonaccrual loans, if any. Interest income on
nonaccrual loans has been included. 2 Tax-exempt income has been adjusted to a tax-equivalent basis using an
incremental rate of 34%. 3 The yield on investment securities is calculated using historical cost basis. -11-




---



##### Table of Contents



The following table sets forth information concerning the Companys change in
TE net interest income for the period that are attributable to changes in
interest rate and changes in volume for the three months and nine months ended
September 30, 2004 compared to the three months and nine months ended September
30, 2003: VALLEY COMMUNITY BANCSHARES, INC.
Volume/Rate Analysis1 For the Three Months ended September 30,
(dollars in thousands) 2004 Compared to 2003Volume
    
    Rate
    
    NetTE Interest incomeLoans (including fees) 2
    
    $
    61
    
    
    $
    (69
    )
    
    $
    (8
    )Investment securities 3
    
    
    (2
    )
    
    
    8
    
    
    
    6Other earning assets
    
    
    (2
    )
    
    
    21
    
    
    
    1957
    
    
    
    (40
    )
    
    
    17Interest-bearing liabilitiesTotal deposits
    
    
    (1
    )
    
    
    (26
    )
    
    
    (27
    )Other borrowed funds
    
    
    (1
    )
    
    
    (26
    )
    
    
    (27
    )$
    58
    
    
    $
    (14
    )
    
    $
    44
 VALLEY COMMUNITY BANCSHARES, INC.
Volume/Rate Analysis1 For the Nine Months ended September 30,
(dollars in thousands) 2004 Compared to 2003Volume
    
    Rate
    
    NetTE Interest incomeLoans (including fees) 2
    
    $
    333
    
    
    $
    (471
    )
    
    $
    (138
    )Investment securities 3
    
    
    60
    
    
    
    (54
    )
    
    
    6Other earning assets
    
    
    (76
    )
    
    
    38
    
    
    
    (38
    )317
    
    
    
    (487
    )
    
    
    (170
    )Interest-bearing liabilitiesTotal deposits
    
    
    (2
    )
    
    
    (281
    )
    
    
    (283
    )Other borrowed funds
    
    
    (2
    )
    
    
    (281
    )
    
    
    (283
    )$
    319
    
    
    $
    (206
    )
    
    $
    113
   1 The change in interest due to both volume and yield/rate has been allocated
to change due to volume and change due to yield/rate in proportion to the
absolute value of the change in each. 2 Balances of nonaccrual loans, if any, and related income recognized have been
included for computational purposes. 3 Tax-exempt income has been converted to a tax-equivalent basis using an
incremental rate of 34%. -12-




---



##### Table of Contents



Provision for loan losses Provisions for loan losses reduce net interest income. The Company provided $0
for loan losses for the three months and nine months ended September 30, 2004
and 2003. Management believes the amount of the allowance for loan losses to be adequate
to absorb losses in the current portfolio. This belief is based upon
managements continuing evaluation of inherent risks in the current loan
portfolio, current levels of classified assets, and economic factors. The
Company will continue to monitor the allowance and make future adjustments to
the allowance as conditions dictate. For further discussion regarding the
allowance for loan losses, see the discussion on allowance for loan losses
under Risk Elements. Noninterest income and expense Net income is increased by noninterest income (primarily service charges,
origination fees on mortgage loans brokered, and other operating income) and
reduced by noninterest expenses (primarily salaries and employee benefits,
occupancy, equipment, and other operating expenses). Noninterest income was $252,000 and $783,000 for the three months and nine
months ended September 30, 2004, respectively, compared to $460,000 and
$1,169,000 during the same respective periods a year ago. The decrease in noninterest income was primarily the result of lower deposit
service charges (NSF fees), lower loan origination fees on mortgage loans
brokered, and a decrease in the amortization of deferred gain on the sale of
real estate. The decrease was partially offset by gains realized on the sale of
investment securities. The significant reduction in origination fees on
mortgage loans brokered is the result of residential loan customer reducing
their demand for mortgage refinance loans. The reduction in demand occurred
because most mortgage loan refinance customers refinanced their mortgages
shortly after the Federal Reserve lowered interest rates for the last time in
2003. Included in 2003 was the amortization of the $211,000 deferred gain
realized on the sale of real estate that the Bank previously held for
investment purpose. The following table sets forth information concerning the various components of
the Companys noninterest income for the three months and nine months ended
September 30, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Income
(dollars in thousands) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Noninterest IncomeService charges
    
    $
    103
    
    
    $
    114
    
    
    $
    310
    
    
    $
    351Gain on sale of investment securities, net
    
    
    
    
    
    
    
    
    
    
    49
    
    
    
    15Income and fees from the printing and sale of checks
    
    
    13
    
    
    
    4
    
    
    
    36
    
    
    
    12Income and fees from automated teller machines
    
    
    10
    
    
    
    10
    
    
    
    29
    
    
    
    31Safe deposit box rent
    
    
    8
    
    
    
    7
    
    
    
    23
    
    
    
    23Real estate brokerage income
    
    
    44
    
    
    
    119
    
    
    
    121
    
    
    
    320Debit card surcharge income
    
    
    27
    
    
    
    23
    
    
    
    78
    
    
    
    70Amortization of deferred gain on sale of real estate
    
    
    
    
    
    
    173
    
    
    
    
    
    
    
    211Other
    
    
    47
    
    
    
    10
    
    
    
    137
    
    
    
    136Total noninterest income
    
    $
    252
    
    
    $
    460
    
    
    $
    783
    
    
    $
    1,169
 Noninterest expense was $1,524,000 and $4,652,000 for the three months and nine
months ended September 30, 2004, respectively, compared to $1,531,000 and
$4,665,000 during the same respective periods a year ago. Noninterest expense was relatively stable during the three and nine months

ended September 30, 2004 compared to the same periods a year ago. The
percentage of noninterest expense to average assets was 3.43 percent for the
nine months ended September 30, 2004, compared to 3.53 percent during the same
period last year. -13-




---



##### Table of Contents



The following table sets forth information concerning the various components of
the Companys noninterest expense for the three months and nine months ended
September 30, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Expense
(dollars in thousands) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Noninterest ExpenseSalaries
    
    $
    656
    
    
    $
    644
    
    
    $
    1,953
    
    
    $
    1,955Employee benefits
    
    
    156
    
    
    
    165
    
    
    
    492
    
    
    
    504Occupancy
    
    
    129
    
    
    
    143
    
    
    
    414
    
    
    
    415Equipment
    
    
    116
    
    
    
    115
    
    
    
    352
    
    
    
    330Advertising and marketing expenses
    
    
    30
    
    
    
    49
    
    
    
    102
    
    
    
    124Directors fees
    
    
    28
    
    
    
    28
    
    
    
    84
    
    
    
    84Printing, stationery, and supplies
    
    
    18
    
    
    
    24
    
    
    
    143
    
    
    
    168Postage
    
    
    21
    
    
    
    23
    
    
    
    72
    
    
    
    72ATM and debit card expense
    
    
    37
    
    
    
    33
    
    
    
    112
    
    
    
    109Business and occupation tax
    
    
    34
    
    
    
    33
    
    
    
    103
    
    
    
    101Telephone expense
    
    
    34
    
    
    
    33
    
    
    
    98
    
    
    
    105Other
    
    
    265
    
    
    
    241
    
    
    
    727
    
    
    
    698Total noninterest expense
    
    $
    1,524
    
    
    $
    1,531
    
    
    $
    4,652
    
    
    $
    4,665
 The Companys efficiency ratio, which is the ratio of noninterest expense to
net interest income plus noninterest income, was 69.4 percent for the nine
months ended September 30, 2004 compared to 66.7 percent for the nine months
ended September 30, 2003. Provision for income tax The Companys provision for income tax is a significant reduction of operating
income. The provision for the three months ended September 30, 2004, was
$219,000 compared to $288,000 for the three months ended September 30, 2003.
The provision for the nine months ended September 30, 2004, was $633,000
compared to $730,000 for the nine months ended September 30, 2003. The
provision represents an effective tax rate of 31 percent during 2004 and 2003,
respectively. The Companys marginal tax rate is currently 34 percent. The
difference between the Companys effective and marginal tax rate is primarily
related to investments made in tax-exempt securities. Financial Condition The Companys total consolidated assets increased 5.7 percent to $192.7 million
as of September 30, 2004, compared to $182.2 million as of December 31, 2003.
Loans and deposits increased 2.0 percent and 6.2 percent, respectively during
the nine months ended September 30, 2004. The increase in loans was funded with
increased deposits. The increase in deposits also funded the increase in
interest-bearing deposits with banks and securities available-for-sale.
Stockholders equity increased as a result earnings during the nine months
ended September 30, 2004 partially offset by the payment of a 60cent(s) per
share cash dividend to stockholders and a decrease in other comprehensive
income. Investment Portfolio The major classifications of investments at September 30, 2004 and December 31,
2003, are summarized in Note 4  Investment Securities in the Notes to
Condensed Consolidated Financial Statements. At September 30, 2004, the Company had $41.7 million of securities
available-for-sale, compared to $38.6 million as of December 31, 2003. The
investment portfolio increased by $3.1 million during 2004, as a result of the
by the purchase of approximately $14.5 million in securities partially offset
by the sale and maturity of approximately $11.0 million of securities. At September 30, 2004, all of the Companys securities were classified as
available-for-sale. Management believes that holding securities as
available-for-sale provides greater flexibility to respond to interest rate
changes and liquidity needs to fund loan growth. -14-




---



##### Table of Contents



Loan Portfolio The major classifications of loans at September 30, 2004 and December 31, 2003,
are summarized in Note 5  Loans in the Notes to Condensed Consolidated
Financial Statements. In addition to the major classifications of loans summarized in Note 5, the
Company has additional loan concentrations exceeding 10 percent of total loans
at September 30, 2004. They include loans to medical doctors and dentists in
the amount of approximately $25.3 million. Loans were $116.6 million as of September 30, 2004, compared to $114.3 million
as of December 31, 2003, an increase of 2.0 percent. The increase was primarily
in real estate construction and commercial loans, partially offset by a
decrease in real estate residential and real estate commercial loans. The
percentage of loans to total assets increased to 60.5 percent at September 30,
2004 compared to 62.7 percent at December 31, 2003. It continues to be
managements intent to grow the loan portfolio and to increase the percent of
loans to assets, which potentially could improve the Companys net interest
margin. Risk Elements The following table sets forth information concerning the Companys
non-performing assets as of the dates indicated (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Non-performing Assets September 30,
    
    December 31,2004
    
    2003Non-performing assets:Nonaccrual loans
    
    $
    -0-
    
    
    $
    10Loans 90 days or more past dueRestructured loans-0-
    
    
    
    10Other real estate ownedTotal non-performing assets
    
    $
    -0-
    
    
    $
    10
 As of September 30, 2004, the Company had no nonperforming assets, which
include nonaccrual loans, loans 90 days or more past due and still accruing
interest, and restructured loans. The Company had $10,000 in nonperforming
assets as of December 31, 2003. The accrual of interest on nonaccrual and other impaired loans is discontinued
at 90 days or when, in the opinion of management, the borrower may be unable to
meet payments as they become due. When interest accrual is discontinued, all
unpaid accrued interest is reversed. Interest income is subsequently recognized
only to the extent cash payments are received. Interest income on restructured
loans is recognized pursuant to the terms of the new loan agreement. Interest
income on other impaired loans is monitored and based upon the terms of the
underlying loan agreement. However, the recorded net investment in impaired
loans, including accrued interest, is limited to the present value of the
expected cash flows of the impaired loan or the observable fair market value of
the loans collateral. During the nine months ended September 30, 2004, and 2003 there was one loan on
nonaccrual status which was paid off in full. The gross income that would have
been recorded for the nine months ended September 30, 2004, and 2003 if the
nonaccrual loan had been current and in accordance with its original term was
insignificant. Interest recognized on the loan for the year was insignificant. Potential Problem Loans At September 30, 2004 and December 31, 2003, the Company had potential problem
loans totaling approximately $2,141,300 and $2,349,000, respectively. The
decrease was the result of a favorable reclassification of a large commercial
real estate credit partially offset by recent adverse classification of loan
credits within the Companys Auburn and Kent markets. The Company believes that
the loans are secured by sufficient collateral and guarantor financial strength
to repay the loans, although there can be no assurances given with respect to
potential losses in these -15-




---



##### Table of Contents



credits. These loans are in addition to those categorized as non-performing
listed above. Although these loans are currently classified as performing,
management has information regarding credit weakness inherent in the loans. Summary of Loan Loss Experience Changes in the Allowance for Loan Losses The activity in the allowance for loan losses is summarized in Note 6 -
Allowance for Loan Losses in the Notes to Condensed Consolidated Financial
Statements. The allowance for loan losses is increased by charges to income and decreased
by charge-offs (net of recoveries), and established through a provision for
loan losses charged to expense. Loans are charged against the allowance for
credit losses when management believes that the collectibility of the principal
is unlikely. The allowance is an amount that management believes will be
adequate to absorb losses inherent in existing loans, commitments to extend
credit and standby letters of credit based on evaluations of collectibility and
prior loss experience of loans, commitments to extend credit and standby
letters of credit. The evaluations take into consideration such factors as
changes in the nature and volume of the portfolio, overall portfolio quality,
loan concentrations, specific problem loans, commitments, standby letters of
credit and current economic conditions that may affect the borrowers ability
to pay. The majority of the Companys loan portfolio consists of commercial loans and
single-family residential loans secured by real estate in the Puyallup and
Pierce County areas and also in the Auburn, Kent and King County areas. Real
estate prices in this market are stable at this time but may weaken as a result
of a slow local and national economy. Therefore, the ultimate collectibility of
a substantial portion of the Companys loan portfolio may be susceptible to
change as local market conditions change in the future. While management uses available information to recognize losses on loans,
further reductions in the carrying amounts of loans may be necessary based on
changes in local economic conditions. In addition, regulatory agencies, as an
integral part of their examination process, periodically review the estimated
losses on loans. Such agencies may require the Company to recognize additional
losses based on their judgment about information available to them at the time
of their examination. The following table sets forth other information regarding the allowance for
loan losses for the dates indicated (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Loan Loss Experience Analysis of the Allowance for Loan LossesThree months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Average Allowance for Loan Losses
    
    $
    1,388
    
    
    $
    1,388
    
    
    $
    1,388
    
    
    $
    1,388Average Loans Outstanding
    
    $
    116,186
    
    
    $
    112,349
    
    
    $
    116,422
    
    
    $
    109,874Ratio of net charge-offs during the
period to average loans outstanding
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Ratio of average allowance for loan losses
to average loans outstanding
    
    
    1.19
    %
    
    
    1.24
    %
    
    
    1.19
    %
    
    
    1.26
    %
 The ratio of the allowance for loan losses as a percentage of loans decreased
to 1.19 percent at September 30, 2004 compared to 1.24 percent at September 30,
2003. The decrease in the ratio during the past year was due to several factors
including positive credit performance within several of the Companys larger
classified credits, no loan charge-offs, slowing loan demand, the effects of an
improving economy, and managements current evaluation of the loan portfolio.
Management continues to emphasize credit quality and carefully monitors the
loan portfolio especially given the softness within the local economy. Any
changes to the Companys loan loss allowance will be considered as
circumstances warrant. -16-




---



##### Table of Contents



Deposits The Companys primary source of funds is customer deposits. The Company
attempts to maintain a high percentage of noninterest-bearing deposits, which
are a low cost funding source. In addition, the Company offers a variety of
interest-bearing accounts designed to attract both short-term and longer-term
deposits from customers. Interest-bearing accounts earn interest at rates
established by management based on competitive market factors and the Companys
need for funds. The Company traditionally has not purchased brokered deposits
and does not intend to do so in the future. Deposits increased 6.2 percent to $167.0 million as of September 30, 2004,
compared to $157.2 million as of December 31, 2003. The increase occurred
primarily in demand deposits, money market deposits and savings deposits during
the nine months, partially offset by a decrease in time certificates of deposit
less than $100,000. The following table sets forth the balances for each major category of deposit
by amount and percent during the period indicated: VALLEY COMMUNITY BANCSHARES, INC.
Deposits
(dollars in thousands) Period ended,September 30, 2004
    
    December 31, 2003Amount
    
    Percent
    
    Amount
    
    PercentNoninterest bearing demand
    
    $
    38,210
    
    
    $
    22.9
    %
    
    $
    34,675
    
    
    
    22.1
    %Interest bearing demand
    
    
    25,978
    
    
    
    15.6
    %
    
    
    24,110
    
    
    
    15.3
    %Money market
    
    
    41,952
    
    
    
    25.1
    %
    
    
    39,018
    
    
    
    24.8
    %Savings
    
    
    18,750
    
    
    
    11.2
    %
    
    
    16,500
    
    
    
    10.5
    %Time certificates < $100,000
    
    
    20,418
    
    
    
    12.2
    %
    
    
    21,657
    
    
    
    13.8
    %Time certificates > $100,000
    
    
    21,700
    
    
    
    13.0
    %
    
    
    21,271
    
    
    
    13.5
    %$
    167,008
    
    
    $
    100.0
    %
    
    $
    157,231
    
    
    
    100.0
    %
 Liquidity and Capital Resources Management actively analyzes and manages the Companys liquidity position. The
objective of liquidity management is to ensure the availability of sufficient
cash flows to meet all financial commitments and to capitalize on opportunities
for profitable business expansion. Management believes that the Companys cash
flow will be sufficient to support its existing operations for the foreseeable
future. Cash flows from operations contribute to liquidity as well as proceeds from
maturities of securities and customer deposits. As indicated on the Companys
Condensed Consolidated Statement of Cash Flows, net cash from operating
activities for the nine months ended September 30, 2004 contributed $2.1 to
liquidity compared to $3.1 million for the nine months ended September 30,
2003. The majority of the Companys funding comes from customer deposits within
its operating region. During the nine months ended September 30, 2004 customer
deposits increased $9.8 million compared to a $13.1 million increase for the
nine months ended September 30, 2003. Other sources of liquidity include
investments in federal funds and interest-bearing deposits with banks and the
Companys securities portfolio. The Company generally maintains a ladder of
securities that provides prepayments and payments at maturity and a portfolio
of available-for-sale securities that could be converted to cash quickly.
Proceeds from maturity and sale of securities provided $11.0 million for the
nine months ended September 30, 2004 compared to $18.7 million for the nine
months ended September 30, 2003. At September 30, 2004, the Company held cash and due from banks,
interest-bearing deposits with banks, and federal funds sold of approximately
$28.6 million. In addition, at such date all of the Companys $41.7 million in
investments were classified as available for sale. The Bank has the capacity to borrow funds, up to ten percent of assets, from
the Federal Home Loan Bank of Seattle (FHLB) through pre-approved credit
lines as a secondary source of liquidity. However, these credit lines have
pledge requirements whereby the Bank must maintain unencumbered collateral with
a value at least equal to the outstanding balance. In addition to the FHLB
credit line, the Bank has committed line of credit agreements totaling
approximately $9.5 million from unaffiliated banks. At September 30, 2004, the
Bank had no advances outstanding to the FHLB or from unaffiliated banks. -17-




---



##### Table of Contents



The Bank has commitments to extend credit, which may have an impact on the
Companys liquidity position. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition
established in the commitment. Commitments generally have fixed expiration
dates. Since some commitments are expected to expire without being drawn upon,
the total commitment amounts do not represent future cash requirements. The
Company experience suggests customers draw on approximately 75 percent of loan
commitments. Commitments to extend credit at September 30, 2004 and December
31, 2003 were $22.9 and $21.5 million, respectively. The Companys total stockholders equity increased to $24.3 million at
September 30, 2004 from $23.7 million at December 31, 2003. The increase was
the result of net income earned during the nine months ended September 30, 2004
partially offset by a 60cent(s) dividend per share paid to stockholders of
record on December 31, 2003 and unrealized losses recorded on securities
available for sale, net of income tax. At September 30, 2004, stockholders
equity was 12.6 percent of total assets, compared to 13.0 percent at December
31, 2003. The market value of available-for-sale securities was higher than book value at
September 30, 2004 and at December 31, 2003. The decrease in market value was
primarily the result of higher market interest rates, which resulted in
unrealized losses in the investment portfolio. In the event market interest
rates continue to increase, the market value of the Companys investment
portfolio may continue to decrease. Because changes in the market value of
available-for-sale securities are a component of other comprehensive income,
within stockholders equity, a decrease in market value of securities would
negatively impact stockholders equity. At September 30, 2004, the Company
performed a simulation analysis of changes in the market value of the
investment portfolio given a 300 basis point increase in interest rates. The
analysis indicated a decrease in market value of approximately $1.7 million net
of federal income tax. Although stockholders equity would be reduced by
approximately 7.14 percent, the Company would still be well in excess of
capital adequacy requirements in the event the Company would be required to
liquidate these securities for unforeseen liquidity needs. Capital Adequacy Requirements The capital levels of the Company currently exceed applicable regulatory
guidelines, and the Bank is qualified as well-capitalized at September 30,
2004. Management believes that under the current regulations the Bank will
continue to meet well-capitalized capital requirements in the foreseeable
future. However, events beyond the control of the Bank such as a downturn in
the economy where the Bank have most of their loans, could adversely affect
future earnings and, consequently, the ability of the Bank to meet future
well-capitalized capital requirements. For a full discussion of capital adequacy requirements, refer to the Companys
annual report on Form 10-K for the year ended December 31, 2003. The capital amounts and ratios for the Company and the Bank as of September 30,
2004, are presented in the following table (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Capital To Be WellCapitalized UnderFor Capital
    
    Prompt CorrectiveActual
    
    Adequacy Purposes
    
    Action ProvisionsAs of September 30, 2004
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioTotal Capital(to Risk-Weighted Assets)Consolidated
    
    $
    25,379
    
    
    
    18.8%      3
    
    
    $
    10,801
    
    
    
    8.0%      3
    
    
    $
    13,502
    
    
    
    10.0
    %Valley Bank
    
    $
    23,499
    
    
    
    17.4%      3
    
    
    $
    10,801
    
    
    
    8.0%      3
    
    
    $
    13,502
    
    
    
    10.0
    %Tier I Capital(to Risk-Weighted Assets)Consolidated
    
    $
    23,991
    
    
    
    17.8%      3
    
    
    $
    5,401
    
    
    
    4.0%      3
    
    
    $
    8,101
    
    
    
    6.0
    %Valley Bank
    
    $
    22,111
    
    
    
    16.4%      3
    
    
    $
    5,401
    
    
    
    4.0%      3
    
    
    $
    8,101
    
    
    
    6.0
    %Tier I Capital(to Average Assets)Consolidated
    
    $
    23,991
    
    
    
    12.8%      3
    
    
    $
    7,471
    
    
    
    4.0%      3
    
    
    $
    9,339
    
    
    
    5.0
    %Valley Bank
    
    $
    22,111
    
    
    
    11.8%      3
    
    
    $
    7,471
    
    
    
    4.0%      3
    
    
    $
    9,339
    
    
    
    5.0
    %
 -18-




---



##### Table of Contents



Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys results of operation are dependent upon its ability to manage
interest rate risk. Management considers interest rate risk to be a significant
risk that could have a material effect on the Companys financial condition and
results of operations. The Company does not currently use derivatives to manage
market and interest rate risk. A number of measures are used to monitor and manage interest rate risk,
including income simulations and interest sensitivity (gap) analyses. An
income simulation model is the primary tool used to assess the direction and
magnitude of changes in net interest income resulting from changes in interest
rates. Key assumptions in the model include repayment speeds on certain
assets, cash flows and maturities of other investment securities, loan and
deposit volumes and pricing. These assumptions are inherently uncertain and,
as a result, the model cannot precisely estimate net interest income or
precisely predict the impact of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to timing, magnitude and
frequency of interest rate changes and changes in market conditions and
management strategies, among other factors. At September 30, 2004, based on
the measures used to monitor and manage interest rate risk, there has not been
a material change in the Companys interest rate risk since December 31, 2003.
For additional information, refer to the Companys annual report on Form 10-K
for the year ended December 31, 2003. 
 Item 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the
Companys disclosure controls and procedures (as defined in Section 13(a)-14(c)
of the Securities Exchange Act of 1934 (the Act)) was carried out under the
supervision and with the participation of the Companys Chief Executive
Officer, Chief Financial Officer and several other members of the Companys
senior management as of September 30, 2004. The Companys Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures as currently in effect are effective in ensuring that
the information required to be disclosed by the Company in the reports it files
or submits under the Act is (i) accumulated and communicated to the Companys
management (including the Chief Executive Officer and Chief Financial Officer)
in a timely manner, and (ii) recorded, processed, summarized and reported
within the time period specified in the SECs rules and forms. (b) Changes in Internal Controls: In the quarter ended September 30, 2004, the
Company did not make any significant changes in, nor take any corrective
actions regarding, its internal controls or other factors that has materially
affected or is reasonably likely to affect these controls. Limitations on the Effectiveness of Controls.The Companys management,
including the CEO and CFO, does not expect that our Disclosure Controls or our
Internal Controls will prevent all error and all fraud. A control system, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the company have been detected. These
inherent limitations include the realities that judgments in decision-making
can be faulty, and that breakdowns can occur because of simple error or
mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control. The design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions; over time, control may become inadequate because
of changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur
and not be detected. -19-




---



##### Table of Contents



FORWARD-LOOKING STATEMENTS This quarterly report on Form 10-Q includes forward-looking statements about
the future operations of the Company. These forward-looking statements involve
certain risks and uncertainties that could cause actual results to differ
materially from those in the forward-looking statements. Such risks and
uncertainties include, but are not limited to, the following factors:
unforeseen legal proceedings, unexpected costs in connection with internet
banking initiative, competitive pressure in the banking industry significantly
increasing; increases or decreases in the interest rate environment reducing
margins; general economic conditions, either nationally or regionally, are less
favorable than expected, resulting in, among other things, a deterioration in
credit quality and an increase in the provision for possible loan losses;
changes in the regulatory environment; loan delinquency rates; changes in
business conditions; volatility of rate sensitive deposits; operational risks
including data processing system failures or fraud; asset/liability matching
risks and liquidity risks; and changes in the securities markets. Because of
these uncertainties, actual future results may be materially different from the
results indicated by these forward-looking statements. In addition, the
Companys past results do not necessarily indicate its future results. See also
the risk factors in the Companys 2003 Annual Report on Form 10-K. 
 PART II   OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS The Company faces ordinary routine litigation arising in the normal course of
business. In the opinion of management, liabilities (if any) arising from such
claims will not have a material adverse effect upon the business, results of
operations or financial condition of the Company. 
 Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable 
 Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable 
 Item 5. OTHER INFORMATION Not applicable. -20-




---



##### Table of Contents



Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits  3.1
    
    Articles of Incorporation of Valley Community Bancshares, Inc.
*3.2
    
    Restated Bylaws of Valley Community Bancshares, Inc. ^10.
    
    Material contracts of Valley Community Bancshares, Inc.  10.1
    
    Severance agreement for Mr. Brown *10.2
    
    Severance agreement for Mr. Thompson *10.3
    
    Severance agreement for Mr. Riordan *10.4
    
    Deferred Compensation Agreement for Mr. Brown *10.5
    
    Deferred Compensation Agreement for Mr. Thompson #10.6
    
    1998 Stock Option Plan *10.7
    
    401(k) Defined Contribution Plan and Noncontributory Profit Sharing Plan Adoption Agreement *  31.
    
    Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  31.1
    
    Certification of Chief Executive Officer31.2
    
    Certification of Chief Financial Officer  32.
    
    Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  *
    
    Incorporated by reference to the Exhibits set forth on Registrants
Amended Registration Statement on Form 10 filed with the Securities and
Exchange Commission on September 6, 2000.#
    
    Incorporated by reference to the Exhibits set forth on Registrants 2000
Annual Report on Form 10-K filed with the Securities and Exchange
Commission on March 27, 2001.^
    
    Incorporated by reference to the Exhibits set forth on Registrants June
2002 Quarterly Report on Form 10-Q filed with the Securities and Exchange
Commission on August 9, 2002. (b) Reports on Form 8-K The Company filed a current report on Items 7 and 12 of Form 8-K on August 2,
2004. The report included a press release announcing financial results for the
three months and six months ended June 30, 2004. The Company filed a current report on Item 5.02 of Form 8-K on September 24,
2004. The report included a statement regarding the retirement of Director
Warren Hunt on September 22, 2004. -21-




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. VALLEY COMMUNITY BANCSHARES, INC.
                    (Registrant) Date:
    
    November 1, 2004
    
    By /s/           David H. BrownDavid H. BrownPresident andChief Executive OfficerDate:
    
    November 1, 2004
    
    By /s/          Joseph E. RiordanJoseph E. RiordanExecutive Vice President andChief Financial Officer
 -22-