##### 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 March 31, 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 x 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 x The number of shares of the issuers Common Stock, $1.00 par value,
outstanding at May 4, 2004 was 1,238,083.




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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
INDEX TO QUARTERLY REPORT ON FORM 10-Q PART I FINANCIAL INFORMATION PageItem 1. Financial StatementsCondensed Consolidated Balance Sheet March 31, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statement of Income  Three Months
Ended March 31, 2004 and 2003
    
    
    2Condensed Consolidated Statement of Cash Flows  Three Months
Ended March 31, 2004 and 2003
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition
And Results of Operation
    
    
    9Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    21Item 4. Controls and Procedures
    
    
    21FORWARD-LOOKING STATEMENTS
    
    
    22PART II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    22Item 2. Changes in Securities and Use of Proceeds
    
    
    22Item 3. Defaults upon Senior Securities
    
    
    22Item 4. Submission of Matters to a Vote of Security Holders
    
    
    22Item 5. Other Information
    
    
    22Item 6. Exhibits and Reports on Form 8-K
    
    
    23Signatures
    
    
    24Certifications
    
    
    25EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32
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Item 1. FINANCIAL STATEMENTS 
 VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
(dollars in thousands) March 31,
    
    December 31,2004
    
    2003ASSETSCash and due from banks
    
    $
    5,270
    
    
    $
    5,199Interest-bearing deposits with banks
    
    
    9,275
    
    
    
    8,503Federal funds sold
    
    
    4,835
    
    
    
    9,765Securities available-for-sale
    
    
    37,019
    
    
    
    38,560Federal Home Loan Bank stock
    
    
    371
    
    
    
    37256,770
    
    
    
    62,399Loans
    
    
    115,976
    
    
    
    114,261Less allowance for loan losses
    
    
    1,388
    
    
    
    1,388Loans, net
    
    
    114,588
    
    
    
    112,873Accrued interest receivable
    
    
    730
    
    
    
    681Premises and equipment, net
    
    
    5,820
    
    
    
    5,850Other assets
    
    
    401
    
    
    
    417Total assets
    
    $
    178,309
    
    
    $
    182,220LIABILITIESDeposits
Noninterest-bearing
    
    $
    32,921
    
    
    $
    34,675Interest-bearing
    
    
    120,215
    
    
    
    122,556Total deposits
    
    
    153,136
    
    
    
    157,231Other borrowed funds
    
    
    557
    
    
    
    580Accrued interest payable
    
    
    146
    
    
    
    145Other liabilities
    
    
    975
    
    
    
    611Total liabilities
    
    
    154,814
    
    
    
    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 March 31, 2004 and December 31, 2003, respectively.
    
    
    1,238
    
    
    
    1,175Additional paid-in capital
    
    
    18,760
    
    
    
    16,903Retained earnings
    
    
    3,085
    
    
    
    5,204Accumulated other comprehensive income, net of tax
    
    
    412
    
    
    
    371Total stockholders equity
    
    
    23,495
    
    
    
    23,653Total liabilities and stockholders equity
    
    $
    178,309
    
    
    $
    182,220
 The accompanying notes are an integral part of these financial statements -1-




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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(unaudited)
(dollars in thousands, except for per share amounts) Three Months EndedMarch 31,2004
    
    2003INTEREST INCOMEInterest and fees on loans
    
    $
    1,845
    
    
    $
    1,904Interest on federal funds sold and deposits in banks
    
    
    63
    
    
    
    92Interest on securities
    
    
    285
    
    
    
    293Total interest income
    
    
    2,193
    
    
    
    2,289INTEREST EXPENSEInterest on deposits
    
    
    220
    
    
    
    377Interest on federal funds and other short-term borrowings
    
    
    1
    
    
    
    2Total interest expense
    
    
    221
    
    
    
    379Net interest income
    
    
    1,972
    
    
    
    1,910PROVISION FOR LOAN LOSSESNet interest income after provision
for loan losses
    
    
    1,972
    
    
    
    1,910NONINTEREST INCOMEService charges
    
    
    105
    
    
    
    115Gain on sale of investment securities, net
    
    
    42
    
    
    
    15Origination fees on mortgage loans brokered
    
    
    28
    
    
    
    124Other operating income
    
    
    101
    
    
    
    85Total noninterest income
    
    
    276
    
    
    
    339NONINTEREST EXPENSESalaries
    
    
    666
    
    
    
    681Employee benefits
    
    
    177
    
    
    
    176Occupancy
    
    
    140
    
    
    
    139Equipment
    
    
    115
    
    
    
    111Other operating expenses
    
    
    474
    
    
    
    497Total noninterest expense
    
    
    1,572
    
    
    
    1,604INCOME BEFORE INCOME TAX
    
    
    676
    
    
    
    645PROVISION FOR INCOME TAX
    
    
    208
    
    
    
    200NET INCOME
    
    $
    468
    
    
    $
    445EARNINGS PER SHAREBasic
    
    $
    0.38
    
    
    $
    0.36Diluted
    
    $
    0.38
    
    
    $
    0.36Weighted average shares outstanding
    
    
    1,236,277
    
    
    
    1,230,123Weighted average diluted shares outstanding
    
    
    1,245,304
    
    
    
    1,235,064
 The accompanying notes are an integral part of these financial statements -2-




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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
(dollars in thousands, except for per share amounts) Three Months EndedMarch 31,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    468
    
    
    $
    445Adjustments to reconcile net income to net cash from operating activities:Depreciation
    
    
    117
    
    
    
    114Deferred income tax
    
    
    (11
    )
    
    
    4Net amortization on securities
    
    
    68
    
    
    
    77FHLB stock dividends
    
    
    (4
    )
    
    
    (7
    )Gain on sale of securities available-for-sale
    
    
    (42
    )
    
    
    (15
    )Amortization of intangible assets
    
    
    10
    
    
    
    12Changes in operating assets and liabilities:(Increase) decrease in accrued interest receivable
    
    
    (49
    )
    
    
    20Increase in accrued interest payable
    
    
    1
    
    
    
    8(Increase) decrease in other assets
    
    
    (1
    )
    
    
    23Increase (decrease) in other liabilities
    
    
    353
    
    
    
    (5
    )Net cash from operating activities
    
    
    910
    
    
    
    676Net decrease (increase) in federal funds sold
    
    
    4,930
    
    
    
    (132
    )Net decrease (increase) in interest-bearing deposits with banks
    
    
    (772
    )
    
    
    8,537Purchase of securities available-for-sale
    
    
    (3,963
    )
    
    
    (12,182
    )Proceeds from sales of securities available-for-sale
    
    
    1,044
    
    
    
    2,672Proceeds from maturities of securities available-for-sale
    
    
    4,496
    
    
    
    5,611Federal Home Loan Bank stock redeemed
    
    
    5
    
    
    
    7Net increase in loans
    
    
    (1,715
    )
    
    
    (3,212
    )Additions to premises and equipment
    
    
    (80
    )
    
    
    (25
    )Net cash from investing activities
    
    
    3,945
    
    
    
    1,276CASH FLOWS FROM FINANCING ACTIVITIESNet increase (decrease) in deposits
    
    
    (4,095
    )
    
    
    758Net decrease in other borrowed funds
    
    
    (23
    )
    
    
    (319
    )Cash dividends paid
    
    
    (715
    )
    
    
    (675
    )Stock options exercised
    
    
    49Net cash from financing activities
    
    
    (4,784
    )
    
    
    (236
    )NET INCREASE IN CASH AND DUE FROM BANKS
    
    
    71
    
    
    
    1,716CASH AND DUE FROM BANKS, beginning of year
    
    
    5,199
    
    
    
    4,847CASH AND DUE FROM BANKS, at end of period
    
    $
    5,270
    
    
    $
    6,563SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONCash payments
forInterest
    
    $
    220
    
    
    $
    371Income taxes
    
    
    35SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIESUnrealized gains (losses) on securities available-for-sale
    
    $
    62
    
    
    $
    (88
    )Deferred tax on unrealized (gains) losses on securities available-for-sale
    
    
    (21
    )
    
    
    30Distribution of five percent stock dividend
    
    
    1,871
    
    
    
    1,389
 The accompanying notes are an integral part of these financial statements -3-




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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1  Basis of Presentation Valley Community Bancshares, Inc. (the Company) prepared the condensed
consolidated financial statements of the Company for the three-month periods
ended March 31, 2004 and March 31, 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 ended March 31, 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. The preparation of the 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 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. 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. VALLEY COMMUNITY BANCSHARES, INC.Stock Option Plan
    
    Three Months EndedIn thousands, except for per-share amounts
    
    March 31,2004
    
    2003Pro forma disclosures:Net income as reported
    
    $
    468
    
    
    $
    445Additional compensation for fair
value of stock options
    
    
    6
    
    
    
    3Pro forma net income
    
    $
    462
    
    
    $
    442Earnings per share:BasicAs reported
    
    $
    0.38
    
    
    $
    0.36Pro forma
    
    $
    0.37
    
    
    $
    0.36DilutedAs reported
    
    $
    0.38
    
    
    $
    0.36Pro forma
    
    $
    0.37
    
    
    $
    0.36
 -4-




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Note 2  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 ended March 31, 2004 and 2003 (dollars in
thousands, except per share amounts): VALLEY COMMUNITY BANCSHARES, INC.Earnings Per ShareThree Months EndedMarch 31,2004
    
    2003NUMERATOR:Net income
    
    $
    468
    
    
    $
    445DENOMINATOR:Denominator for basic earnings per share:Weighted average shares
    
    
    1,236,277
    
    
    
    1,230,123Effect of diluted securities  stock options
    
    
    9,027
    
    
    
    4,941Denominator for diluted earnings per share:Weighted average shares and assumed
conversion of diluted stock options
    
    
    1,245,304
    
    
    
    1,235,064Basic earnings per share
    
    $
    0.38
    
    
    $
    0.36Diluted earnings per share
    
    $
    0.38
    
    
    $
    0.36
 Note 3 Comprehensive Income Total comprehensive income, which includes net income and unrealized gains and
losses on the Companys available-for-sale securities, amounted to $509,000 and
$387,000, respectively, for the three months ended March 31, 2004 and 2003,
respectively. Note 4  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): March 31, 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
    
    $
    11,520
    
    
    $
    86
    
    
    $
    1
    
    
    $
    
    
    
    $
    11,605State and political subdivisions
    
    
    8,194
    
    
    
    376
    
    
    
    4
    
    
    
    
    
    
    
    8,566Mortgage-backed securities
    
    
    16,681
    
    
    
    180
    
    
    
    13
    
    
    
    
    
    
    
    16,848$
    36,395
    
    
    $
    642
    
    
    $
    18
    
    
    $
    
    
    
    $
    37,019
 -5-




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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 March 31, 2004 and December 31, 2003, there were approximately 13 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 5  Loans The major classifications of loans at March 31, 2004 and December 31, 2003 are
summarized as follows (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Loan Portfolio
(dollars in thousands) March 31,
    
    December 31,2004
    
    2003Amount
    
    Percent
    
    Amount
    
    PercentReal
EstateConstruction
    
    $
    10,381
    
    
    
    8.9
    %
    
    $
    9,913
    
    
    
    8.7
    %Residential
    
    
    11,811
    
    
    
    10.3
    %
    
    
    12,095
    
    
    
    10.6
    %Commercial
    
    
    64,280
    
    
    
    55.3
    %
    
    
    65,114
    
    
    
    56.9
    %Commercial
    
    
    26,045
    
    
    
    22.4
    %
    
    
    24,872
    
    
    
    21.7
    %Consumer and other
    
    
    3,589
    
    
    
    3.1
    %
    
    
    2,409
    
    
    
    2.1
    %Lease financing
    
    
    58
    
    
    
    0.0
    %
    
    
    63
    
    
    
    0.0
    %Total loans
    
    
    116,164
    
    
    
    100.0
    %
    
    
    114,466
    
    
    
    100.0
    %Deferred loan fees
    
    
    (188
    )
    
    
    
    
    
    
    (205
    )Net loans
    
    $
    115,976
    
    
    
    
    
    
    $
    114,261
 Note 6  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 March 31, 2004 and December 31, 2003, totaled
$1,388,000. Management believes that the allowance for loan losses at March 31,
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. -6-




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The following table summarizes the activity in the allowance for loan losses
(dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Loan Loss Experience Three months March 31,2004
    
    2003Balance at beginning of period
    
    $
    1,388
    
    
    $
    1,388Charge-offs
Recoveries:Net recoveries
    
    
    -0-
    
    
    
    -0-Additions charged to operationsBalance at end of period
    
    $
    1,388
    
    
    $
    1,388
 Note 7  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-month period ended March 31, 2004 and 2003. Note 8  Recent Accounting Pronouncements The following accounting pronouncements were recently issued by the Financial
Accounting Standards Board (FASB) and Accounting Standards Executive
Committee (AcSEC) of the American Institute of Certified Public Accountants. In December 2003, the FASB amended FASB Statement No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefitsan amendment of
FASB Statements No. 87, 88, and 106.This Statement revises employers
disclosures about pension plans and other postretirement benefit plans. It does
not change the measurement or recognition of those plans required by FASB
Statements No. 87, Employers Accounting for Pensions, No. 88, Employers
Accounting for Settlements and Curtailments of Defined Benefit Pension Plans
and for Termination Benefits, and No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. This Statement retains the
disclosure requirements contained in FASB Statement No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefits, which it
replaces. It requires additional disclosures to those in the original Statement
132 about the assets, obligations, cash flows, and net periodic benefit cost of
defined benefit pension plans and other defined benefit postretirement plans.
The required information should be provided separately for pension plans and
for other postretirement benefit plans. This Statement is effective for
financial statements with fiscal years ending after December 15, 2003. The
interim-period disclosures required by this Statement are effective for interim
periods beginning after December 15, 2003. This statement did not result in a
material impact of the Companys financial position or results of operation. In December 2003, the FASB issued a revision of FIN 46 (FIN 46®) which
replaced the Interpretation issued in January 2003. The revised Interpretation
clarifies some of the provisions of FIN 46 and provides additional exemptions
for certain entities. The provisions of FIN 46® are required to be adopted
for periods ending after March 15, 2004. -7-




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The adoption of FIN 46® did not have a material impact on the Companys
financial condition, results of operations or cash flows. In December 2003, AcSEC issued Statement of Position (SOP) 03-3, Accounting
for Certain Loans or Debt Securities Acquired in a Transfer. The SOP is
effective for loans acquired in fiscal years beginning after December 15, 2004,
with earlier application encouraged. A certain transition provision applies for
certain aspects of loans currently within the scope of Practice Bulletin 6,
Amortization of Discounts on Certain Acquired Loans. The SOP addresses
accounting for differences between contractual cash flows and cash flows
expected to be collected from an investors initial investment in loans or debt
securities (loans) acquired in a transfer if those differences are
attributable, at least in part, to credit quality. Loans acquired in business
combinations are included in the scope of the SOP. The SOP does not apply to
loans originated by the entity. The Company has not yet adopted the provisions
of the SOP and does not expect them to have a material impact on the Companys
financial condition, results of operations or cash flows. -8-




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Valley Community Bancshares, Inc. Valley Community Bancshares, Inc. (the Company) is a bank holding company
registered under the Bank Holding Company Act of 1956, as amended. The Company
was organized and incorporated under the laws of the State of Washington as a
holding company for its principal banking subsidiary, Valley Bank, a state
chartered, Federal Deposit Insurance Corporation (the FDIC) insured
commercial bank, through a reorganization completed on July 1, 1998.
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 Valley 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 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 offer 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. Valley Bank Valley Bank is a Washington state-chartered commercial bank, which commenced
operations as Puyallup Valley Bank in October 1973. In January 1999 the
Company opened Valley Bank, a state chartered FDIC insured commercial bank
subsidiary located in Auburn, Washington. On January 17, 2003, Puyallup Valley
Bank and Valley Bank merged and renamed the resulting institution Valley Bank. The Bank provides full-service banking to businesses and residents within the
Puyallup, Auburn and Kent communities and its surrounding areas. The Bank
places particular emphasis on serving the small to medium-sized business
segment of the market by making available a line of banking products tailored
to their needs, with those services delivered by experienced professionals
concerned with building long-term relationships. The Bank conducts business out
of eight full-service offices and one drive-up facility. The Bank also provides mortgage banking services to its customers through Puget
Sound Mortgage Brokers. The Bank purchased various tangible and intangible
assets of Puget Sound Mortgage Brokers, Inc., a Washington Corporation on May
16, 2002. The mortgage operation is operated as a division of the Bank and
operates in a leased facility in Puyallup. Valley Bank is a wholly owned subsidiary of the Company. -9-




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##### Table of Contents



Results of Operations The Companys net income is derived principally from the operating results of
its banking subsidiary Valley Bank. Valley Bank is a well-established
commercial bank and generates substantially all of the Companys operating
income. The Company earned net income of $468,000 or $0.38 per diluted share for the
three months ended March 31, 2004, compared to net income of $445,000 or $0.36
per diluted share, for the three months ended March 31, 2003, an increase of
5.2 percent. The Companys return on average assets was 1.05 percent for the
three months ended March 31, 2004, compared to 1.04 percent for the three
months ended March 31, 2003. The improvement in net income for the three months ended March 31, 2004 was the
result of an increase in net interest income and a decrease in non-interest
expense partially offset by a decrease in non-interest income. The major
reasons for the quarterly change are as follows:  
    
    A higher volume of earning assets along with continued reduction in
deposit interest expense was primarily responsible for the increase in
net interest income during the first quarter of 2004 when compared to
the same period a year ago.
    
    Non-interest expense was higher in 2003, when compared to 2004,
largely as a result of non-recurring merger related expenses (between
Puyallup Valley Bank and Valley Bank) incurred in 2003.
    
    Non-interest income decreased during 2004 as a result of a significant
reduction in origination fees on mortgage loans brokered as
residential loan customers slowed their mortgage refinancing activity. The Company anticipates higher non-interest expenses during the second quarter
of 2004 as the implementation of the Banks internet banking product is
completed. 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 following table shows the various performance ratios for the Company for
the three months ended March 31, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC.
Selected Financial Data 1
(dollars in thousands, except per share amounts) Three Months Ended March 31,2004
    
    2003Financial PerformanceNet Income
    
    $
    468
    
    
    $
    445Average Assets
    
    
    178,818
    
    
    
    172,730Average Stockholders Equity
    
    
    23,509
    
    
    
    22,112Return on Assets (net income divided by average assets)
    
    
    1.05
    %
    
    
    1.04
    %Return on Equity (net income divided by average equity)
    
    
    8.01
    %
    
    
    8.16
    %Net Interest Margin (net interest income (tax adjusted)
Divided by earning assets)
    
    
    4.84
    %
    
    
    4.92
    %Efficiency Ratio (noninterest expense divided by
noninterest income plus net interest income)
    
    
    69.93
    %
    
    
    71.32
    %Ratio of noninterest income to average assets
    
    
    3.54
    %
    
    
    3.77
    %
 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.   1 The 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. -10-




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##### Table of Contents



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 March 31,2004
    
    2003Interest income, as reported
    
    $
    2,193
    
    
    $
    2,289Effect of tax exempt income
    
    
    39
    
    
    
    32TE interest income
    
    
    2,232
    
    
    
    2,321Interest expense
    
    
    221
    
    
    
    379TE net interest income
    
    $
    2,011
    
    
    $
    1,942
 TE net interest income, divided by average earning assets is referred to as net
interest margin. For the three months ended March 31, 2004 the Companys net
interest margin was 4.84 percent compared to 4.92 percent for the three months
ended March 31, 2003. TE net interest income was $2,011,000 for the three
months ended March 31, 2004 compared to $1,942,000 for the three months ended
March 31, 2003. The increase in TE net interest income, for the three months
ended March 31, 2004 compared to the same period a year ago, was the result of
earnings realized on a higher volume of earning assets and a continued
reduction in deposit interest expense, partially offset by a reduction in the
interest rate earned on earning assets. TE interest income was $2,232,000 for the three months ended March 31, 2004
compared to $2,321,000 for the three months ended March 31, 2003. The
three-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 5.37 percent for the three months ended March 31, 2004 compared to
5.88 percent during the same period a year ago. The yield decrease reflects an
overall decline in market interest rates. Interest expense was $221,000 for the three months ended March 31, 2004
compared to $379,000 for the three months ended March 31, 2003. The cost of
funds decreased to 0.74 percent for the three months ended March 31, 2004
compared to 1.28 percent during the same period a year ago. The decrease for
the three-month period was due to a decrease in the Companys cost of funds
resulting from an overall decline in market interest rates. 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. This 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 are somewhat
limited. -11-




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##### 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 three months ended March 31, 2004 and 2003: VALLEY COMMUNITY BANCSHARES, INC.
AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands) For the Three Months Ended March 31,2004
    
    2003Average
    
    Revenue/
    
    Yield/
    
    Average
    
    Revenue/
    
    Yield/Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateASSETSInterest-earning
assetsLoans (including fees) 1
    
    $
    115,386
    
    
    $
    1,845
    
    
    
    6.43
    %
    
    $
    106,906
    
    
    $
    1,904
    
    
    
    7.22
    %Investment securities 2 3
    
    
    37,097
    
    
    
    324
    
    
    
    3.51
    %
    
    
    31,626
    
    
    
    318
    
    
    
    4.08
    %Interest bearing deposits with banks
    
    
    9,266
    
    
    
    48
    
    
    
    2.08
    %
    
    
    19,549
    
    
    
    87
    
    
    
    1.80
    %Federal funds sold
    
    
    4,983
    
    
    
    11
    
    
    
    0.89
    %
    
    
    1,678
    
    
    
    5
    
    
    
    1.21
    %Federal Home Loan Bank Stock
    
    
    368
    
    
    
    4
    
    
    
    4.37
    %
    
    
    393
    
    
    
    7
    
    
    
    7.22
    %Total Interest-earning assets
    
    
    167,100
    
    
    
    2,232
    
    
    
    5.37
    %
    
    
    160,152
    
    
    
    2,321
    
    
    
    5.88
    %Total noninterest-earning assets
    
    
    11,718
    
    
    
    
    
    
    
    
    
    
    
    12,578TOTAL ASSETS
    
    $
    178,818
    
    
    
    
    
    
    
    
    
    
    $
    172,730Interest-bearing
liabilitiesDeposits
    
    $
    120,114
    
    
    $
    220
    
    
    
    0.74
    %
    
    $
    119,163
    
    
    $
    377
    
    
    
    1.28
    %Other borrowed funds
    
    
    419
    
    
    
    1
    
    
    
    0.96
    %
    
    
    484
    
    
    
    2
    
    
    
    1.68
    %Total Interest-bearing liabilities
    
    
    120,533
    
    
    
    221
    
    
    
    0.74
    %
    
    
    119,647
    
    
    
    379
    
    
    
    1.28
    %Noninterest-bearing liabilities
    
    
    34,776
    
    
    
    
    
    
    
    
    
    
    
    30,971Stockholders equity
    
    
    23,509
    
    
    
    
    
    
    
    
    
    
    
    22,112TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    178,818
    
    
    
    
    
    
    
    
    
    
    $
    172,730Net interest spread
    
    
    
    
    
    $
    2,011
    
    
    
    4.63
    %
    
    
    
    
    
    $
    1,942
    
    
    
    4.59
    %Margin
AnalysisTE interest income/earning assets
    
    
    
    
    
    $
    2,232
    
    
    
    5.37
    %
    
    
    
    
    
    $
    2,321
    
    
    
    5.88
    %Interest expense/earning assets
    
    
    
    
    
    
    221
    
    
    
    0.53
    %
    
    
    
    
    
    
    379
    
    
    
    0.96
    %Net interest margin
    
    
    
    
    
    $
    2,011
    
    
    
    4.84
    %
    
    
    
    
    
    $
    1,942
    
    
    
    4.92
    %
   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. -12-




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The following table sets forth information concerning the Companys change in
TE net interest income for the periods that are attributable to changes in
interest rate and changes in volume for the three month period ended March 31,
2004 compared to the three month period ended March 31, 2003: VALLEY COMMUNITY BANCSHARES, INC.
Volume/Rate Analysis 1  For the Three Months ended March 31,
(dollars in thousands) 2004 Compared to 2003Volume
    
    Rate
    
    NetTE Interest
incomeLoans (including fees) 2
    
    $
    152
    
    
    $
    (211
    )
    
    $
    (59
    )Investment securities 3
    
    
    53
    
    
    
    (47
    )
    
    
    6Interest bearing deposits with banks
    
    
    (52
    )
    
    
    13
    
    
    
    (39
    )Federal funds sold
    
    
    8
    
    
    
    (2
    )
    
    
    6Federal Home Loan Bank Stock
    
    
    
    
    
    
    (3
    )
    
    
    (3
    )161
    
    
    
    (250
    )
    
    
    (89
    )Interest-bearing
liabilitiesTotal deposits
    
    
    3
    
    
    
    (160
    )
    
    
    (157
    )Other borrowed funds
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )3
    
    
    
    (161
    )
    
    
    (158
    )$
    158
    
    
    $
    (89
    )
    
    $
    69
 Provision for loan losses Provisions for loan losses reduce net interest income. The Company provided $0
for loan losses for the three months ended March 31, 2004 and 2003. Management believes the amount of the allowance for loan losses to be adequate
to absorb losses in the current portfolio. This statement 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 $276,000 for the three months ended March 31, 2004, a
18.6 percent decrease from $339,000 for the three months ended March 31, 2003.
The decrease in noninterest income for the three-month period ended March 31,
2004 was the result of lower loan origination fees on mortgage loans brokered,
partially offset by gains realized on the sale of investment securities and
increased other operating income. 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.   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%. -13-




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##### Table of Contents



The following table sets forth information concerning the various components of
the Companys noninterest income for the three months ended March 31, 2004 and
2003, respectively: VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Income
(dollars in thousands) Three Months Ended March 31,2004
    
    2003Noninterest IncomeService charges
    
    $
    105
    
    
    $
    115Gain on sale of investment securities, net
    
    
    42
    
    
    
    15Origination fees on mortgage loans brokered
    
    
    28
    
    
    
    124Mutual fund and insurance commissions
    
    
    21
    
    
    
    9Customer check charges
    
    
    11
    
    
    
    4ATM and debit card
    
    
    32
    
    
    
    31Merchant bank card income, net
    
    
    12
    
    
    
    15Other
    
    
    25
    
    
    
    26Total noninterest income
    
    $
    276
    
    
    $
    339
 Noninterest expense was $1,572,000 for the three months ended March 31, 2004, a
2.0 percent decrease from $1,604,000 for the three months ended March 31, 2003.
The decrease in noninterest expense for the three-month period ended March 31,
2004 was primarily the result of decreased salaries and employee benefits and
from lower professional fees. The decrease in salaries and benefits was the
result of decreased commissions paid to residential mortgage originators
resulting from a drop in mortgage refinancing activity. The decrease in
professional fees in 2004 occurred largely as a result of non-recurring merger
related expenses (between Puyallup Valley Bank and Valley Bank) that were paid
in 2003. The percentage of noninterest expense to average assets was 3.54
percent for the three months ended March 31, 2004, compared to 3.77 percent
during the same period last year The following table sets forth information concerning the various components of
the Companys noninterest expense for the three months ended March 31, 2004 and
2003, respectively: VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Expense
(dollars in thousands) Three Months Ended March 31,2004
    
    2003Noninterest ExpenseSalaries
    
    $
    666
    
    
    $
    681Employee benefits
    
    
    177
    
    
    
    176Occupancy
    
    
    140
    
    
    
    139Equipment
    
    
    115
    
    
    
    111Operating
    
    
    130
    
    
    
    139Software
    
    
    50
    
    
    
    53Advertising and marketing
    
    
    29
    
    
    
    31Professional
    
    
    60
    
    
    
    81Directors
    
    
    28
    
    
    
    28ATM and debit card
    
    
    35
    
    
    
    31Business and occupation tax
    
    
    32
    
    
    
    33Other
    
    
    110
    
    
    
    101Total noninterest expense
    
    $
    1,572
    
    
    $
    1,604
 The Companys efficiency ratio, which is the ratio of noninterest expense to
net interest income plus noninterest income, was 69.9 percent for the three
months ended March 31, 2004 compared to 71.3 percent for the three months ended
March 31, 2003. The decrease in the ratio was primarily due to an increase in
net interest income and a decrease in noninterest expense, partially offset by
a decrease in noninterest income. Provision for income tax The Companys provision for income tax is a significant reduction of operating
income. The provision for the three months March 31, 2004, was $208,000
compared to $200,000 for the three month ended March 31, 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. -14-




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##### Table of Contents



Financial Condition The Companys total consolidated assets decreased 2.1 percent to $178.3 million
as of March 31, 2004, compared to $182.2 million as of December 31, 2003. Loans
increased and deposits decreased 1.5 percent and 2.6 percent, respectively
during the three month period ended March 31, 2004. The decrease in deposits
was funded by a draw down of federal funds sold. Stockholders equity decreased
slightly as a result of the payment of a 60¢ per share cash dividend to
stockholders partially offset by earnings during the three-month period ended
March 31, 2004 and a increase in other comprehensive income. Investment Portfolio The major classifications of investments at March 31, 2004 and December 31,
2003, are summarized in Note 4  Investment Securities in the Notes to
Condensed Consolidated Financial Statements. At March 31, 2004, the Company had $37.0 million of securities
available-for-sale, compared to $38.6 million as of December 31, 2003. The
Company purchased approximately $4.0 million in securities this year, although
investment securities decreased by $1.5 million during 2004. They were funded
primarily with $5.5 million of securities either maturing or sold during 2004. At March 31, 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. Loan Portfolio The major classifications of loans at March 31, 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 March 31, 2004. They include loans to medical doctors and dentists in the
amount of approximately $23.1 million. Loans were $116.0 million as of March 31, 2004, compared to $114.3 million as
of December 31, 2003, an increase of 1.5 percent. The increase was primarily in
real estate construction and real estate commercial loans, partially offset by
a decrease in real estate mortgage loans. The percentage of loans to total
assets increased to 65.0 percent at March 31, 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. -15-




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##### Table of Contents



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 March 31,
    
    December 31,2004
    
    2003Non-performing assets:Nonaccrual loans
    
    $
    10
    
    
    $
    10Loans
90 days or more past dueRestructured loans10
    
    
    
    10Other real estate ownedTotal non-performing assets
    
    $
    10
    
    
    $
    10
 As of March 31, 2004, the Company had $10,000 in 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 three-month periods ended March 31, 2004, and 2003 there was one
loan on nonaccrual status. The gross income that would have been recorded for
the three-month periods ended March 31, 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 March 31, 2004 and December 31, 2003, the Company had two potential problem
commercial real estate loans totaling approximately $2,342,000 and $2,349,000,
respectively. 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 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. -16-




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##### Table of Contents



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 Allowancefor Loan LossesThree months endedMarch 31,2004
    
    2003Average Allowance for Loan Losses
    
    $
    1,388
    
    
    $
    1,388Average Loans Outstanding
    
    $
    115,386
    
    
    $
    106,906Ratio of net charge-offs during the
period to average loans outstanding
    
    
    0.00
    %
    
    
    0.00
    %Ratio of average allowance for loan losses
to average loans outstanding
    
    
    1.20
    %
    
    
    1.30
    %
 The ratio of the allowance for loan losses as a percentage of average loans
decreased to1.20 percent at March 31, 2004 compared to 1.21 percent and 1.30
percent at December 31, 2003 and March 31, 2003, respectively. The decrease in
the ratio during the past year was due to several factors including positive
credit performance trends, 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. -17-




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Analysis of the Allowance for Loan Losses The allowance for loan losses is maintained at a level considered adequate by
management to provide for loan losses inherent in the loan portfolio based on
managements assessment of various factors affecting the loan portfolio,
including, local economic conditions, growth of the loan portfolio and its
composition. Non-performing loans and net charge-offs during the periods
presented have been minimal demonstrating strong credit quality. Management determines the amount of the allowance for loan losses by utilizing
a loan grading system to determine risk in the loan portfolio and by
considering the results of credit reviews. The loan portfolio is separated by
quality and then by loan type. Loans of acceptable quality are evaluated as a
group, by loan type, with a specific loss rate assigned to the total loans in
each type, but unallocated to any individual loan. Conversely, each adversely
classified loan is individually analyzed, to determine an estimated loss
amount. A valuation allowance is also assigned to these adversely classified
loans, but at a higher loss rate due to the greater risk of loss. For those
loans where the estimated loss is greater than the background percentage, the
estimated loss amount is considered specifically allocated to the allowance.
Although management has allocated a portion of the allowance to the loan
categories using the method described above, the adequacy of the allowance must
be considered as a whole. To mitigate the imprecision in most estimates of
expected loan losses, the allocated component of the allowance is supplemented
by an unallocated component. The unallocated portion includes managements
judgmental determination of the amounts necessary for qualitative factors such
as the consideration of new products and policies, economic conditions,
concentrations of credit risk, and the experience and abilities of lending
personnel. Loan concentrations, quality, terms and basic underlying assumptions
remained substantially unchanged during the period. The Company uses the historical loss experience method in conjunction with the
specific identification method for calculation of the amount of allowance for
loan losses. A six-year average historical loan loss rate is calculated. This
experience loss rate is applied to graded loans that are not adversely
classified for a subtotal of needed allowance. Loans adversely classified are
analyzed for potential loss on an individual basis. This subtotal is added to
the experience subtotal and the total is compared to the allowance for loan
losses. The Company also evaluates current conditions and may adjust the historical
loss estimate by qualitative factors that effect loan repayment. These factors
may include levels of, and trends in, delinquencies and non-accruals; trends in
volume and terms of loans; effects of any changes in lending policies;
experience, ability and depth of management and lending staff; national and
local economic trends; concentrations of credit; and any legal and regulatory
requirements. 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 decreased 2.6 percent to $153.1 million as of March 31, 2004, compared
to $157.2 million as of December 31, 2003. The decrease occurred in money
market deposits, savings deposits and time certificates of deposit less than
$100,000 during the three-month period, partially offset by an increase in
demand deposits and in time certificates of deposit greater than $100,000. -18-




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The following table sets forth the balances for each major category of deposit
by amount and percent during the periods indicated: VALLEY COMMUNITY BANCSHARES, INC.
Deposits
(dollars in thousands) Period ended,March 31, 2004
    
    December 31, 2003Amount
    
    Percent
    
    Amount
    
    PercentNoninterest bearing demand
    
    $
    32,920
    
    
    $
    21.5
    %
    
    $
    34,675
    
    
    
    22.1
    %Interest bearing demand
    
    
    26,187
    
    
    
    17.1
    %
    
    
    24,110
    
    
    
    15.3
    %Money market
    
    
    36,098
    
    
    
    23.6
    %
    
    
    39,018
    
    
    
    24.8
    %Savings
    
    
    16,107
    
    
    
    10.5
    %
    
    
    16,500
    
    
    
    10.5
    %Time certificates < $100,000
    
    
    20,322
    
    
    
    13.3
    %
    
    
    21,657
    
    
    
    13.8
    %Time certificates > $100,000
    
    
    21,501
    
    
    
    14.0
    %
    
    
    21,271
    
    
    
    13.5
    %$
    153,135
    
    
    $
    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 three months ended March 31, 2004 contributed $910,000 to
liquidity compared to $676,000 for the three months ended March 31, 2003. The
majority of the Companys funding comes from customer deposits within its
operating region. However, during the three months ended March 31, 2004
customer deposits decreased $4.1 million compared to a $.76 million increase
for the three months ended March 31, 2003. For the three months ended March 31,
2004, decreases in money market, savings, and time certificates of deposit less
than $100,000 was responsible for the majority of the deposit run-off. 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 $5.5 million for the three months ended March 31, 2004
compared to $8.4 million for the three months ended March 31, 2003. At March 31, 2004, the Company held cash and due from banks, interest-bearing
deposits with banks, and federal funds sold of approximately $19.4 million. In
addition, at such date $37.0 million of the Companys 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 March 31, 2004, the Bank
had no advances outstanding to the FHLB or from unaffiliated banks. 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 March 31, 2004 and December 31,
2003 were $18.6 and $21.5 million, respectively. -19-




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The Companys total stockholders equity decreased to $23.5 million at March
31, 2004 from $23.7 million at December 31, 2003. The slight decrease was the
result of a 60¢ dividend per share paid to stockholders of record on December
31, 2003, partially offset by net income earned during the three months ended
March 31, 2004 and higher unrealized gains recorded on securities available for
sale, net of income tax. At March 31, 2004, stockholders equity was 13.2
percent of total assets, compared to 13.0 percent at December 31, 2003. The market value of available-for-sale securities was greater than book value
at both March 31, 2004 and December 31, 2003, primarily as a result of low
market interest rates, which resulted in unrealized gains in the investment
portfolio. In the event market interest rates increase, the market value of the
Companys investment portfolio may 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 March 31, 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 $1.3 million net
of federal income tax. Although stockholders equity would be reduced by
approximately 5.5 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 Federal Reserve and the FDIC have adopted risk-based capital guidelines for
banks and bank holding companies that are designed to make regulatory capital
requirements more sensitive to differences in risk profiles among banks and
bank holding companies and account for off-balance sheet items. The guidelines
are minimums, and the federal regulators have noted that banks and bank holding
companies contemplating significant expansion programs should not allow
expansion to diminish their capital ratios and should maintain ratios in excess
of the minimums. Failure to achieve and maintain adequate capital levels may
give rise to supervisory action through the issuance of a capital directive to
ensure the maintenance of required capital levels. The current guidelines require all federally-regulated banks to maintain a
minimum risk-based total capital ratio equal to 8%, of which at least 4% must
be Tier 1 capital. Tier 1 capital includes common shareholders equity,
qualifying perpetual preferred stock, and minority interests in equity accounts
of consolidated subsidiaries, but excludes goodwill and most other intangibles
and the allowance for loan and lease losses. Tier 2 capital includes the
excess of any preferred stock not included in Tier 1 capital, mandatory
convertible securities, hybrid capital instruments, subordinated debt and
intermediate term-preferred stock, 20% of unrealized gain of equity securities,
and general reserves for loan and lease losses up to 1.25% of risk-weighted
assets. The Bank has not received any notice indicating that it will be
subject to higher capital requirements. Under these guidelines, bank assets are given risk-weights of 0%, 20%, 50% or
100%. Most loans are assigned to the 100% risk category, except for first
mortgage loans fully secured by residential property and, under certain
circumstances, residential construction loans (both carry a 50% rating). Most
investment securities are assigned to the 20% category, except for municipal or
state revenue bonds (which have a 50% rating) and direct obligations of or
obligations guaranteed by the United States Treasury or United States
Government Agencies (which have a 0% rating).
The Agencies have also implemented a leverage ratio, which is equal to Tier 1
capital as a percentage of average total assets less intangibles, to be used as
a supplement to the risk-based guidelines. The principal objective of the
leverage ratio is to limit the maximum degree to which a bank may leverage its
equity capital base. The minimum required leverage ratio for top-rated
institutions is 3%, but most institutions are required to maintain an
additional cushion of at least 100 to 200 basis points. Any institution
operating at or near the 3% level is expected to be a strong banking
organization without any supervisory, financial or operational weaknesses or
deficiencies. Any institutions experiencing or anticipating significant growth
would be expected to maintain capital ratios, including tangible capital
positions, well above the minimum levels. The capital levels of the Company currently exceed applicable regulatory
guidelines, and the Bank is qualified as well-capitalized at March 31, 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. -20-




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##### Table of Contents



The capital amounts and ratios for the Company and the Bank as of March 31,
2004, are presented in the following table (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC.
Capital To Be WellCapitalized UnderFor Capital
    
    Prompt CorrectiveAs of March 31, 2004
    
    Actual
    
    Adequacy Purposes
    
    Action ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioTotal Capital(to Risk-Weighted Assets)Consolidated
    
    $
    24,408
    
    
    
    18.6%
    3
    
    $
    10,514
    
    
    
    8.0%
    3
    
    $
    13,143
    
    
    
    10.0
    %Valley Bank
    
    $
    23,116
    
    
    
    17.6%
    3
    
    $
    10,514
    
    
    
    8.0%
    3
    
    $
    13,143
    
    
    
    10.0
    %Tier I Capital(to Risk-Weighted Assets)Consolidated
    
    $
    23,020
    
    
    
    17.5%
    3
    
    $
    5,257
    
    
    
    4.0%
    3
    
    $
    7,886
    
    
    
    6.0
    %Valley Bank
    
    $
    21,728
    
    
    
    16.5%
    3
    
    $
    5,257
    
    
    
    4.0%
    3
    
    $
    7,886
    
    
    
    6.0
    %Tier I Capital(to Average Assets)Consolidated
    
    $
    23,020
    
    
    
    12.9%
    3
    
    $
    7,150
    
    
    
    4.0%
    3
    
    $
    8,938
    
    
    
    5.0
    %Valley Bank
    
    $
    21,728
    
    
    
    12.2%
    3
    
    $
    7,150
    
    
    
    4.0%
    3
    
    $
    8,938
    
    
    
    5.0
    %
 
 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 March 31, 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 March 31, 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 periods specified in the SECs rules and forms. (b) Changes in Internal Controls: In the quarter ended March 31, 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. -21-




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##### Table of Contents



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. 
 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:
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. -22-




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##### 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 Officer
31.2 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 January 29,
2004. The report included a press release announcing the full year 2003
financial results. -23-




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##### 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:
    
    May 4, 2004
    
    By
    
    /s/ David H. BrownDavid H. Brown
                 President and
Chief Executive OfficerDate:
    
    May 4, 2004
    
    By
    
    /s/ Joseph E. RiordanJoseph E. Riordan
Executive Vice President and
          Chief Financial Officer
 -24-