Executive Summary / Key Takeaways

• First National Corporation ($FXNC) is undergoing a significant transformation following its October 2024 acquisition of Touchstone Bankshares, Inc., which substantially expanded its geographic footprint and operational scale.
• First quarter 2025 financial results reflect the immediate impact of this merger, showing a decrease in net income driven by significant merger-related and duplicative operating expenses, despite a strong increase in net interest income from the larger balance sheet.
• The company operates in a competitive landscape against larger regional banks and fintech, relying on its community focus and expanded branch network in Virginia and North Carolina as key differentiators, while also investing in digital delivery channels.
• Asset quality metrics show some stabilization post-merger, though management continues to monitor credit risk, particularly within acquired and purchased loan portfolios.
• The investment thesis hinges on the successful integration of the acquired operations and the realization of anticipated synergies, which are currently masked by integration costs.

Setting the Stage: A Community Bank in Transition

First National Corporation, founded in 1907 in Strasburg, Virginia, has evolved from a local institution into a regional bank holding company for First Bank. Its core business revolves around providing comprehensive commercial banking services to small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The company's offerings span traditional loan and deposit products, alongside wealth management services.

Strategically, FXNC has focused on building a strong presence in attractive markets along key interstate corridors in Virginia and northern North Carolina. This strategy culminated in a significant expansion on October 1, 2024, with the acquisition of Touchstone Bankshares, Inc. This merger added 12 branches, deepening FXNC's footprint in central Virginia and extending its reach into contiguous markets, effectively increasing its branch network to thirty-three offices and three loan production offices. This expansion is central to the company's current narrative, positioning it to leverage a larger scale and broader market access.

The banking industry landscape in which FXNC operates is intensely competitive. The company faces direct competition from larger regional players like Truist Financial (TFC), PNC Financial Services Group (PNC), Atlantic Union Bankshares (AUBS), M&T Bank (MTB), and Regions Financial (RF), as well as smaller community banks. Additionally, the rise of non-bank financial technology (Fintech) companies offering digital-first solutions presents an indirect competitive threat, particularly impacting areas like transaction processing and account opening efficiency. FXNC positions itself by emphasizing its deep community ties, personalized service, and local decision-making, aiming to foster stronger customer loyalty compared to larger, more distant institutions.

FXNC delivers its services through a multi-channel approach, including its physical branch network, loan production offices, customer service centers, mobile banking platform, website, and ATM network. While specific details on proprietary technological differentiators are not extensively disclosed, the company's operational capabilities rely on its data processing systems, which were notably impacted by duplicative expenses during the recent integration period. The strategic intent behind maintaining and developing these channels is to compete effectively in a market increasingly demanding digital convenience, while preserving the high-touch service characteristic of community banking.

The Impact of Transformation: Q1 2025 Financial Performance

The first quarter of 2025 provides the initial glimpse into the combined entity's financial performance post-merger, and the results clearly reflect the transitional phase. Net income for the three months ended March 31, 2025, decreased significantly to $1.6 million, or $0.18 per diluted share, compared to $3.2 million, or $0.51 per diluted share, for the same period in 2024. This decline in profitability was primarily driven by a substantial increase in noninterest expenses, which surged by $8.4 million.

This expense increase is directly attributable to the Touchstone merger, including $1.9 million in specific merger expenses recognized during the quarter. Beyond these direct costs, the integration process led to higher operating expenses, such as a $2.8 million increase in salaries and employee benefits (reflecting a larger workforce and increased incentives/stock compensation), a $534 thousand increase in occupancy expense, and a notable $516 thousand increase in data processing expense. The increase in data processing costs highlights the operational challenge and expense associated with integrating disparate systems, a process that was completed in February 2025. Amortization expense also increased by $438 thousand, partly due to time deposit accretion on acquired deposits.

Despite the pressure on the bottom line from expenses, the underlying banking operations showed strength, particularly in net interest income (NII). NII increased by a robust $6.6 million, or 61%, reaching $17.5 million for the first quarter of 2025. This significant growth was fueled by a $7.7 million increase in total interest income, partially offset by a $1.1 million rise in total interest expense. The expansion of the balance sheet due to the Touchstone merger was a primary driver, resulting in a 38.7% increase in average earning assets.

The net interest margin (NIM) also expanded, increasing by 53 basis points to 3.77% compared to 3.24% in the prior year period. This margin improvement occurred as the yield on earning assets continued to increase, while the cost of funds decreased compared to prior quarters, consistent with the broader interest rate environment and federal funds rate movements in late 2024. The increase in interest income on loans was particularly strong, rising by $7.2 million (53%), driven by both a 15-basis point increase in yield and a 50% increase in average loan balances post-merger. While interest expense on deposits increased by $1.3 million due to higher average balances (up 48%), the cost of interest-bearing deposits decreased by 30 basis points, contributing positively to the NIM.

Noninterest income saw a decrease of $436 thousand, or 11%, primarily due to a large loan recovery recognized in the prior year period that did not recur. However, core noninterest income streams like service charges on deposit accounts and ATM and check card fees showed increases of $359 thousand and $226 thousand, respectively, benefiting from the expanded customer base.

Balance Sheet Evolution and Asset Quality

As of March 31, 2025, total assets stood at $2.03 billion, an annualized increase of 4.6% since December 31, 2024. The asset mix shifted slightly, with interest-bearing deposits in banks increasing by $40.6 million, while loans (net) decreased by $15 million and total securities decreased by $3.6 million. Total liabilities grew by $20.9 million, largely driven by a $21.2 million (4.7% annualized) increase in total deposits, which reached $1.82 billion. The deposit composition remained relatively stable, with noninterest-bearing deposits representing 30%, savings and interest-bearing deposits 51%, and time deposits 20% of the total.

The loan portfolio totaled $1.44 billion net of the allowance for credit losses (ACL) at March 31, 2025. The portfolio is primarily concentrated in real estate loans (one-to-four family residential at 38%, other real estate at 46%) and commercial and industrial (C&I) loans (9%). The portfolio includes loans acquired through business combinations, which carry unaccreted discounts ($14.5 million), and purchased C&I loans from a third-party originator specializing in healthcare professionals ($17.8 million outstanding, including $5.4 million in unamortized premiums).

Asset quality metrics showed some improvement from year-end 2024. Non-performing assets decreased to $4.9 million (0.24% of total assets) from $7.1 million (0.35% of total assets) at December 31, 2024. Nonaccrual loans also decreased to $4.9 million from $7.1 million. The reduction was partly influenced by charge-offs during the quarter. Notably, $2.2 million of the purchased C&I loans were on non-accrual status and individually evaluated, with specific reserves of $1.6 million allocated to them within the ACL. Management believes its reserves are sufficient, considering economic conditions, historical losses, and loan quality. However, the risk remains that future conditions could necessitate additional provisions.

Liquidity remains a focus, with available sources totaling $800.2 million at March 31, 2025, up from $758.0 million at year-end 2024. This includes interest-bearing deposits, unpledged securities, and available lines of credit, providing capacity to fund growth and manage deposit fluctuations. Estimated uninsured customer deposits stood at $549.3 million, or $458.7 million excluding municipal deposits. The Bank maintains capital ratios well above regulatory minimums, qualifying as well capitalized, which provides a buffer against potential losses and supports future growth initiatives.

Competitive Dynamics and Strategic Positioning

FXNC operates in a competitive environment where scale and technological capabilities are increasingly important. Larger regional banks like TFC and PNC leverage vast branch networks and significant investments in digital platforms, often achieving greater efficiency in customer acquisition and transaction processing. For instance, PNC's digital platforms can offer faster online transaction speeds, while TFC benefits from economies of scale.

In this context, FXNC's strategic response centers on leveraging its expanded footprint post-Touchstone merger and emphasizing its community banking model. While specific quantifiable technological advantages of FXNC's platforms are not detailed, the company's delivery channels (mobile, online, ATM) are essential for meeting customer expectations. The increase in data processing expenses in Q1 2025 underscores the costs associated with maintaining and integrating these systems, a necessary investment to remain competitive.

FXNC differentiates itself through its local brand strength and deep community ties, particularly in its niche markets. This focus can translate into higher customer loyalty and retention rates, especially among small businesses and individuals seeking personalized service. The company's expertise in areas like wealth management and localized lending (construction, commercial real estate) also provides a competitive edge against larger, more generalized institutions. While larger competitors may have lower per-unit operating costs due to scale, FXNC aims for efficiency within its regional model and through tailored service delivery.

The competitive landscape analysis highlights that while FXNC's growth rate has been strong, its profitability margins (Net Profit Margin 5.61% TTM) lag behind some larger competitors like PNC (17% TTM) and MTB (19% TTM), partly reflecting the scale difference and integration costs. The company's return on equity (ROE 4% TTM) also trails peers (TFC 8%, PNC 11%, MTB 9%, RF 11% TTM), indicating the impact of recent merger-related expenses on profitability. The success of the integration and the ability to realize cost synergies will be critical in improving these metrics and strengthening FXNC's competitive standing.

Risks and Outlook

The primary risk currently facing First National Corporation is the successful integration of the Touchstone operations. While system integration was completed in February 2025, the financial results for Q1 2025 clearly show the significant impact of merger-related and duplicative expenses. Failure to fully realize anticipated cost savings and revenue synergies from the merger could hinder future profitability.

Other pertinent risks include those inherent in the banking sector, such as changes in economic conditions (inflation, unemployment, recession) that could negatively impact asset quality and necessitate higher provisions for credit losses. Interest rate fluctuations pose a market risk, affecting both the value of the securities portfolio and net interest income, as well as borrowers' ability to repay loans. Competition from both traditional banks and fintech remains a constant pressure on margins and market share. Maintaining adequate liquidity and managing regulatory changes are also ongoing challenges.

While the Q1 2025 results are not necessarily indicative of the full year, they provide a clear picture of the immediate post-merger financial state. The increase in net interest income demonstrates the potential of the expanded balance sheet, while the elevated noninterest expenses highlight the temporary costs of integration. The outlook for FXNC will largely depend on its ability to effectively manage these integration costs, realize operational efficiencies from the combined entity, and leverage its expanded market presence to drive profitable loan and deposit growth in a competitive environment. Specific forward-looking quantitative guidance was not available.

Conclusion

First National Corporation is navigating a pivotal period marked by its transformative acquisition of Touchstone Bankshares. The first quarter of 2025 financial results underscore the immediate financial impact of this merger, with significant integration costs temporarily weighing on net income despite a strong underlying performance in net interest income driven by the expanded balance sheet.

The investment narrative for FXNC is centered on the successful execution of this integration. As the company moves beyond the initial phase of duplicative expenses, the focus shifts to realizing the strategic benefits of a larger, more geographically diverse franchise. While facing intense competition from larger, more technologically advanced rivals, FXNC's strength lies in its reinforced community banking model and local market expertise. The ability to effectively blend its high-touch service with necessary digital capabilities, while achieving operational efficiencies from the combined entity, will be key to unlocking value for shareholders and improving profitability metrics in the periods ahead.